The Financial Crisis
I. The Old Days
In the old days, banks knew their customers. They used our savings to make
loans to credit-worthy customers and held the loans until they were paid off (we
savers got our money back with interest).
Bank
Mortgage
Savers (people
like us)
Credit-worthy
borrowers
red-lining
Non creditworthy people
II. Post-CRA
1977: The Community Reinvestment Act (CRA) forced banks to make loans to
under-served but high-risk, unprofitable communities. Banks looked for ways to
make these loans profitable.
Innovation #1 Collateralized Debt Obligations
Eventually banks developed collateralized debt obligations. Here’s how these
work:
Mortgage brokers write loans to people with bad credit histories (or no credit
histories or no verifiable income). Then the mortgage brokers sell these subprime
mortgages to investment banks. The investment banks take thousands of
subprime mortgages and repackage them into CDOs called mortgage backed
securities.
Mortgage
Mortgage
Mortgage
Mortgage
Mortgage
AAA
Mortgage Pool
An investment
bank creates a
set of securities
(tranches)
backed by a
mortgage pool
BBB
Junk
Imagine thousands of these mortgages
being put into a pool
The investment banks sell these newly created securities to banks, pension
funds, college saving funds, universities, cities, etc. (That is, they sell them to
people like us.)
As the mortgage holders/“home owners” in this pool make their monthly
payments, the AAA-security holders start receiving their payments. Once these
AAA-security holders get their investment (plus interest) back, then the BBBsecurity holders start receiving payments. Assuming that the mortgage holders
continue making payments, once the BBB-security holders get their promised
payments, the junk bond holders start receiving payments.
Since it is highly unlikely that the junk bond holders will be paid off (let’s say that
the experts expect 33% of mortgage holders in this pool to default), no one would
buy the junk bonds. So the investment banks created shell companies to buy the
junk CDOs. This moved the junk bonds off of the investment banks’ balance
sheets.
Agency problems working against the CDO purchasers (people like us):
1. The mortgage brokers were their own agents, not the agent of the CDO
purchaser. The mortgage brokers who originated the loans had no incentive to
make sure the borrowers were credit-worthy because the mortgage brokers did
not hold the mortgages. They made their money through loan origination fees.
2. The property appraisers were the agents of the mortgage brokers, not of the
CDO purchaser. Mortgage brokers hired appraisers to ascertain the value of the
property. The appraisers would not be rehired if they said the property was worth
less than the mortgage broker claimed it was worth.
3. The credit rating agencies were the agents of the investment banks, not the
CDO purchaser. The investment banks hired credit rating agencies to (1) rate the
securities and (2) to give advice on how to get high ratings.
4. Ultimately, remember, the CDOs are held by our pension funds, etc. There are
allegations that some fund managers received kickbacks from the investment
banks. If this is so, these fund managers were acting as their own agents, not as
the agents of people like us.
Innovation #2 Credit-default insurance
I buy homeowners insurance that will pay me if my house burns down. CDO
purchasers bought credit-default insurance that would pay off if their CDO went
into default (that is, if the borrowers stopped making payments).
AIG and other insurers sold this insurance (called credit default swaps). The
difference here is that anyone could buy this insurance. You didn’t have to own
the CDO.
AIG used credit default swaps to insure over $440 billion worth of securities that
were originally AAA rated. $57.8 billion were backed by subprime loans.
Innovation #3 Adjustable Rate Mortgages
Adjustable Rate Mortgages had low, introductory interest rates, making them
affordable to subprime borrowers. As long as housing prices were rising,
borrowers were able to refinance when the rates climbed.
III. The Housing Boom
Several factors fueled a housing boom:
1. Federal Reserve actions (under Alan Greenspan) which pushed the federal
funds rate to record low levels
2. World-wide wealth boom which fueled foreign investment in the U.S.
3. Tech bust of 2001 which fueled investor flight into real estate
4. Financial innovations which fueled subprime lending
IV. The Housing Bust
“Moody's Economy.com estimates that banks made 15 million sketchy mortgage loans from 2004
to 2007 and that ultimately 10 million of those will default.” WSJ, 10/26/2008.
A couple of factors led to the housing bust:
1. Builders overbuilt, driving housing prices down.
2. The Fed raised the federal funds rate (driving up other interest rates, including
mortgage rates).
Subprime borrowers, faced with higher interest rates, wanted to refinance their
loans, but could not do so when lower housing prices drove down the value of
their property. Many borrowers found themselves “underwater,” where they owed
more than their house was worth. Borrowers began to default, creating a vicious
cycle:
As they defaulted, the supply of homes increased yet again, reducing home
prices further and driving even more borrowers underwater.
Also as they defaulted, the value of the CDOs fell. Banks that owned them
incurred losses, leaving them with less money to lend out. As this vicious cycle
continued a credit crunch occurred, slowing economic activity and pushing the
economy into a recession.
