General

The Global Financial System Crisis-2008, Simplified

February 11, 2015

“Honest, industrious, peaceful citizens were classed as bloodsuckers, if they asked to be paid a living wage. And they saw that praise was reserved henceforth for those who devised means of getting paid enormously for committing crimes against which no laws had been passed. Thus the American dream turned belly up, turned green, bobbed to the scummy surface of cupidity unlimited, filled with gas, went bang in the noonday sun.”

Kurt Vonnegut

Foreword

The global financial crisis that struck in 2008 was triggered by the complex interplay of certain policies and practices in the US financial markets in general and in the housing mortgage segment of the US economy in particular. Hundreds of books and articles have been written on the subject. But these writings mostly catered to the professional reader leaving non-experts in global economics, poorly enlightened. So, I thought it might be a good idea to put together an article capturing the causes and consequences of this crisis in a language intelligible to the general reader. This post is the outcome of that thought.  I hope that this article would give the a broad idea on the complex topic for readers who have the interest, time and patience.

Although this post is targeted to the inexpert, the use of some technical terms is unavoidable. I have tried to provide a short definition of most such terms within the article itself at places where the term is first used. Also, a basic knowledge of Mortgage Backed Securities (MBS) is necessary for the reader to follow the discussions gainfully. Therefore, readers not conversant with MBS may first read the Annexure.

Let me confess that I am not an expert in global finance. So, it is quite possible that some of the information presented herein or my comprehension on it is erroneous or inadequate.  I shall be grateful to be enlightened on these.

Introduction

In 2008, the ‘US Housing Mortgage Bubble’ went bust sending the US economy into a tailspin. Banks, insurance companies and other institutions that had participated in the housing mortgage related securities came crashing down. Lakhs lost their homes and occupations. People were driven out on to the streets. Scores turned penniless overnight and had to find shelter on park benches and pavements in the freezing US cold.  Because of its sheer size, when US economy sneezed, the world economy caught cold. National economies across the globe tumbled spreading panic, pandemonium and penury.

The crash did not occur overnight.  Referring to some of the dangerous trends witnessed in the global financial system, Raghuram Rajan, the present Governor of the Reserve Bank of India said on Saturday, August 27, 2005 that, “… one could well have a full-blown financial crisis”. Rajan was then the Economic Counsellor and Director of the International Monitory Fund’s (IMF) Research Department and was speaking at an annual gathering of high-powered economists at Jackson Hole, Wyoming. His audience included Alan Greenspan, the then Chairman of the US Federal Reserve.  Rajan told his august audience that in the mad scramble for short-term profits to which executive incentives were linked, huge risks were being taken by institutions operating in the financial markets, which was causing serious instabilities in the financial system. “But every once in a while, disaster will strike and the creditor will default”, he cautioned. He emphasised the need for urgent and adequate interventions to set the situation right. He exhorted central banks “…to be vigilant for any possible shortfalls in aggregate liquidity”.

Rajan was not alone in forewarning the world about an impending financial system catastrophe. But all those who tried to raise the alarm were ignored, criticised or side-lined.  As Barry Ritholtz says, “The denying of reality has been an issue, from Galileo to Columbus to modern times. Reality always triumphs eventually, but there are very real costs to it…”

The Making of the Crash

The crisis was in the making for two decades or more. At the heart of the crisis was Mortgage Backed Securities.  A staggering rise in the number of housing mortgages originated by lenders and securitized by Government-Sponsored and Private enterprises put an unsustainable volume of debt-backed securities into the US financial system. All these securities had its value tied to the loan amount and interest on it to be repaid by the borrowers in the long term and ultimately to the value of the collateral (the price of the houses pledged as security for the loan).  As long as home prices kept rising, everything looked hunky-dory. But, once home prices tanked, the securities deriving its value from the price of the homes, crumbled. All investment in such securities melted away in no time.

Contributors to the Crash

The crash was essentially the result of the greed and folly of several players in the US financial system. Some of these players were in the governmental domain and others outside it. Let us look into how some of the major players who contributed to the crisis.

