Reading: Lesson 6 - The Global Economic Crisis

1.6.A - The Global Economic Crisis

1. The Globalization of Mortgage Market Securitization

1. First, we will identify the different links in the financial chain between the retirees and mortgagees. Second, we will explain why there were so many weak links.
   
2. HOME PURCHASE In exchange for cash, a seller in Florida turned over ownership of a house to a buyer.
   
3. MORTGAGE ORIGINATION To get the cash used to purchase the house, the buyer signed a mortgage loan agreement and gave it to an “originator.” Years ago the originator would probably have been an S&L or a bank, but more recently the originators have been specialized mortgage brokers, as in this case. The broker gathered and examined the borrower’s credit information, arranged for an independent appraisal of the house’s value, handled the paperwork, and received a fee for these services. Some of the tranches were themselves re-combined and then re-divided into securities called collateralized debt obligations (CDOs), some of which were themselves combined and subdivided into other securities, commonly called CDOs-squared. For example, Lehman Brothers often bought different tranches, split them into CDOs of differing risk, and then had the different CDOs rated by an agency like Moody’s or Standard & Poor’s. There are three very important points to notice. First, the process didn’t change the total amount of risk embedded in the mortgages, but it did make it possible to create some securities that were less risky than average and some that were more risky. Second, the complexity of the CDOs spread a little bit of each mortgage’s risk to very many different investors, making it difficult for investors to determine the aggregate risk of a particular CDO. Third, each time a new security was created or rated, fees were being earned by the investment banks and rating agencies.
   
4. THE INVESTORS In exchange for cash, the securitizing firms sold the newly created securities to individual investors, hedge funds, college endowments, insurance companies, and other financial institutions. Keep in mind that financial institutions are funded by individuals, so cash begins with individuals and flows through the system until it is eventually received by the seller of the home. If all goes according to plan, payments on the mortgages eventually return to the individuals who originally provided the cash. But in this case, the chain was broken by a wave of mortgage defaults.

2. The Sub-Prime Mortgage Meltdown

1. In the 1980s and early 1990s, regulations did not permit a nonqualifying mortgage to be securitized, so most originators mandated that borrowers meet certain requirements, including having at least a certain minimum level of income relative to the mortgage payments and a minimum down payment relative to the size of the mortgage. But in the mid-1990s, Washington politicians wanted to extend home ownership to groups that traditionally had difficulty obtaining mortgages. To accomplish this, regulations were relaxed so that nonqualifying mortgages could be securitized. Such loans are commonly called sub-prime or Alt-A mortgages. Thus, riskier mortgages were soon being securitized and sold to investors. Again, there was nothing inherently wrong, provided the two following questions were being answered in the affirmative: One, were home buyers making sound decisions regarding their ability to repay the loans? And two, did the ultimate investors recognize the additional risk? We now know that the answer to both questions is a resounding “no.” Homeowners were signing mortgages that they could not hope to repay, and investors treated these mortgages as if they were much safer than they actually were.
   
2. With more people able to get a mortgage, including people who should not have obtained one, the demand for homes increased. This alone would have driven up house prices. However, the Fed also slashed interest rates to historic lows after the terrorist attacks of 9/11 to prevent a recession, and it kept them low for a long time. These low rates made mortgage payments lower, which made home ownership seem even more affordable, again contributing to an increase in the demand for housing. The previous Figure shows that the combination of lower mortgage qualifications and lower interest rates caused house prices to skyrocket. Thus, the Fed contributed to an artificial bubble in real estate.
   
3. Even with low interest rates, how could sub-prime borrowers afford the mortgage payments, especially with house prices rising? First, most sub-prime borrowers chose an adjustable rate mortgage (ARM) with an interest rate based on a short-term rate, such as that on 1-year Treasury bonds, to which the lender added a couple of percentage points. Because the Fed had pushed short-term rates so low, the initial rates on ARMs were very low. With a traditional fixed-rate mortgage, the payments remain fixed over time. But with an ARM, an increase in market interest rates triggers higher monthly payments, so an ARM is riskier than a fixed-rate mortgage. However, many borrowers chose an even riskier mortgage, the “option ARM,” where the borrower can choose to make such low payments during the first couple of years that they don’t even cover the interest, causing the loan balance to actually increase each month! At a later date, the payments would be reset to reflect both the current market interest rate and the higher loan balance.
   
4. Years ago, S&Ls and banks had a vested interest in the mortgages they originated because they held them for the life of the loan—up to 30 years. If a mortgage went bad, the bank or S&L would lose money, so they were careful to verify that the borrower would be able to repay the loan. In the bubble years, though, over 80% of mortgages were arranged by independent mortgage brokers who received a commission. Thus, the broker’s incentive was to complete deals even if the borrowers couldn’t make the payments after the soon- to-come reset.
   
