Today the markets plunged, with the major indices falling around 7%. (Usually the Dow and S&P 500 average a 1 or 2 percent change in a day.) The immediate cause of this is the tightening credit markets, but our "real" economy, or our productivity is also suffering and will lead to more long-term problems. I wanted to discuss the immediate cause of the recent volatility, which is the mortgage crisis. How did it happen? The following is what I have pieced together over the last months, and I look forward to hearing your theories as well.
The growth of the global economy has created a great deal of wealth, and institutions and governments need somewhere to put this money that is safe and provides a reasonable return. It used to be US treasury bonds, until Fed Chair Alan Greenspan lowered the federal funds rate to 1% in 2003. After this, the investors needed somewhere else to put their money that was secure and had a good return. Wall street decided that residential mortgages would be a safe bet, and figured out how to sell mortgages to investors. Here is what they did:
1. A citizen wants to buy a home, so he gets a mortgage from his local mortgage broker. Presumably the citizen can afford to pay the mortgage.
2. The local mortgage broker sells this mortgage (essentially an income stream) to another mortgage broker.
3. Mortgage broker number two packages hundreds of mortgages together and then sells them to investment banks. At this point, when packaged correctly, these mortgage-backed securities have a AAA rating (very, very safe).
4. These Mortgage Backed Securities (MBS) were sold to Wall Street and then sold to governments and institutions as a safe place to invest that had a decent return. According to credit rating agencies, it was as safe as a Treasury bond.
5. Insurers, like AIG, insured these securities but didn’t have the cash to pay out. They never expected things to go so wrong.
It is important to note that at every step in this process, almost every player was using borrowed money to carry out these transactions, leveraging themselves at ratios as high as 20 to 1. At Lehman it was 40 to 1. Now everyone was happy, that is until they ran out of mortgages. Once everyone that could afford to buy a home bought a home, the supply of MBSs dried up. Wall street called mortgage brokers demanding more. So, the brokers gave them more, but they had to lower their standards when it came to screening homebuyers. This process spiraled lower and lower until there came into existence the NINA loan: No Income No Assets. An individual could get a loan without any proof of income and without any assets. By the time this loan was packaged and sold to Wall Street, no one knew what the real risk was because all of their risk assessment tools were based on old data, from a time when a homebuyer was carefully screened. There was no data on these new sub prime mortgages.
Even with all of the holes in these investments, the payments from homeowners continued to come in. These securities were working the way that they were supposed to and there was no reason to complain. But, the reason they were working was that home prices continued to increase as demand continued to increase. So, when a homeowner couldn’t afford to make the mortgage payments, he could borrow money on the value of his home in the form of a home-equity loan. Many people were using home-equity loans to pay their mortgages.
Then, in 2006, home prices stopped increasing and homeowners stopped making payments. Once they couldn’t make payments, they defaulted and their home was now on the market. The market flooded with homes and prices started dropping leaving homeowners unable to even borrow money to pay their mortgage. This created a chain reaction that killed all of the middleman mortgage brokers. They died because they never truly had the money in the first place. They borrowed money to buy mortgages, then flipped the mortgages to the investment banks and used the proceeds to pay off their debt. As soon as they couldn’t sell the mortgages and pay off their debt, they went out of business, but not before they had poisoned every major investment bank on Wall Street.
This was the “sub prime housing crisis,” which frightened the global investors and they went running back to investments like treasury bonds. This fear created what we are currently referring to as the “credit crisis.” Now, global investors are afraid to invest in anything that even resembles a potential risk. Because of this, businesses can’t get financing, which they are dependent upon to operate. And borrowed money is the lifeblood of our financial industry, as made evident by the extinction of the investment bank as we knew it.
All of this began with a rational proposition: that investments based on home mortgages would be safe and stable. And they were safe when these securities were invented decades ago. At first, the mortgages were based on a sound investigation of the homeowner’s ability to make the payments. But, a combination of greed and diffusion of responsibility turned what could have been an investment fad of little consequence into a crisis.
6 comments:
I think your summary of the crisis is very good. I have just a few things to add to it.
#1 - As you mentioned, one of the effects of the low interest rates in the early 2000s was that treasury bonds were less attractive. But another effect was that low mortgage rates made buying a home more affordable and attractive.