The US Federal Reserve

Federal Reserve is the US Central Bank (Similar to the Reserve Bank of India).  Federal Reserve controls the US interest rates.  For a long period prior to the crash, the interest rates were kept at the lowest possible level of just one per cent (which was considered zero per cent in effect). Such a policy was followed by the Fed in the aftermath of the dot-com bust.   Let us briefly look in to the dot-com bust.

As many other technologies the world now uses, the Internet too was the brainchild of the US military.  But the kind of massive growth it witnessed was beyond anybody’s imaginations.  By 1995, Internet had around eighteen million users and kept spreading like wild fire. Internet was turning into a big idea of a ‘new economy’. New buzzwords like networking, information technologies, consumer-driven navigation and tailored web experience etc. came into everyday use. This excited entrepreneurs and investors. New enterprises seeking to exploit the possibilities of the Internet technologies (dot-coms) mushroomed and their Initial Public Offers (IPOs) (the first offer of shares of a company to the public) were blindly gobbled up by investors. (Investors had nurtured wild dreams of every dot-com company growing and flourishing like Microsoft Corporation). In most cases, the share values of such companies doubled on the first day of trading. But the craze and euphoria did not last long. The whole dot-com boom had no support of any rational or tangible business plans to sustain it. Before long, the dot-com companies floundered.  By the year 2000, the dot-com bubble burst. Almost 80% of the investments in such companies simply evaporated into thin air.

The dot-com crash put the fear of god into the hearts of the investors, which led to a savings glut in the sense that people had money, which they were disinclined to invest in enterprises for fear of dot-com bust like wipe-outs. The only trustworthy proposition for them was to invest in government securities. The Federal Reserve seized the opportunity and tried make hay while the sun shined by dropping the interest rates to just one per cent and holding it there for an unduly long period. Investors grudgingly put their money into government securities for measly returns. The market lusted for alternative investment opportunities providing safety with higher returns. As fate would have it, it was a period in US history when a series of political and policy pushes were being initiated to make every American a homeowner. The housing loan business boomed. The finance whizz kids became highly creative and innovative to invent a myriad of investable financial instruments (Securities).  These Securities, commonly known as Derivatives (a contract which derives its value from its underlying asset) with housing mortgages as its underlying asset, were created. It was propagated that Mortgage Backed Securities had banished all investment risks. It also provided guarantees of great returns on investments. That lured investors into MBS. The demand for MBS skyrocketed. Lending institutions originated more mortgages and Securitizing Institutions turned them into MBS quickly to feed the intensifying investor hunger.

These developments in the US attracted investors from outside. Hundreds of billions of dollars poured into the US from abroad.  Financiers looking for imaginative ways to make a profit turned to real estate. The philosophy of many was “Buy-high-sell-higher!” Since investors expected the home prices to keep climbing forever, a house resold (“flipped”) in the next six months or one year after its purchase was raking in huge (short-term) profits. That brought speculators in to the mortgage market in legions. Salespersons minted money in the form of incentives by promising big returns in quick time to prospective buyers.

As housing prices soared because of increasing demand, mortgage companies and banks turned eager and ambitious to lend even to people with very poor credit scores (financial background). Many of the mortgages involved very low down payments (borrower’s own share of the home price to be brought in at the point of buying it) and low monthly payments to start with. In certain type of arrangements, the monthly payment was zero for a while.  One or two years later, the size of the repayment instalments would zoom. (Both the Bush and Clinton administrations made it a national priority to encourage more people to buy houses, assuming this social engineering would be good for everyone).

The speculative real-estate bug infected not only residential buildings. It also spread to all kinds of commercial real estate such as office buildings, shopping centres, apartment complexes, hotels, casinos and even empty parcels of land. People who loaned money to real estate firms were confident of a minimum 20% return against 1% that Fed offered for investments in public securities.

US Federal Government

Certain key policies of the US government actually turned out to fuel the greed of institutions that sought to milk the home mortgage market. These policies were not promulgated when the markets were going berserk over mortgage-backed securities.  It had already been there for a long time.  But the madness in the MBS market presented an alluring opportunity to the lending and securitizing institutions to exploit those government policies to make a quick buck. Let us briefly review the crucial policies that helped the build-up of the US Mortgage Bubble.

