In January 2009, just months after the 2008 financial crisis, I wrote a lengthy (9,000 word) study of the financial crisis—analyzing what happened, what caused it, and what I thought we should do to prevent it from happening again.
Below I am publishing the study in its entirety. If you are interested in what what led to the financial crisis in 2009, and enjoy extensive detail, send it to Instapaper—this is for you.
Homeowners and home buyers were convinced home prices would continue to rise. Indeed, the entire market was convinced. People bought homes with mortgages they could not afford, because their home equity would pay for the loan; lenders made loans without verification of the recipient’s income or credit; financial groups poured money into mortgage-backed securities, and Fannie Mae and Freddie Mac bought and securitized an incredible number of mortgages — roughly half of the U.S.’s $12 trillion mortgage market (Duhigg).
A “bubble” was created in the housing industry, a market condition where one industry receives too much investment and, like a plane flying straight up, must stall and come down quickly. Alan Greenspan called it “irrational exuberance,” and that is an apt description — people disregard logic and invest wildly into one industry. For a time, as everyone is investing in it, this works and everyone makes money; but eventually, the rapid rise must turn into a rapid decline.
Usually, bubbles are contained in one industry. This bubble, however, was different. In this case, the entire United States economy and, indeed, the world economy, was involved. For years, the savings rate for U.S. households declined, as home prices rose. Rather than use their income to save, U.S. households used their home equity as their savings, using income they would normally save for consumption.
Moreover, after the technology bubble collapsed in 2000, investment firms moved their capital into mortgage-backed securities, and foreign central and private banks and firms, too, invested in mortgage-backed securities and related securities. China, using the vast dollar reserves it accumulates from trade with the U.S., was one of the largest state investors in related securities, owning $376 billion of Government Sponsored Enterprise-issued securities. Asia as a whole owned $800 billion in 2007 (Timmons).
Consumer spending (which largely fueled economic growth since 2000) and the finance industry (whose lending is integral for the overall economy to function) were directly tied to housing prices. Moreover, the Chinese economy’s fortune is vitally dependent on U.S. consumer spending, and the world had invested in the U.S. housing boom. Thus, because economic growth in the U.S. and world was so dependent on the housing market, the housing bubble’s collapse in 2006 not only threatened the U.S. economy, but the entire world economy.
The resulting stock market collapse in 2008 has caused severe losses in the U.S. and across the world. World stock markets, overall, declined by 48 percent in 2008; China, whose economy is dependent on exports, saw exports decrease nearly 3 percent in December 2008 (“Economic Crisis Hits Exports”); and Iceland’s government, hit by criticism over the effects of the financial crisis, collapsed January 26.
This paper will consider both the short and long-term causes of the 2008 financial crisis and, based on these causes, note the lessons we can derive from them, both for government and companies.
Part of what makes the financial crisis so confusing are the many different terms and ideas involved, whose meanings are not always immediately obvious. For clarity, I have defined a few terms and ideas.
Mortgage-backed securities (MBS) are securities which pool residential or commercial securities together, and are then sold to investors. MBS refers to a number of different securities, including Collateralized Debt Obligation (CDO). Mortgage-backed securities allow mortgage-originators, such as banks or lending-companies to easily move mortgages they make off of their balance sheets and re-capitalize so they can continue lending.
Collateralized Debt Obligations (CDO) are a type of asset-backed securities which pool assets together, such as residential and commercial mortgages, and break them up into different “tranches,” or grades, and are then sold to investors. The tranches act like bonds. There are three tranches: senior tranches (rated AAA), mezzanine tranches (rated AA to BB), and equity tranches (unrated). Losses are applied first to the lower tranches, and so the lower tranches also have higher coupon rates to compensate for the additional risk. There are also synthetic CDOs, which is a CDO whose underlying assets are tranches of other CDOs. This makes the CDO market extremely complex and, because CDOs are not actively traded, CDOs are difficult to accurately price. This led to a sense of confusion in summer 2007 and throughout 2008 which created panic in the markets.
Richard Zabel explains:
Credit Default Swaps (CDS) are a private contract between two parties in which the buyer of protection agrees to pay premiums to a seller of protection over a set period of time, the most common period being five years. In return, the seller of protection agrees to pay the buyer an amount of loss created by a “credit event” related to an underlying credit asset (loan or bond) – the most common events are bankruptcy, restructuring or default.
Credit default swaps are used for two reasons. The first is to hedge an investment. If, for example, a mutual fund invests $10 million into a risky company’s bonds, they may buy a $10 million credit default swap. Although the mutual fund may lose the periodic payments they pay, buying the credit default swap insures they do not lose the entire $10 million.
The second is speculation. Speculators, who may not own the underlying asset at all, buy credit default swaps to speculate on whether a company will default or not. $20 trillion of the $45 trillion credit default swap market is speculative (Zabel).
Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are government-sponsored enterprises whose business is to buy mortgages, pool them into mortgage-backed securities and sell them to investors in the secondary mortgage market. This takes the mortgages off of the lender’s balance sheet, and re-capitalizes them, allowing them to continue lending. In this way, Fannie Mae and Freddie Mac make it easier for home buyers to secure mortgages. The Congressional Budget Office estimates that Fannie Mae and Freddie Mac’s involvement in the mortgage market causes interest rates to be a quarter-point lower than they otherwise would be.
The 2008 financial crisis began in 2006, when the housing boom, which fueled the U.S. economy since the collapse of the technology boom in 2000, ended. Homeowners began defaulting on mortgages they could not afford and as adjustable-rate mortgages (ARM) switched from their low, introductory rate to the higher rate.
In August 2006, foreclosures in the U.S. increased 53 percent over 2005, and continued to rise in 2007 (Christie). This placed greater downward pressure on housing prices, because it increased supply in an already saturated housing market. This caused mortgage-backed securities to begin losing value in 2007, because investors became afraid that mortgage-backed securities could immediately lose their value.
In June 2007, two hedge funds owned by Bear Stearns, which were heavily invested in subprime mortgage-backed securities, collapsed. Their securities lost 28 percent of their value since the beginning of 2007. Because Bear Stearns’s securities were considered very safe, this set off fears that the market had underestimated the risk of lending with relaxed standards, and that other companies, which held similar securities, were facing the same losses but had not yet disclosed them.
In August 2007, a year after foreclosures began increasing, the financial markets faced a “credit crunch.” Fearful that mortgage-backed securities would continue their decline, investors began moving their money from mortgage-backed securities into the safest securities, U.S. Treasuries, causing mortgage-backed securities to become illiquid, or unable to be sold at almost any price.
This created a general risk aversion in the market, and as investors quickly bought up 3-month Treasury bills, their yield dropped from 4.69 percent August 13 to 3.09 percent on August 20. This is the single-biggest decline in Treasury bills yield since the October 20, 1987 stock market crash.
The effects were not limited to mortgage-backed securities. Daryl E. Getter, et al. of the Congressional Research Service explain, “As a result, many types of corporate and financial borrowers — even some with few or no links to mortgage markets — had trouble obtaining credit, whether to fund new projects or transactions, or to refinance existing debt” (4). Investors and lenders became afraid these assets would bring down other institutions, and thus were not willing to lend to or invest in them. Because so many different institutions throughout the U.S. and world had heavily invested in mortgage-backed securities, people were unwilling to lend or invest.
Speaking to Bloomberg on August 20, 2007, John Jansen, a New York-based Treasuries trader, captured the market’s feeling. “The market is totally, absolutely, completely in fear mode,” he said. “People are afraid that lots and lots of mortgage paper and mortgage paper derivatives of all sorts is completely opaque and they can’t price it” (Finestone).
Jansen described the problem succinctly. Lenders and investors were intent on reducing their risk. Seemingly unrelated areas like commercial paper and money market funds then dried up. Commercial paper funds day-to-day operations for businesses and investment firms and is sometimes secured by assets, including mortgages. In the rush to reduce risk, the market for mortgage-backed commercial paper dried up, and investors insisted on buying only commercial paper from the highest-rated firms.
Money market funds are important because they help fund commercial paper and are very large, with possibly one trillion dollars flowing into them in July 2007 (Getter, et al). But in August 2007, it was revealed that several funds held mortgage-backed commercial paper, and this caused a flight from money market funds.
These rapid movements of capital caused severe fluctuations in the stock markets. From April to July, the Dow Jones Industrial was relatively stable, but beginning in July and peaking in August, hundred-point swings became the norm. This further stoked market fear, because normal market conditions did not apply. Market participants were unsure what would happen next, creating a panic. To protect themselves, lenders and investors stopped lending to individuals who, under normal market conditions, would be qualified to receive it. The credit markets froze.
The credit crunch of 2007 led to massive failures in 2008. Just as Bear Stearns had begun the 2007 credit crunch, it also started the wave of failures in 2008. Bear Stearns reported a $1.5 billion net loss in 2007, and in December 2007, they wrote down $1.9 billion of their mortgage-backed securities (“Bear Stearns Company News”). Taken together with the collapse of their hedge funds, investors lost all confidence in Bear Stearns, and their stock price dropped precipitously in February. To prevent the collapse of Bear Stearns, which could have set off a market collapse due to the liquidation of its assets, large credit default swap settlements, and decline in confidence in other institutions, the Federal Reserve stepped in on March 16 and facilitated the sale of Bear Stearns to J.P. Morgan & Chase for $10 a share, or $1.4 billion. This was a dramatic reduction from Bear Stearns’s peak market value in January 2007, $25 billion.
