Suppose, you buy a house. House costs you, say, 100. Now, you only have 20 with you, so you borrow 80.
100 = 20 + 80 i.e. Uses of Funds = Sources of Funds
Again, say bank pays 80 and expects a return of 10% from you. Suppose, you have to repay bank in a balloon payment of 130 after five years. The above equation must hold true after 5 years as well.
i.e. Uses of Funds = Sources of Funds. We know that sources of funds are equity and debt, while the uses of funds create assets. So, we can say that assets = equity + liabilities.
After 5 years your liability has gone up to 130. So now your equity value will be
Equity (after 5 years) = (Assets – 130)
Notice anything? Your equity could go negative! When? How? Well, if the asset value remains below 130.
So, if your house value does not go beyond 150 you are not benefitted from the transaction in those 5 years.
Suppose your asset value remains same i.e. 100 after 5 years. Your equity value becomes (100 – 130) i.e. -30.
What will you do when the bank comes to you asking for 130, after 5 years? Would it be sensible to repay 130 or would it be sensible to default?
What happened in 2008 in the USA was a similar story!!! The value of houses fell down, i.e. went below 100. So the equity goes even more negative than -30. So, people started defaulting. As the loans were mostly non-recourse, banks had no claim on the personal assets other than the houses.
See the same from the perspective of a bank. Bank was hoping to get a cash inflow of 130. But ended up getting a house whose market value is less than 100. Banks were in great losses and so was the economy. The problems were aggravated because of the Asset-Backed Securities(ABS) which pooled the bank loans and sold the same. Now, these ABS where the assets pooled were mortgages were called Mortgage Backed Securities (MBS).
MBS also involved a process called tranching, which divided the risks among investors and investors can choose to take their own risks. One of the tranches even got a rating of AAA. But, when the people started defaulting on a large scale, there were no cash inflows for the MBS and even the AAA-rated tranche did not receive any money.
MBS was supposed to be a boon for the banks, but banks were actually doomed because of the same.
It became clear that there was a serious need for some fast government intervention so that the whole financial system did not collapse. The government measures taken in the financial crisis consisted of four types.
The first aim was to protect savers so that the panic that had erupted into a ‘bank run’. A second was to maintain the liquidity of the banks so that bank to bank lending did not grind to a halt. The third was to keep the capital in banks at a level that meant they could not go into liquidation. Final was to ensure that banks continued to lend to borrowers without exposing the institutions to the high risks that had been one of the main causes of the problems.