Community Reinvestment Act (CRA)

This law was enacted in 1977 to ensure that banks did not discriminate against the poor and the vulnerable sections of the society. The Act mandated regulators to examine whether the insured banks, (commercial banks whose deposits are guaranteed by the US Federal Deposit Insurance Corporation (FDIC)), were serving the community as a whole or were only catering to selected segments of the community. CRA did not create any flutter in the mortgage market for fifteen odd years. But in the year 1992, Boston Regional Branch of the Federal Reserve conducted a study on the pattern of home mortgage lending. The study concluded that loan officers were favouring white borrowers to the disadvantage of the rest. Although questions were raised later, about the methodology applied in the study, the media and the politicians made a huge clamour about the alleged prejudice of the lenders towards the non-white population.  In order to silence the politicians and the media, in 1995, the regulators came out with new rules and evaluation parameters for housing mortgages. And that substantially altered the situation. How?

Until 1995, banks could escape their underperformance in the area of housing loans to the non-white sections of the society with the alibi that they could not find enough qualified borrowers. But once the regulation changes came into effect in1995, it became essential for the lenders to disburse the prescribed quota of housing loans to Low and Moderate Income (LMI) borrowers. The lenders were directed to use “innovative or flexible” lending practices to meet the credit needs of the LMI segment. The focus of the regulators was in highlighting the egalitarianism of the US lending system. None apparently bothered about repayment defaults or bad debts.

But the mere change in the regulation did not alter the ground realities with regard to the creditworthiness of the borrowers. So, lenders had to dilute their lending standards to make ineligible borrowers eligible for housing loans which in turn increased default risks.  In order to compensate for the risk of default, the lenders started levying higher processing fees and interest rates on mortgages involving people whose credit scores were poor. This led to the emergence of three classes of housing mortgages – the prime mortgage, the Alt-A mortgage and the sub-prime mortgage.  The prime market adhered to traditional lending standards, the sub-prime market catered to the LMI segment that enjoyed liberal credit score evaluations. Alt-A mortgages represented the middle position – neither prime nor subprime.

But, the problems did not end even with that.  The loan-to-value (the quantum of loan in comparison to the value of the collateral) and debt-to-income (the quantum of loan in comparison to the established income, and therefore, the repaying capacity of the borrower) ratios were quite liberal in the case subprime mortgages. This helped borrowers get loans often far exceeding the value of the collateral and their capacity to repay. So, borrowers who were actually qualified for prime mortgages too started seeking subprime mortgages.  Moving to the subprime level gave them higher amounts of loans for the same collateral in comparison to prime mortgages. The loan approvers could not refuse such requests since such applicants were far better qualified in comparison to general subprime level borrowers. Gradually, the dilution of lending standards crept into the prime market too. The size of the subprime mortgages kept bulging while that of the prime mortgages steadily contracted. House prices kept spiralling in view of the mounting demand for homes. The banking and financial systems were flooded with loans and securities based on mortgages in which the creditworthiness of the borrowers were highly suspect. Everyone was scrambling to lay hands on a piece of the money oozing housing mortgage pie.

The Affordable Housing Mission

The affordable housing mission was added to the charters of the Government Sponsored Enterprises (GSEs) Fannie May and Freddie Mac, in 1992.  This permitted US Congress to subsidize LMI housing finance without setting apart any funds for the purpose.  In the aftermath of AHM, these companies began to accept mortgages that they had previously rejected on grounds of being too risky. The investment of GSEs in debt based financial instruments zoomed beyond its permissible limits. (The restrictions on the quantum of such instruments were imposed with the intention of discouraging GSEs from overinvesting in debt instruments since overdependence on debt could jeopardise its very existence if things went wrong). But once the affordable housing mission was added to the charter of GSEs, they breached their debt holding limits with impunity by arguing that if the US Congress enforced limits on the size of their mortgage portfolios, they would not be in a position to meet their targets under the Affordable Housing Mission.