Failures mounted through summer and fall 2008. IndyMac, formerly the largest savings and loan in the Los Angeles area and seventh-largest mortgage originator in the U.S., began facing problems in late 2007. IndyMac focused on “Alt-A” mortgages, or loans that require less income documentation and lower credit scores than prime mortgages, but are still considered less risky than subprime mortgages. After the 2007 credit crunch, they could not securitize and sell these loans. IndyMac was forced to move $10.7 billion loans intended for sale into the “intended for investment” category (“OTS Fact Sheet”).
In 2007, they lost $614 million, compared to $343 million of profit in 2006. In their May 12th 10-Q report, they reported $1.85 billion of non-performing loans, and most damaging, that their risk-based capital ratio, which must be 10 percent to be considered “well-capitalized” by the Federal Reserve, had dropped to 10.26 percent, and that by June 30, would be 9.27 percent (Hagerty).
IndyMac needed a capital infusion or to sell the firm, but looking for an investor or buyer was futile — no one was interested. Due to negative media coverage and the release of Senator Charles Schumer’s letter to the FDIC, where he explained his concerns for the firm, a bank run began on June 26. Already in dire need of a capital infusion, the bank quickly lost sufficient liquidity to meet its obligations (“OTS Fact Sheet”). The Office of Thrift Supervision placed IndyMac in receivership on July 11 and placed the new federally-owned thrift under FDIC conservatorship.
Fannie Mae and Freddie Mac were next. More than any other firm directly involved in the mortgage business, Fannie Mae and Freddie Mac are intimately tied to the industry’s success, as they own or guarantee $5 trillion of the U.S.’s $12 trillion mortgage market (Jickling). Fannie Mae or Freddie Mac’s failure would make it much more difficult for loan originators to lend, and thus for homeowners to receive loans. News that they too were facing steep losses was especially disturbing for the market. In February 2008, Fannie Mae reported a $2 billion loss in 2007, and Freddie Mac reported $2.5 billion in losses. On May 6, 2008, Fannie Mae reported $2.2 billion loss for first-quarter of 2008 alone. Due both to the extent of their losses, and the panicked atmosphere in the financial markets, investors feared the two firms would not have sufficient liquidity to handle future delinquencies, which threatened to be much worse than those seen through 2007 and 2008. As their market value dropped off of a cliff through August and early September, the federal government placed Fannie Mae and Freddie Mac into conservatorship on September 7th, backing their $5 trillion of responsibilities with the full faith and credit of the U.S. government.
Events moved quickly after September 7th. Lehman Brothers, once one of the proudest investment banks on Wall Street, unraveled in 2008. After reporting a $2.9 billion loss in the second quarter, and despite raising $6 billion in new capital in early June meant to alleviate pressure on their balance sheet, their stock began a rapid decline, losing 73 percent of its value by September (Anderson, “For Lehman, More Cuts…”). After a possible deal to sell a 25 percent-stake in the firm to the state-run Korea Development Bank evaporated on September 9, the stock fell into a free-fall.
As Lehman Brothers teetered, the entire stock market did, too. On news the deal to buy a stake in Lehman had failed, the Dow Jones Industrial fell 300 points (“Dow Plunges… 300 points”). On September 10, Lehman said it expected a $3.9 billion loss in the third quarter, and their stock declined 40 percent on September 11 (Anderson, “Lehman… Looking for a Buyer”).
The federal government, though, fearful they had created a moral hazard by helping save Bear Stearns, IndyMac, Fannie Mae and Freddie Mac, refused to save Lehman Brothers. Lehman Brothers filed Chapter 11 bankruptcy on September 15, and the Dow Jones dropped 500 points, the biggest single-day drop since the September 11 attacks.
After $51.8 billion in losses or write-downs stemming from mortgage-backed securities and the general credit crunch, Merrill Lynch was sold to Bank of America on September 14.
Worse, American International Group (AIG), which was heavily involved in the CDS market, faced failure. After losing $37.6 billion through the first three quarters of 2008 (“AIG: Income Statement”), AIG’s debt rating was lowered. This forced AIG to post another $15 billion in collateral for its CDSs and CDOs, which they were unable to do (Morgenson, “The Reckoning”). Their failure was imminent.
For the same reasons they were resistant to help Lehman Brothers, the Federal Reserve did not want to save AIG. But because AIG’s CDSs were so interwoven into the financial market, their collapse (and default on their guarantees) could have brought down many more companies, including Goldman Sachs, which reportedly had $20 billion of risk with AIG.1 Fearing a cascading effect across the entire market, on September 16 the Federal Reserve offered AIG an $85 billion loan secured by AIG’s assets and in return for a 79.9 percent equity interest, which would allow it time to sell off its toxic assets. The Dow Jones fell anyway, dropping nearly 500 points (“Credit Crisis”).