V. Responding to the Financial Crisis
A. Commercial Banks
As banks incurred losses, a number found themselves short of required capital
reserves and failed (they were either shut down or the government sold their
assets to other banks). See
http://www.fdic.gov/bank/individual/failed/banklist.html. In October 2008 the Fed
announced that it would begin paying interest on bank reserves held at the Fed.
To prevent bank runs, the FDIC announced that it would temporarily insure
deposits up to $250,000. The FOMC lowered the target federal funds rate from 51/4 percent to effectively 0 percent. In December 2007 the Fed announced the
creation of the Temporary Auction Facility, designed to make more funds
available to banks.
B. Investment Banks
As the value of the CDOs fell, investment banks also found themselves in
trouble. Bear Stearns, for example, had borrowed heavily to buy CDOs
(leveraging). As its CDOs fell in value, investors worried that it would default
(perhaps because of rumors started by firms that had bought insurance betting
that it would fail) and started pulling their money out. Bear Stearns had to sell its
assets at fire sale prices in order to pay back the investors. The Fed thought that
Bear Stearns was too interconnected to other firms to fail and so orchestrated a
sale of Bear Stearns to J.P. Morgan Chase in March, 2008. Of the other five
largest investment banks, Lehman fails, Merrill Lynch is sold to Bank of America,
and Morgan Stanley and Goldman Sachs become commercial bank holding
companies (so that they can borrow from the Fed).
C. Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were government-sponsored enterprises that
operated a secondary market for mortgages. They were nationalized on
September 7, 2008 (see www.nytimes.com/2008/09/08/business/08fannie.html).
A 3rd GSE, Farmer Mac, was rescued by its lenders.
D. American International Group
As the value of the CDOs fell, AIG had to pay out billions of dollars more than
expected. Its shareholders started dumping its stock and it found itself
undercapitalized. On September 16th, 2008, the U.S. government bailed it out in
exchange majority stock ownership (79.9%). As of March 2009, the government
has made over $170 billion available to AIG. Sudeep Reddy, Liam
Pleven. (2009, March 3). For AIG, a Buy-and-Hold Strategy --- U.S. Resigned to Long Stewardship
After Failing to Sell Insurer in Pieces. Wall Street Journal.
http://online.wsj.com/article/SB123599072033008283.html (scroll down to table
at bottom).
E. Money Market Reserve Primary Funds
Also on September 16th, 2008, three money market reserve primary funds “broke
a buck, leading to a run on money market primary funds by institutional investors.
The funds fell from $65 billion to $27 billion of assets in one day (and eventually
to less than $7 billion). The Treasury stopped the flight by promising to rescue
those under $1.
Shefali Anand, Diya Gullapalli. (2008, September 20). The Financial Crisis: Bailout of Money Funds
Seems to Stanch Outflow; Fear That Had Gripped $3.4 Trillion Market Abates, Ending the Reluctance
of Funds to Buy Vital Commercial Paper. Wall Street Journal.
F. Corporations
In October 2008 the Fed created the Commercial Paper Funding Facility to buy
short-term commercial paper (corporate debt) directly from issuers. “The Federal
Reserve created the Commercial Paper Funding Facility (CPFF) to provide a liquidity backstop to U.S.
issuers of commercial paper. The CPFF is intended to improve liquidity in short-term funding markets
and thereby contribute to greater availability of credit for businesses and households. Under the CPFF,
the Federal Reserve Bank of New York will finance the purchase of highly rated unsecured and assetbacked commercial paper from eligible issuers via eligible primary dealers.”
http://www.federalreserve.gov/monetarypolicy/cpff.htm
G. People who have student loans, auto loans, credit card loans, loans or
leases relating to business equipment, leases of vehicle fleets, floor plan
loans, mortgage servicing advances, or loans guaranteed by the Small
Business Administration (SBA)
In November 2008 the Fed created the Term Asset-Backed Loan Facility to “help
market participants meet the credit needs of households and small businesses by supporting the
issuance of asset-backed securities (ABS) collateralized by loans of various types to consumers and
businesses of all sizes. Under the TALF, the Federal Reserve Bank of New York (FRBNY) will lend up
to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and
recently originated consumer and small business loans. The FRBNY will lend an amount equal to the
market value of the ABS less a haircut and will be secured at all times by the ABS. The U.S. Treasury
Department--under the Troubled Assets Relief Program (TARP) of the Emergency Economic
Stabilization Act of 2008--will provide $20 billion of credit protection to the FRBNY in connection with
the TALF.” http://www.federalreserve.gov/monetarypolicy/talf.htm
H. Steps by Congress
On October 3, 2008, Congress passed the pork-laden Troubled Asset Relief
Program (TARP) to authorizing the purchase of $850 billion of troubled assets in
order to get them off the books of banks and other institutions.
http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
http://www.federalreserve.gov/monetarypolicy/bst_table1popup.htm