(Incidentally, by 2007, Fannie and Freddie were required to show that 55 per cent of their mortgage purchases were LMI loans. Within that goal, 38 per cent of all purchases were to come from underserved areas and 25 per cent were to be loans to low-income and very-low-income borrowers. Meeting these goals required the GSEs to purchase subprime mortgages fraught with risks and deficiencies. The GSEs eventually ended up with a $1.6 trillion portfolio of junk loans).

The repeal of Glass-Steagall legislation

The Glass-Steagall Act (GSA) was promulgated to separate Commercial Banks and Investment Banks. It was done in 1933 in the wake of the US stock market crash of 1929 and Great Depression that had hit US in the aftermath of the First World War. (It was believed that crash was caused mainly by speculative financial market interventions by commercial banks). GSA prevented overzealous commercial banks from getting into stock market speculations at the risk of their depositor’s money.

But commercial banks were not happy with the restrictions that the GSA had imposed on their freedom to gamble in the financial market. There was intense lobbying for the repeal of the Act. And in November 1999, Congress replaced GSA with Gramm-Leach-Bliley Act. The commercial banks whose deposits were guaranteed by the Federal Deposit Insurance Corporation (FDIC) once again became free to use the funds of its depositors to indulge in speculative deals in the financial markets.   

The Securities and Exchange Commission (SEC)

The 1977 Net Capitalization rules had prescribed a 12-to-1 leverage limit for banks dealing with debt based securities. (The 12-to-1 leverage limit in the given context means that for every 12 dollar investment in debt, the company must have at least one dollar Net Capital i.e. cash and other assets that can be converted into cash in the short-term (also called liquid assets)). But in the year 2004, the leverage rules were changed by the SEC for just five Wall Street banks – Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. This move of the SEC allowed unlimited leverage for these banks. The leverage position for these banks eventually went up to 20, 30, and even 40-to-1. Such highly disproportionate levels of debt left little room for error.  (In the aftermath of 2008 crash, just two out of these five banks survived. And those survived did so only because the US government bailed them out by pumping phenomenal sums of US taxpayers’ money into them).

The Comptroller of the Currency

There were US State laws that regulated mortgage credits.  But in 2004, the Office of the Comptroller of the Currency pre-empted (overrode)state laws that regulated mortgage credit and national banks. Liberated from state regulations, national lenders sold increasingly risky housing loan products in the states. Shortly thereafter, the default and foreclosure rates of these mortgages simply vaulted. (Foreclosure is the premature closure of mortgages. When mortgages are closed before it runs its full term, the investors who had put their money in the securities derived from these mortgages lose their expected long term returns in the form of high rates of interest.)

US State Governments

While the US Federal (Union) Government was busy making policies and repealing state controls to enable people to become homeowners irrespective of their capacities to repay which in turn allowed financial institutions to play dice in the market using securities derived from the home loan mortgages, the state governments too chipped in with their own share of adventures to queer the pitch further. 

Residential Finance Laws

State-based residential finance laws gave homeowners the option to refinance a mortgage (close the existing mortgage by paying off the loan thorough a new mortgage) without any penalty whenever interest rates fell or home prices rose to a point ‘where there is significant equity in the home’.

(The term ‘equity’ in this context is ‘the difference between the market value of the asset (collateral) and the claims held (mortgage) against it’. To clarify it with an example, let us assume that I hold a housing mortgage for 500,000 created based on a price of 550,000 for the house (collateral). After a year, the price of the house rises to say, 750,000. Also, assume that out of the 500,000 mortgage, I have already repaid 25,000 of the loan and the interests due on it so far. Thus, the claim against a property now worth 750,000 is only 475,000. Consequently there is an equity in the house to the extent of 275,000 (750,000-(500,000-25,000). The law allowed the homeowner to get this extra cash out of the property.  Going by the above example, the borrower can opt for refinancing to receive another loan for a sum up to 275,000 against the same collateral. And the borrower does not have to pay anything extra as charges or fees for this exercise). 