Troubles continued. On September 14, Merrill Lynch was sold to Bank of America, and on September 16, money-market accounts, which fund commercial paper, almost collapsed but were saved by a $105 billion liquidity injection by the Federal Reserve (Gray). This would have devastated the “real” economy, as commercial paper is used to fund day-to-day operations.
Until this point, the government’s response had been haphazard; some companies were saved, and others were allowed to collapse. The federal government’s inconsistent response was widely seen as contributing to the financial markets’ instability. Beginning September 19, the federal government began systemic responses to the crisis. The first move was to ban short-selling on financial stocks which, during times of crisis, can drive down stock prices by amounts not based in reality (Bajaj, “S.E.C.… Blocks Short Sales”).
The next step was to provide a solution to the central problem: bad assets sitting on banks’ balance sheets were either bringing them down or creating enough uncertainty to cause them to fail. On September 19, Treasury Secretary Henry Paulson proposed the Troub?led Asset Relief Program (TARP), whose goal is to buy the troubled assets from the banks to remove them from their balance sheets and restore calm. The plan evolved into a $700 billion program, and was voted on in the House of Representatives on September 29. Facing strong public opposition, and with House Republicans angry at the prospect of providing nearly a trillion dollars to private companies, the bill failed to pass. The markets swung wildly; the Dow Jones fell nearly seven percent, or 777 points.
One trader captured the day’s feeling. “You just felt like the world was unraveling,” Ryan Larson, Voyageur Asset Management’s senior equity trader, said. “People started to sell and they sold hard. It didn’t matter what you had — you sold” (Bajaj, “For Stocks, Worst Single-Day”). The feeling was panic.
The Senate version of the bill, which included tax breaks and increased FDIC bank deposit protection, passed the Senate and House, and was signed by President Bush on October 3.
Trouble was not reserved to the U.S. Russia’s stock market declined precipitously through September and October, and the Russian government suspended trading. European banks all faced steep losses and threatened collapse, and members of the European Union first acted individually. The Irish and Germans guaranteed bank deposits, while others did not; Britain made £25 billion available to British banks, with another £25 billion scheduled; and Iceland nationalized its largest bank, Kaupþing banki (Dougherty).
Europe’s unorganized response contributed to market chaos around the world. The week of October 10, the Dow Jones closed down 18.2 percent, its worst fall ever; Britain’s FTSE closed down 21 percent, and Japan’s Nikkei 225 24.3 percent.
There has been much discussion of the immediate causes of the financial crisis — over-investment in subprime mortgages, “exotic” securities, highly leveraged financial institutions, et cetera. The “immediate causes,” though, are not the underlying causes. Responding only to the immediate causes is much like only treating a disease’s symptoms, rather than the conditions which make people susceptible. It may help in the short term, but it will only be a matter of time until the situation repeats itself.
There are two kinds of underlying causes for this crisis which make it especially devastating: direct causes, and accentuating causes, which did not contribute directly to the financial crisis but helped to make it worse.
Household Debt and Consumer Spending
Beginning in the 1980s, American households began saving less and taking on more debt. This coincided with the creation of Collateralized Mortgage Obligations (CMO) for Freddie Mac, which addressed pre-payment risk, and allowed mortgage-backed securities to take off (“Hearing on Protecting Homeowners”). At the same time, Japanese capital was flowing into the U.S. due to Japan’s trade surplus. Japanese investment helped fuel the 1980s mortgage-backed securities market, and the general housing market boom.
The creation of the CMO was vital to the 1980s housing boom, and rising home prices through 1996-2006, because they made mortgages, which are inherently illiquid, into highly liquid securities, and reduced the risk associated with investing in them.
Housing prices began rising in the 1980s, and then rose precipitously from 1996 to 2006. As home prices consistently rose, U.S. households began taking on more debt. The personal savings rate in 1980 was 10.2 percent of income, and by 2000, the rate dropped to 1.2 percent (“Households Savings and Debt”).
Homeowners were using their home equity as savings. Income that normally would be saved was instead used for consumer spending. Consumer spending has been the main driver of U.S. Gross Domestic Product growth since 1980. In 1982, consumer spending accounted for 62.3 percent of U.S. GDP, and in 2004, it accounted for 70 percent (van Eeden).
This means that not only are U.S. households more leveraged than before, and thus more susceptible to any economic downturn which pushes down housing prices, but because economic growth is so dependent on consumer spending, the economy is extremely fragile.
From 1980 to present, the U.S. economy was contingent on housing prices. As they increase, and households are thus able to spend more of their income (or borrow against their home equity), the economy grows quite well; when there is a downturn, and housing prices decrease, the economy will face strong decline.