5. The relaxed regulations didn’t require the mortgage broker to verify the borrower’s income, so these loans were called “liar loans” because the borrowers could overstate their income. But even in these cases the broker had to get an appraisal showing that the house’s value was greater than the loan amount. Many real estate appraisers simply assumed that house prices would keep going up, so they were willing to appraise houses at unrealistically high values. Like the mortgage brokers, they were paid at the time of their service. Other than damage to their reputations, they weren’t concerned if the borrower later defaulted and the value of the house turned out to be less than the remaining loan balance, causing a loss for the lender.
   
6. Originating institutions like Countrywide Financial and New Century Mortgage made money when they sold the mortgages, long before any of the mortgages defaulted. The same is true for securitizing firms such as Bear Stearns, Merrill Lynch, and Lehman Brothers. Their incentives were to generate volume through originating loans, not to ensure that the loans were safe investments. This started at the top—CEOs and other top executives received stock options and bonuses based on their firms’ profits, and profits depended on volume. Thus, the top officers pushed their subordinates to generate volume, those subordinates pushed the originators to write more mortgages, and the originators pushed the appraisers to come up with high values. 
   
7. Investors who purchased the complicated mortgage-backed securities wanted to know how risky they were, so they insisted on seeing the bonds’ “ratings.” The securitizing firms paid rating agencies to investigate the details of each bond and to assign a rating that reflected the security’s risk. For example, Lehman Brothers hired Moody’s to rate some of its CDOs. Indeed, the investment banks would actually pay for advice from the rating agencies as they were designing the securities. The rating and consulting activities were extremely lucrative for the agencies, which ignored the obvious conflict of interest: The investment bank wanted a high rating, the rating agency got paid to help design securities that would qualify for a high rating, and high ratings led to continued business for the raters.
   
8. To provide a higher rating and make these mortgage-backed securities look even more attractive to investors, the issuers would frequently purchase a type of insurance policy on the security called a credit default swap. For example, suppose you had wanted to purchase a CDO from Lehman Brothers but worried about the risk. What if Lehman Brothers had agreed to pay an annual fee to an insurance company such as AIG, which would guarantee the CDO’s payments if the underlying mortgages defaulted? You probably would have felt confident enough to buy the CDO.
   
9. In the early 2000s, low-rated debt (including mortgage-backed securities), hedge funds, and private equity funds produced great rates of return. Many investors jumped into this debt to keep up with the Joneses. As shown in Chapter 4 when we discuss bond ratings and bond spreads, investors began lowering the premium they required for taking on extra risk. Thus, investors focused primarily on returns and largely ignored risk. In fairness, some investors assumed the credit ratings were accurate, and they trusted the representatives of the investment banks selling the securities. In retrospect, however, Warren Buffett’s maxim that “I only invest in companies I understand” seems wiser than ever.
   
10. In 2006, many of the option ARMs began to reset, borrowers began to default, and home prices first leveled off and then began to fall. Things got worse in 2007 and 2008, and by early 2009, almost 1 out of 10 mortgages was in default or foreclosure, resulting in displaced families and virtual ghost towns of new subdivisions. As homeowners defaulted on their mortgages, so did the CDOs backed by the mortgages. That brought down the counterparties like AIG who had insured the CDOs via credit default swaps. Virtually overnight, investors realized that mortgage-backed security default rates were headed higher and that the houses used as collateral were worth less than the mortgages. Mortgage-backed security prices plummeted, investors quit buying newly securitized mortgages, and liquidity in the secondary market disappeared. Thus, the investors who owned these securities were stuck with pieces of paper that were substantially lower than the values reported on their balance sheets,
    

3. From Sub-Prime Meltdown to Liquidity Crisis to Economic Crisis

1. Securitization allocated the sub-prime risk to many investors and financial institutions. The huge amount of credit default swaps linked to sub-prime-backed securities spread the risk to even more institutions. Unlike previous downturns in a single market, such as the dot-com bubble in 2002, the decline in the sub-prime mortgage values affected many, if not most, financial institutions.
   
2. Banks were more vulnerable than at any time since the 1929 Depression. Congress had “repealed” the Glass-Steagall Act in 1999, allowing commercial banks and investment banks to be part of a single financial institution. The SEC compounded the problem in 2004 when it allowed large investment banks’ brokerage operations to take on much higher leverage. Some, like Bear Stearns, ended up with $33 of debt for every dollar of its own equity. With such leverage, a small increase in the value of its investments would create enormous gains for the equity holders and large bonuses for the managers; conversely a small decline would ruin the firm.
   
3. When the sub-prime market mortgages began defaulting, mortgage companies were the first to fall. Many originating firms had not sold all of their sub-prime mortgages, and they failed. For example, New Century declared bankruptcy in 2007, IndyMac was placed under FDIC control in 2008, and Countrywide was acquired by Bank of America in 2008 to avoid bankruptcy.
   