The consequence of this kind of free and liberalized refinancing options was the emergence of the so-called cash-out refinancing.  In the cash-out refinancing, homeowners treat their homes like savings accounts to withdraw funds to buy cars, boats, second homes or to settle their credit card bills. People who owned a house the value  of which had doubled could and did refinance their mortgage for the higher amount, and pocketed the difference. By the end of 2006, eighty six percent of all home mortgage re-financings were cash-outs.  In the year 2006 alone, a sum amounting to $327 billion was taken out by house owners through cash-out refinancing.  (Incidentally, there was another incentive to the borrowers to go for cash-out refinancing.  That was tax relief. Since these withdrawals are also treated as housing loans, the borrowers received income tax reliefs, irrespective of the actual purpose for which it was used).

But what happens when the home prices fall? Well… the equity would turn negative in the sense that the loan outstanding exceeds what the sale of the house can fetch. Under such a situation, the borrowers have little reason to continue making payments on the mortgage. This was exactly what happened. The borrowers simply walked away. The lenders were left holding houses that did not carry value sufficient to recoup their loans.  And the situation turned worse by the day.  Eventually the home prices crashed and none came forward to buy houses even for a mere one dollar. All mortgage based financial instruments turned valueless pieces of paper.

The Financial Market

The Government-Sponsored Enterprises (GSEs)

Government-Sponsored Enterprises are giant financial services corporations created by Acts of the US Congress with the objective of improving the flow of credit into certain housing markets.  Freddie Mac (Federal Home Loan Mortgage Corporation) Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) are the most prominent among such enterprises. Ginnie Mae is a Government Corporation within the Department of Housing and Urban Development. Fannie Mae and Freddie Mac are privately owned Corporations (Companies) chartered by the federal government. The public purpose of the GSEs is enabling a steady flow of low-cost mortgage funds into the market.  The Department of Housing and Urban Development (HUD) gives them annual housing targets for low and moderate-income (LMI) citizens and social minorities. The profits for these companies come from guarantee fees and financial assets (portfolios) retained by them.

GSEs are Securitizing Institutions. (The basic securitization process is explained in the Annexure) The lenders sell their housing mortgages directly to Fannie Mae and Freddie Mac. These companies convert the mortgages they buy into Mortgage Backed Security (MBS) and provide added guarantees. These securities are sold in the market, mostly to institutional investors. Investors felt more reassured with the guarantees given by the GSEs since they believed that if anything went wrong, the U.S. government would step in to protect their investments.  The GSEs too invested heavily in their own securities. (Guarantee is something like a giant insurance policy earning regular premiums. The two companies had credit guarantees on $2.9 trillion of MBSs by the close of the year 2006. A guarantee fee of 0.12% to 0.50% annually would generate a humungous sum as their revenue. Similarly, the size of the mortgage portfolios retained by these two companies stood at $1.4 trillion in 2006.)

The prime mortgage market had remained more or less an exclusive domain for the GSEs. They had the advantage of government backing which helped them keep the private players out of the prime mortgage market. So the private-label issuers (securitizing institutions in the private sector) had flourished in the sub-prime and Alt-A mortgage markets. But when the Affordable Housing Mission came into force, things changed. The GSEs entered the domain of sub-prime and Alt-A mortgage market to meet their targets under Affordable Housing Mission.  When this happened, the private securitizing enterprises started losing their market share. It triggered a competition in the subprime and Alt-A markets, which, in turn increased the demand for sub-prime and Alt-A mortgages.  So the originators of the mortgages (lending institutions) started looking for ‘innovative and flexible ways’ to sell more subprime housing mortgages to meet the growing demand.  Thus, people who had neither the plans nor the financial wherewithal to buy houses were lured into subprime mortgages. As a result, many more marginally qualified or unqualified applicants received home loans. (In the years just before the collapse of home prices started, about half of all home loans approved in the United States were non-prime loans). 

It may all look formidable and seductive when the going is good. But due to the sheer size of their commitments, the GSEs posed too large of a systemic risk to the US economy. At the end of 2006, Fannie Mae and Freddie Mac had about $4.3 trillion of mortgage credit exposures. Their mortgage related and other debt obligations totalled $5.2 trillion against the total publicly held debt of $4.9 trillion of the US government. If something would go wrong with their risk and portfolio management practices, the US economy will crash and its tremors would be felt worldwide. Well.  “Anything that can go wrong, will (go wrong)“, says Murphy’s Law. In the year 2008, things did go wrong.   