This was not a cause of the financial crisis, but an amplifier to the crisis and the recession. It is an amplifier to the crisis because the housing market is so integral to the greater economy, which makes it more attractive to invest in. As housing prices continue rising, personal saving decreases, and investment in mortgage-backed securities rises, there is a self-feeding process that promotes higher housing prices, less saving, more consumer spending, and more investment.
It is also an amplifier to the resulting recession because growth in the “real” economy is dependent on consumer spending, and thus housing prices. The rapid and steep decline in housing prices since 2006 has pushed households to decrease consumption. This multiplies the recession’s reach, because rather than be contained to the housing industry, consumer spending decreases and a multitude of industries will be affected.
Promoting Corporate Debt
There are two ways of financing a corporation: equity, which either comes from retained earnings or stockholders, and debt. Both are theoretically equal; whether they use debt or equity to finance their operations, corporations must compensate stockholders or debtors for the right to use their capital. Payments to debtors are called interest, and payment to stockholders are called dividends. There is little incentive for corporations to use one rather than another.
That would be true, except for the federal corporate income tax. The federal income tax makes interest paid on debt tax-deductible, while dividends are not. This makes debt a more attractive option for financing than equity, which is comparatively more expensive.
This encourages debt-taking. This is especially problematic in the financial industry because profit margins tend to be low, and thus to maximize return on equity, firms are more likely to have higher leverage ratios.
This is the backdrop for 2000-2006, where issuance of and investment in subprime mortgages, and the general housing market, took off. This did not by any stretch cause the current financial crisis, but by encouraging debt-taking, the federal government helped set the stage.
Fannie Mae was chartered by Congress in 1968 as a Government Sponsored Enterprise (GSE), which means that although it is technically a private company, it has a public mission and is not subject to the same tax and accounting rules as all other publicly-traded firms. Freddie Mac, also a GSE, was charted in 1970 to provide competition to Fannie Mae.
Their public mission is to provide liquidity in the secondary mortgage market, and thus make it easier for homebuyers to attain loans. Their business is to buy mortgages, pool them together, and sell them as mortgage-backed securities. Together, they own or guarantee almost half of the $12 trillion mortgage market.
Fannie Mae and Freddie Mac are able to buy mortgages and sell them as securities and make a profit because of their special GSE status. As GSEs, the market considered their debt as being backed by the federal government, and thus they received financing at near the “risk-free” rate, or what it costs for the federal government to borrow money. Because this rate is much less than the market rate, Fannie Mae and Freddie Mac could, using cheap financing, buy mortgages, create securities and sell them on the open market for a higher rate (but still lower than what private firms could offer). By doing so, the two firms took mortgages off of lending institutions’ balance sheets, allowing them to make more loans. This increased liquidity in the mortgage market by providing a constant buyer for loans.
Although Fannie Mae and Freddie Mac never had the legal backing of the federal government, in practice they did. Because of this implicit backing (which was confirmed in 2008, when the federal government placed the two firms in conservatorship), the federal government was effectively passing its good credit on to American homebuyers through Fannie Mae and Freddie Mac. The Congressional Budget Office estimates that Fannie Mae and Freddie Mac have resulted in mortgage interest rates up to a quarter percentage point lower than they otherwise would be (“The Economic Consequences”).
Fannie Mae and Freddie Mac did not just contribute to the housing bubble by decreasing mortgage interest rates, though. Beginning in the Clinton administration, the federal government pushed for increased homeownership for those with low-income. Both the Clinton and Bush administrations promoted increased homeownership, and Bush called for a “homeownership society.”
Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase the number of mortgages going to low-income or moderate-income borrowers, and in 1994, the department of Housing and Urban Development began setting benchmarks for the two firms to meet. In 1996, 12 percent of their mortgage financing was to go to borrowers whose income was 60 percent of their area’s median income; in 2000, that number had increased to 20 percent, and by 2005, was 22 percent. Between 2000 and 2005, the firms met these benchmarks every year (Schwartz).
To meet these benchmarks, Fannie Mae and Freddie Mac began buying extensive amounts of subprime mortgage-backed securities and Alt-A mortgages in 2002. In 2002, they owned $38 billion subprime mortgage-backed securities; by 2004, they held $168 billion (Shenn). Although they backed off in 2005, between 2006 and 2007 Fannie Mae alone had a combined $388.3 billion subprime-mortgage backed securities and Alt-A mortgages (“The Game Is Over”).
Fannie Mae and Freddie Mac, then, held a substantial amount of subprime and Alt-A mortgages, and like their effect on the prime mortgage market, the two firms expanded the subprime mortgage market. They took these loans off of the lending institutions’ balance sheets, freeing them up to make more subprime mortgages. The two firms were fuel to the subprime fire.