And one way to make a mortgage even more affordable, particularly for those that are stretching to buy a home anyway, is to get an adjustable rate mortgage (ARM). With an ARM you have a lower, fixed interest rate for the first few years (usually 3, 5, or 10 years) and then a floating rate after that. If interest rates rise during or after those first few years, you'll have a higher mortgage payment after the fixed-rate term expires. Thus, ARMs are more affordable (at least in the near term) but more risky.
Amazingly, in 2004 Greenspan encouraged home-buyers to use ARMs. His advice discounted the fact that interest rates were at historical lows and would surely fluctuate over the coming 30 years. When rates rose a few years later, those that were coming to the end of their ARM's fixed-rate periods found that they could no longer afford their mortgages.
#2 - You're right that lax lending standards (not verifying income and creditworthiness) played a large role. There's also some suggestion that some lenders encouraged buyers into risky, complicated loans even though they could have afforded more conventional, safe loans (similar to Greenspan's suggestion that people use ARMs).
#3 - Surely another factor was that there was speculation going on. People, assuming that house prices would always rise, bought houses as investments that they planned to quickly sell for a profit. When house prices turned the other way, they were left holding illiquid assets with mortgages they couldn't afford.
You're also right that the repackaging of mortgages into mortgage backed securities and other complicated financial instruments made it difficult to understand the total exposure to the problem and the extent of the leveraging up of debt amplified the crisis when things turned sour.
There's a good article about all of this by the Federal Reserve Bank of Dallas here.
In hindsight, advice given in 1998 that we avoid unnecessary debt and buy only modest, affordable homes was, shall we say, prophetic.
What does "leveraged themselves at 20 to 1" mean?
It means that if they started with $1 of equity, they then borrowed $20, allowing them to acquire $21 of assets.
It's like paying 5% down on a house. You're leveraged at 20 to 1 on the house. If the house value drops, your equity in the house drops. If it drops far enough, you might end up with negative equity. If, on the other hand, you're leveraged at 2 to 1 (you put 50% down) house prices would have to drop an awful lot more before you're in trouble.
This is exactly what happened with these troubled banks: they borrowed heavily but the assets they bought with that borrowed money are now worth less than what they borrowed so they find themselves in positions of near-zero or negative equity. Now no one will lend to them so they have difficulty keeping their day-to-day operations running.
Traditional banks have restrictions on how much they can borrow (I believe it's near 8 to 1) in return for having their deposits insured by the FDIC. But investment banks aren't regulated as closely as traditional banks so they can borrow more. That explains why this crisis affected Bear Stearns, Lehman Brothers, Morgan Stanley, et cetera before it affected more traditional banks (like Washington Mutual and Wachovia).
Excellent post. Very useful knowledge.
It seems to me from the debates so far that both candidates now recognize the scope and roots of the problem. Their proposed solutions seem similar in many ways.
It seems to me that the central issue between the sides is the regulation/deregulation issue. It seems like economic policy of the last 8 years has focused on deregulation and allowing the market to go where it will. The political left wants to regulate the financial industry and the political right now seems to recognize that more regulation is needed, but I'm sure both sides have differing ideas as to who and how to regulate. I've heard the current situation described as the end of the era of deregulation and "Reganomics".
I wonder what vision of the future financial landscape each side holds. As I understand the arguments, the right would say that regulation discourages innovation that drives market growth which benefits everyone, the left would say that deregulation benefits the "have's" at the expense of the "have not's" and that regulation is needed to protect the "have not's" from the greed of the "have's".
Both sides want the same thing, stable markets. The difference, as with all public policy, is in the details.
I wonder if the financial wizard contributors could explain some of the details from both perspectives.
I think you captured it quite well. Although, for the left I'd say that regulation isn't just about protecting the have nots from the haves. It's also about:
1) Protecting companies against themselves: against unhealthy short term interests.
2) Ensuring that markets function efficiently. If one market player acquires too much (monopoly) power, they can use that monopoly to smother competition, which destroys efficient markets.
A good book on this subject is Everything for Sale: The Virtues and Limits of Markets by Robert Kuttner. There's a good book review here.
Speaking of books, there is also a book about the current credit market crash that explains it in a way that non-business people can understand:
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The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash by Charles R. Morris
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Who would have ever guessed that the average American would be using phrases like Credit Default Swap and Mortgage Backed Security in everyday conversation?
One positive is I think people will be more educated about the market, and will understand that where the Dow closed today can have an effect on their everyday lives.
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