The Private Lenders

It is believed that the driving force behind the 2008 financial crisis was the private sector. Private lenders were not subject to congressional regulations.  So it was easier for them to water down the lending standards. Conforming mortgages (mortgages that conformed to the rules and limits of the GSEs) had stipulations that made them less profitable than the nonconforming (jumbo) loans.

(The term non-conforming mortgage arises out of the fact that these mortgages are not in conformity with the rules and purchasing limits set for the GSEs Fannie Mae and Freddie Mac. The purchasing limit of GSE was $400,000 and any mortgage for more than $415,000 was usually considered a Jumbo or non-conforming loan. Since lenders could not readily sell them to the GSEs, jumbo loans were considered riskier for the lender.  Such mortgages are more or less fully dealt with in the private securities market. In the case of non-conforming loans, usually borrowers have to put more money as down payment and bear higher or non-fixed interest rates.)

Borrowers were lured into mortgage traps by lenders by creating innovative interest payment options like “Option adjustable rate” mortgages (nick-named “Pick-A-Pay”).  This allowed borrowers to decide the size of their repayment instalments.  If the monthly instalment chosen is smaller than the interest due at that point, to the extent of the difference, the principal will increase.  That meant the total principal grows over time and will earn more interest for the lenders. Obviously, as time passes, the borrowers caught in such traps would find it increasingly difficult to repay their loans. (By the year 2008, banks sold these dangerous “option adjustable rate” mortgages to two million customers).

Under their “lend-to-sell-to-securitize” model, the private lenders had to hold the mortgages for a very short period after which they could sell it to the securitizing institutions. This allowed them to relax standards by abandoning traditional lending metrics such as income, credit rating, debt-service history and loan-to-value. To keep up with these rampaging mortgage originators, traditional banks too jumped into the fray. Loan volume irrespective of loan quality became the criterion for employee incentives. The consequence was that over 84 per cent of the subprime mortgages in 2006 were issued by private lending institutions.

The Private Securitizing Institutions

Private-label mortgage backed securities were mostly created out of ‘Jumbo Loans’.  While the housing bubble was building up, house prices kept climbing.  As the average home price rose, higher amount mortgages were created and loans became more and more non-conforming or jumbo. Investors put money in the MBSs issued by GSEs because of the backing of government guarantee.  Private Label MBS did not have such a guarantee. The confidence to invest in such securities arises out of the rating given to these securities by the Credit Rating Agencies. The attraction for them was the promise of comparatively higher returns.

Private label securitization market expanded by leaps and bounds from 2001 to 2007. This overshadowed Fannie Mae and Freddie Mac during the boom. Subprime mortgages lay at the core of the global financial crisis 2008. The vast majority of these loans were underwritten (guaranteed) by unregulated private firms. Since these firms held no public deposits, they were not under the jurisdiction of the FDIC or the Office of Thrift Supervision. The market share of the GSEs dropped from a high of 57% of all new mortgage originations in 2003, down to 37 per cent as the bubble was gaining in size in 2005-2006. Private securitizing Institutions competing with GSEs increased their market share of 10% in 2002 to nearly 40% in 2006.  

The Credit Rating Agencies

Investors generally do not possess the expertise to evaluate and understand the strength and reliability of the securities. In the case of securities issued by GSEs, investors derive their confidence from the government guarantees on it. In the case of securities issued by institutions in the private sector, the investors’ assurance is wholly dependent upon the rating given by Credit Rating Agencies. The credit rating agencies are professional experts who evaluate the safety of each security and provide a rating for it based on that evaluation. Moody’s, Standard & Poor (S&P) and Fitch are internationally renowned credit rating agencies.  Credit rating agencies typically assign letter grades to indicate ratings of securities. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA and AA+ down to C and D. A rating of AAA for a security instrument pronounces the highest level of a safety for the investors in that security. A security with a rating below BBB- is considered junk.