There was another, more basic but less measurable, effect from the political atmosphere. Princeton Finance Professor Harrison Hong argues that the government’s intention to increase homeownership, combined with the technology bubble’s burst in 2000, created an amiable environment for lowering underwriting standards, and thus for subprime mortgages to take root (“Crisis at Princeton”). In effect, the government’s position was “any means necessary.”
After the technology boom at the end of the twentieth century, which ended in March 2000, the U.S. economy was in a recession. By September 2001, the Standard & Poor’s 500 Index was down 29 percent since March 2000, and the Nasdaq was down 67 percent. By that point, the U.S. was in its six month of recession.
The September 11 attacks, which caused severe disruption to the U.S.’s financial markets and economy, made a bad recession worse. On September 17, when the stock market re-opened after the attacks, the Dow Jones dropped 684 points (Barnhart).
On September 17, to promote growth, the Federal Open Market Committee cut the fed funds rate by half a point to 3 percent. On December 1, the Federal Reserve cut the fed funds rate to 1.82 percent, and kept it below 2 percent for 3 years, going as low as 1 percent in November 2003.
The fed funds rate controls the rate at which banks can lend to each other, which means it also has a direct effect on prevailing interest rates for debt. Keeping interest rates under 2 percent for such an extended period of time is rare, and it had its intended affect: banks began lending and the economy recovered.
This also had an unintended effect, though. After the technology bubble’s collapse in 2000, there was excess free capital and it needed to be invested somewhere. For a number of reasons, but particularly because it was politically encouraged, the mortgage-backed securities market was chosen.
In normal times, this would not be an issue, but these were not normal times. Because the fed funds rate was so low, borrowing debt was exceptionally cheap. Lenders had an easy time securing funding to make loans, and thus homebuyers could take mortgages with easy terms (or no terms at all). Even better, investment banks and hedge funds could take incredibly high leverage ratios and invest in mortgage-backed securities, maximizing their profit.
In 2007, Merrill Lynch’s leverage ratio, or the ratio of debt to equity, was 30.9x, compared to 15.6x in 2003; Morgan Stanley’s was 32.4x in 2007, compared to 23.2x in 2003; and Lehman Brothers’ was 29.7x in 2007, compared to 22.7x in 2003. These high leverage ratios, which provide high profits in good times, ultimately caused the collapse or sale of each of these firms.
The effect is not just seen in leveraging. Subprime mortgage-backed securities exploded in 2003. In 2002, there were $172 billion subprime mortgage-backed securities; by 2005, there were more than $500 billion. It is likely that the low fed funds rate helped cause this, because cheap debt (resulting from low interest rates) makes subprime mortgage-backed securities profitable despite their added risk. If it is cheap to borrow money, the borrower can be more risky with it.
The Federal Reserve’s fed funds rate policy from December 2001 to November 2004 helped caused over-investment in the housing market, creating the bubble which burst in 2006.
Credit default swaps were invented by J.P. Morgan Chase in 1997 as a way to shift risk to third-parties, so the risk would not count against regulatory capital requirements (Gillian). A CDS is, in effect, “insurance” against something happening, usually a company defaulting. The buyer pays the seller a periodic fee for protection. This allows firms to hedge against risky investments.
This is not necessarily bad. Indeed, this can increase market efficiency by spreading risk to firms that can take it, and affords them a constant revenue stream. When CDS act like insurance against risk, that is—the buyer holds the asset being referenced by the CDS—they are positive.
In 1999, the CDS market was $900 billion; by 2007, it mushroomed to $45.5 trillion dollars, or roughly twice the size of the U.S. stock market (Morgenson, “Arcane Market is Next”). This dizzying increase is due mostly to how CDSs were used after 2000. Rather than buy a CDS as insurance against default on an asset they hold, investors began buying CDSs without owning the reference asset at all — they were betting against the reference asset’s firm.
In 2007, $20 trillion of the $45.5 trillion CDS market was speculative — almost half. Because there were so many of these speculative CDSs, so widespread throughout the financial markets and so interconnected, it became difficult to know who held what.
But these CDSs had justified the risk firms took when investing in subprime mortgage-backed securities, so when firms like Bear Stearns, IndyMac, and Lehman Brothers began failing, investors realized that they may have to untangle the mess. When Lehman Brothers failed, for example, firms which held CDSs protecting against a Lehman default would have to be paid. Then, the counterparties which paid those buyers likely hedged their own position, creating a daunting situation.
Lehman Brother’s CDS settlement was estimated to be $400 billion. There was fear that not only would the settlement process be a mess, but the large payouts would bring down other firms, like AIG, which issued many CDSs referenced to Lehman Brothers.
Once the settlement was finished, though, only $5 billion changed hands, due to offsetting CDSs. This suggests that although the sheer size and volume of CDSs creates fear in the market, their actual operation may be sound.
While the Lehman Brothers CDS settlement is encouraging evidence of this, the reality is that because the CDS market is so new, we really do not know, and the market will likely still respond with fear to CDS settlements.