4. Securitizing firms also crashed, partly because they kept some of the new securities they created. For example, Fannie Mae and Freddie Mac had huge losses on their portfolio assets, causing them to be virtually taken over by the Federal Housing Finance Agency in 2008. In addition to big losses on their own sub-prime portfolios, many investment banks also had losses related to their positions in credit default swaps. Thus, Lehman Brothers was forced into bankruptcy, Bear Stearns was sold to JPMorgan Chase, and Merrill Lynch was sold to Bank of America, with huge losses to stockholders.
   
5. In normal times, banks provide liquidity to the economy and funding for creditworthy businesses and individuals. These activities are crucial for a well-functioning economy. However, the financial contagion spread to commercial banks because some owned mortgage-backed securities, some owned commercial paper issued by failing institutions, and some had exposure to credit default swaps. As banks worried about their survival in the fall of 2008, they stopped providing credit to other banks and businesses. The market for commercial paper dried up to such an extent that the Fed began buying new commercial paper from issuing companies.
   
6. Prior to the sub-prime meltdown, many nonfinancial corporations had been rolling over short-term financing to take advantage of low interest rates on short-term lending. When the meltdown began, banks began calling in loans rather than renewing them. In response, many companies began throttling back their plans. Consumers and small businesses faced a similar situation: With credit harder to obtain, consumers cut back on spending and small businesses cut back on hiring. Plummeting real estate prices caused a major contraction in the construction industry, putting many builders and suppliers out of work.
   

4. Responding to the Economic Crisis

1. Unlike the beginning of the 1929 Depression, the U.S. government did not take a hands- off approach in the most recent crisis. In late 2008 Congress passed the Troubled Asset Relief Plan (TARP), which authorized the U.S. Treasury to purchase mortgage-related assets from financial institutions. The intent was to simultaneously inject cash into the banking system and get these toxic assets off banks’ balance sheets. The Emergency Economic Stabilization Act of 2008 (EESA) allowed the Treasury to purchase preferred stock in banks (whether they wanted the investment or not). Again, this injected cash into the banking system. Several very large banks have already paid back the funding they received from the TARP and EESA financing, although it is doubtful whether all recipients will be able to do so. It is almost certain that some financial institutions, such as AIG, will leave taxpayers bearing the burden of their bailouts.
   
2. Although TARP and EESA were originally intended for financial institutions, they were subsequently modified so that the Treasury was able to make loans to GM and Chrylser in 2008 and early 2009 so that they could stave off immediate bankruptcy. Both GM and Chrysler went into bankruptcy in the summer of 2009 despite government loans, but quickly emerged as stronger companies. Although the U.S. government is still a shareholder, there is a possibility that GM and Chrysler will pay back the government’s investment.
   
3. The government also used traditional measures, such as stimulus spending, tax cuts, and monetary policy: (1) The American Recovery and Reinvestment Act of 2009 provided over $700 billion in direct stimulus spending for a variety of federal projects and aid for state projects. (2) In 2010 the government also temporarily cut Social Security taxes from 6.2% to 4.2%. (3) The Federal Reserve has purchased around $2 trillion in assets, including long-term bonds, from financial institutions, a process called “quantitative easing.”
   

5. Preventing the Next Crisis

1. Dodd-Frank established the Consumer Financial Protection Bureau, whose objectives include ensuring that borrowers fully understand the terms and risks of the mortgage contracts, that mortgage originators verify borrower’s ability to repay, and that originators maintain an interest in the borrowers by keeping some of the mortgages they originate. The Bureau will also oversee credit cards, debit cards, payday loans, and other areas in which consumers might have been targets of predatory lending practices. 
   
2. The act’s “Volker Rule,” named after former Fed chairman Paul Volcker, would greatly limit a bank’s proprietary trading, such as investing the banks’ own funds into hedge funds. The basic idea is to prevent banks from making highly leveraged bets on risky assets. The Volcker Rule has not been implemented as of early 2012, although Goldman Sachs and Morgan Stanley have cut back their proprietary trading operations.
   
3. The act calls for regulation and transparency in the now-private derivatives markets, including the establishment of a trading exchange. It also provides for more oversight of hedge funds and credit rating agencies in an effort to spot potential landmines before they explode. Not much has been accomplished as of early 2012.
   
4. When a bank gets extremely large and has business connections with many other companies, it can be very dangerous to the rest of the economy if the institution fails and goes bankrupt, as the 2008 failure of Lehman Brothers illustrates. In other words, a bank or other financial institution can become “too big to fail.” Systemic risk is defined as something that affects most companies. When there are a large number of too-big-to-fail institutions and systemic shock hits, the entire world can be dragged into a recession, as we saw in 2008.
   
5. Dodd-Frank gives regulators more oversight of too-big-to-fail institutions, including all banks with $50 billion in assets and any other financial institutions that regulators deem systemically important. This oversight includes authority to require additional capital or reductions in leverage if conditions warrant. In addition, these institutions must prepare “transition” plans that would make it easier for regulators to liquidate the institution should it fail. In other words, this provision seeks to reduce the likelihood that a giant financial institution will fail and to minimize the damage if it does fail.