But, when there is an unholy nexus between the Credit Rating Agencies and the institutions that issue the securities for sale, even junk securities may receive AAA rating. This was indeed the situation before the crash. The Credit Rating Agencies gave AAA ratings to virtually worthless Mortgage Backed Securities and investors blindly relied on these rating agencies and put their money in to these worthless instruments.

Financial Engineering Wizards

The financial ‘engineering’ experts have always been working on making matter highly complex in such ways that when something goes wrong it would be almost impossible to trace out where the transactions commenced, which are the layers it traversed or the exact size and location of its current position. The term Mortgage Backed Securities created by these whiz kids is essentially an umbrella term. Innumerable security variants were created under the umbrella. Many of these instruments are too complex for the comprehension of the inexpert.  Whatever it be, the declared objective all innovations and creative adventures of these people was to eliminate risk from the financial system. And everything depended on the assumptions that home prices always climbed up and never down.

Corporate Compensation schemes

The compensation system of companies operating in the financial market was based on short-term performance. Referring to the situation, Raghuram Rajan, the present governor of the RBI had said in 2005, “Investment managers face a compensation structure that moves up very strongly with good performance, and falls, albeit more mildly, with poor performance. In the jargon of economists, the compensation structure is convex in returns.” This incentivised gambling in the financial markets. Companies took huge risks to show immediate gains and earned jumbo incentives for its executives.  The long-term performances of the investments were never called to question.  The approach of all institutions that operated in the housing mortgage market was to make money as fast as possible and generate whopping annual bonuses and other incentives for senior executives. As an analyst wrote, “The drive to reach short-term goals can translate into business strategies that can ruin a business, cost employees their jobs, and even spill over into the general economy”. This was proved true.

Some of the instances of executive compensation reported in the media might give the reader an idea on the scale of the executive incentives.

AIG (American International Group) is an insurance company that collapsed in the wake of the US housing mortgage crisis. Its former CEO Martin Sullivan received a $47 million severance package when he stepped down. Experts are of the view that Mr Sullivan’s pay was one of the reasons for the demise of the insurance giant. The U.S. government took control of AIG with an initial loan of $85 billion. It has been reported that U.S. taxpayers provided over $180 billion in government support to AIG during 2008 and early 2009.

Countrywide Financial had originated 20% of all American mortgages in 2006. Countrywide gave special incentives to its brokers for selling impossible loans by paying them higher commissions. “Vast majority of the loans had inflated income, almost all without the borrower’s knowledge”, said a complaint filed by the Illinois state government against Countrywide Financial. Countrywidelost $1.6 billion in 2007 and its stock lost 80% of its value. Yet Angelo Mozilo, the CEO of Countrywide received $120 million in compensation and stock sales. The Bank of America bought out Countrywide Financial for $4.1 billion to save it from extinction.

Merrill Lynch lost $10 billion and its stocks lost 45%o of its value. But the company paid its CEO Stanley O’Neal, a sum of $161 million upon retirement. Again, US citizens paid for the stupidities of the company. Merrill Lynch was sold to Bank of America for $50 billion, about half its value a few months before.

Citigroup lost $10 billion and its stocks lost 48% of its value. The CEO of Citigroup, Charles Prince got $10 million bonus, $28 million in stock options and $1.5 million in annual perquisites upon retirement. Needless to say, the US tax payers had to foot the bill. 

To sum up, arrant greed is the most striking reality of annihilating financial system crash 2008. Perhaps, this is a reality with all market crashes.

The Consequences

The most striking aftermath of the bursting of the US Housing Mortgage Bubble was the collapse of the colossal institutions that operated the US and also the global banking and finance systems. Many giants were uprooted. Others teetered on the brink and had to be saved through phenomenal funding by governments across the globe. Ultimately, plain citizens paid out of their pockets for the profligacy of a reckless and greedy market.