China’s economic policy up until 2008 was to promote exports as much as possible, at the expense of domestic consumption. This policy has succeeded; their trade surplus with the U.S. grew from roughly $80 billion in 2000 to roughly $225 billion in 2006, a dramatic increase.
This trade surplus allowed China to accumulate large dollar reserves. Naturally, the Chinese do not just let these dollars sit — they invest them back into the U.S. In 2000, China’s U.S. securities holdings (which includes private and public securities) was less than $100 billion, but by 2006 had reached $699 billion (Morrison, China’s Holdings of U.S. Securities”). In 2007, China is estimated by the Treasury department to hold $922 billion of U.S. securities (Morrison, “China and the Global Finance Crisis”).
Just over 50 percent of their securities holdings are long term U.S. Treasuries, and 8.6 percent ($80 billion) are private securities and debt. Most interestingly, though, is the other 40 percent. In 2007, China held $364 billion of long term U.S. agency debt. U.S. agency debt is mostly issued by Fannie Mae and Freddie Mac, and before 2008, was typically considered to have negligible credit risk because of the implicit backing by the federal government. China’s U.S. agency securities holdings are the largest among foreign nations, 29 percent of the total foreign holdings.
Because Fannie Mae and Freddie Mac are so integral to the housing market — by 2008 they were responsible for 70 percent of new loans (Duhigg) — China was directly funding the U.S.’s housing boom. The Chinese provided nearly half a trillion dollars of financing for Fannie Mae and Freddie Mac, and it is hard to imagine the GSEs operating as they did without so much capital.
There was no single cause to the 2008 financial crisis and recession, but the confluence of several factors. The securitization of mortgages, combined with Fannie Mae and Freddie Mac’s involvement in the housing industry, created excess liquidity, driving up home prices and amplifying the housing market’s natural tendency toward a boom-and-bust cycle. Low household savings rates, and economic growth dependent on consumer spending, set the stage for an especially painful recession. The federal government’s desire for increased homeownership, no matter what the costs, created an ideal environment for subprime mortgages to take off, and it provided fuel by requiring the GSEs to invest in it, creating the trigger for the financial crisis seen in 2007-08.
The Federal Reserve’s low interest rates from 2001 to 2005 provided cheap money, which increased investment in the housing market generally and made the increased risk of subprime mortgages palatable. Chinese capital surged into U.S. markets, providing even more liquidity for the housing market. The housing market frothed in excitement, with excess liquidity and a government encouraging risky investments.
The credit default swap market, still new and untested, was large and provided increasing uncertainty on top of the difficulty of accurately pricing mortgage-backed assets as foreclosures increased.
These factors swirled together, creating what some have called a “perfect storm.” Once the housing boom ended, and housing prices began declining, subprime mortgages were the first to have substantially increased foreclosures because under-qualified or unqualified individuals held them. Fear spread through the market as losses accumulated, and the financial crisis began.
It is tempting to latch on to the immediate symptoms of the crisis — highly leveraged balance sheets, poor mortgage underwriting, widespread use of credit default swaps to reduce risk and as a form of speculation, et cetera, and “solve” those problems without considering their underlying causes. This is also comforting, because the “solution” is control, government regulation. We can pass more regulation which requires larger capital reserves, enforces tighter underwriting standards, limit the use of credit default swaps, and the problem will be solved.
It is comforting to think that, like a child, the market got out of control, because the answer is simple: more control. This view, though, belies the causes of the symptoms, and similar historical examples.
An important lesson is that even well-intended government regulation and involvement has unintended consequences. One simple example are credit default swaps, which were created as a means of circumventing bank capital reserve ratio requirements. They were created to get around regulation, and have changed the face of finance.
Similar to the present crisis’s roots in the Federal Reserve’s interest rate policy, many past financial crises were preceded by a rapid expansion of credit. In Understanding Financial Crises, Franklin Allen and Douglas Gale write:
In many recent cases where asset prices have risen and then collapsed dramatically an expansion in credit following financial liberalization appears to have been an important factor. Perhaps the best known example… is the dramatic rise in real estate and stock prices that occurred in Japan in the late 1980’s… led to an expansion of credit.… Similar events occurred in Norway, Finland and Sweden in the 1980’s (235).
In this crisis, the Federal Reserve’s low interest rates played the same role. A sudden expansion of credit caused a dramatic increase in investment, and a bubble was created. But in this case, politics amplified it further. Increased homeownership, whether economically justified or not, has been the federal government’s policy. It conferred its credit status on two corporations, and provided them with tax and accounting advantages over all other private firms. These two firms, Fannie Mae and Freddie Mac, used their special status to create incredible liquidity in the housing market, which made it much easier for lending institutions to originate loans. In this way, the federal government artificially increased the quantity of homes demanded by making them easier to buy, and thus increased home prices and assets tied to them.
A financial crisis resulted. The government’s intent — to increase homeownership — seemed benign, but through distorting the market, the results were disastrous. Because government distortion of the market is such an important underlying cause of the current financial crisis and past downturns, we should be hesitant to implement more government involvement in the economy as a solution. Unintended consequences usually have a larger effect than the intended ones in the long run, and we should learn from past mistakes in this regard.
Perhaps even more disturbing is what this lesson teaches us about legal tender laws. Because China and the U.S. each print their own currency, and that currency is the only legal tender in each nation, international trade between the two nations requires a bank to convert one currency into another. So, when Chinese firms sell goods in the U.S., they receive dollars, which are not legal tender in China. Thus, the firms trade the dollars for renminbi, and the Chinese state-owned banks receive dollars for doing nothing more than printing renminbi. In effect, the Chinese government receives hundreds of billions of dollars for nothing.
This gives the Chinese government (and any government which receive foreign currency reserves in this way) an inordinate amount of economic power. They can use these reserves to act in their own economic and political self-interest, distorting markets in the process.
This is not an easy problem to solve, and short of replacing the entire international financial system, I am not sure how it can be solved. I will not pretend to offer an answer, but the current crisis certainly raises the question.
I first want to make overarching recommendations that will help insure that crises like this do not happen again. The first recommendation is that the Federal Reserve should only use interest rates to keep the money supply stable. The Federal Reserve’s low interest rates after September 11 provided cheap money for the housing market, and a bubble resulted. A stable money supply helps keeps price levels stable as well, which makes bubbles in any industry less likely to develop.
Second, Fannie Mae and Freddie Mac should be responsibly broken apart and privatized. The central problem with Fannie Mae and Freddie Mac, and what allows them to exist at all in their current form, is their ability to receive financing at the same rate as the federal government — that is, much less than market rates. Removing their GSE-status, severing their tie to the federal government’s credit rating and eliminating their tax and accounting advantages over private firms, would force them to be subject to the same market forces as private firms. This would eliminate a large source of liquidity in the housing market, and thus remove the market distortion created.
It would be irresponsible, though, to do this soon or abruptly. As of September 2008, the GSEs accounted for 71 percent of new mortgages, so eliminating them now would cause the complete collapse of the housing market. This must be a priority after the economy has recovered, and it must be done piece by piece over a period of years, if not decades, so the market is not substantially upset as the process takes place.
Third, after the crisis ends and the economy recovers, and at the same time as the GSEs are being broken apart, Congress should severely limit the federal government’s ability to “bailout” firms. Because so many firms were saved through the 2007-08 financial crisis, the threat of moral hazard has never been larger. Firms believe now more than ever that if they are “too big to fail,” that is, they are so large they are vital to the nation’s economy, the federal government will not let them fail. We have seen the results of this already, with General Motors and Chrysler have requesting access to $14 billion of TARP funds, which they ultimately received.
Fourth, the finance industry must set better long-term incentives for management. Once the housing boom began in earnest, it became difficult for management of financial firms to not get involved, because their performance metrics and compensation were tied to short-term goals. Former chief economist at the International Monetary Fund Rafghuram Rajan argues that if managers are awarded annually for profits, then there should also be mechanisms in place to take back these bonuses when their actions result in future losses. He recommends holding a large portion of this compensation in escrow for long periods of time, only to be released when the firm still sees success over that period of time (Rajan).
This makes sense. A firm’s stock price, which dictates its market value, already places strong pressure on management to perform in the short-term, so using only short-term incentives like bonuses may create too much pressure for management to perform in the short-term rather than the long-term.
Another option is matched equity compensation. Managers can be required to invest a portion of their own money into the firm’s stock, and the firm will match (or exceed it by some factor) their investment. By requiring that managers have some amount of their own wealth at stake, this can help insure they act more responsibly.
Finally, I will make short-term recommendations on what should be done to help end the immediate financial crisis. The first is the federal government should take equity stakes in troubled firms, rather than buy “toxic” assets as the TARP program was originally meant to do. As distasteful as this is, there is a good reason — buying the toxic assets requires setting prices for them, and that will be almost impossible. If the government sets them too high to help the firm, and they must be later sold for less than they were bought for, the U.S. taxpayer will lose money on the program; if the price is set too low, this could cause the firm to collapse anyway.
Because of this, taking equity positions in the troubled firms is the best solution. This will settle the market and give it time to right itself. There should be a firm time-horizon, however, for when the federal government must eliminate its ownership, and it must be relatively soon. If the federal government holds on to these firms for too long, we run the risk of the government, and the market, becoming comfortable with government bank ownership, and it thus would become almost impossible to eliminate. The federal government would be intimately tied into the nation’s financial system from then on.
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