US Government funding to failing institutions was done through Troubled Asset Relief Program (TARP).  Investopedia (www.investopedia.com) defines TARP as “A group of programs created and run by the U.S. Treasury to stabilize the country’s financial system, restore economic growth and prevent foreclosures in the wake of the 2008 financial crisis through purchasing troubled companies’ assets and equity. The Troubled Asset Relief Program initially gave the Treasury purchasing power of $700 billion to buy illiquid mortgage-backed securities and other assets from key institutions in an attempt to restore liquidity to the money markets. The fund was created on October 3, 2008 with the passage of the Emergency Economic Stabilization Act…”

Government Sponsored Enterprises Fannie Mae and Freddie Mac had lost $15 billion on the $5.4 trillion in mortgages they owned.  The securities these companies had issued were widely held in China and many other countries.  The US government took over the control of these companies on September 7, 2008 fearing that a fall of these behemoths would kill international confidence in the US financial system.

AIG, the global giant in insurance, lost $13 billion in the first half of 2008.  The value of its shares fell by 95 per cent.  AIG was “too big” an enterprise to be permitted to go down.  So the US government extended an $85 billion loan to it and took over 80% of its stock.  Government later injected another $38 billion into the company.  In effect AIG, along with Fanny Mae and Freddy Mac were nationalized. 

Lehman Brothers, one of the oldest and largest banks in New York, went bankrupt on September 15, 2008. While most other financial sector giants were rescued, none came forward to save Lehman Brothers.  It was a great fall.  The collapse of Lehman Brothers had a multiplier effect across the world. It weakened several big banks and put the fear of god into the global banking industry.  The credibility of the whole banking system was called to question.

By late November 2008, Citigroup, the world’s largest bank was trembling at its foundations in spite of $25 billion in TARP funding.  The stock market value of the group tanked from $244 billion two years ago to just $21 billion. The company laid off 75,000 of its employees in 2008.

Washington Mutual was the sixth largest US bank with an asset base of $310 billion. It went bankrupt after customers queued up to withdraw $17 billion in a few days. Stockholders of the bank lost everything.  Eventually the US government took it over through FDIC and resold it immediately to JP Morgan Chase, the biggest New York bank. The failure of Washington Mutual is considered, by far, the largest commercial bank failure in American history.

Fortis bank was ranked as world’s 20thbusiness in size. In 2007 when the financial markets were at its peak, Fortis borrowed heavily to finance its $100 billion takeover of its rival ABN Amro. A year later, Fortis discovered that it had no means to repay what it borrowed.  The Dutch, Luxembourg and Belgian governments tried to save the bank by injecting $16 billion capital into the bank.  But in the face of steadily waning customer confidence, it was tough to keep the bank afloat. Eventually, the Dutch wing of the bank was nationalized by Netherlands. The rest was sold to the French bank BNB Paribas for 19 billion dollars.

The British Treasury had to take over Northern Rock, its largest mortgage company. Its total liabilities of over £100 billion were added to the British national debt. Royal Bank of Scotland, Bradford & Bingley, and Alliance & Leicester all came to the precipice. These were rescued by huge public funding.

Britain announced a gigantic £400 billion ($680 billion) rescue plan for its banks. Prime Minister Gordon Brown said banks would still be run by their old managers, but that the government would have to be “satisfied” on matters of salaries, dividends and lending activities. The money involved is about a third of Britain’s annual GDP (comparable to $5 trillion in the U.S. economy.)

The German government gave $68 billion bailout to Hypo Real Estate. The government of Iceland took over its large banks. Most of the European countries hurriedly announced guarantees of personal bank deposits to avert further drop in consumer confidence and runs (sudden withdrawal of deposits) on the banks. 

The European Central Bank aggressively lent money to banks trying to ensure availability of adequate cash. The moves did not impress depositors or investors. The fall of European stock markets was worse than the American stock markets. Other stock markets across the world too tumbled.  

“On October 13, France, Germany, Spain, the Netherlands and Austria committed €1.3 trillion euros ($1.8 trillion dollars) to guarantee bank loans and take stakes in banks, in an emergency effort to head off the collapse of their financial systems”. 

The crisis swept across the Middle East and Asia.  South Korea was the hardest hit. China, the world’s greatest growth machine slowed down. In November 2008, China’s government announced a spending of 4 trillion yuan ($586 billion) through the end of 2010 to stimulate its economy. 

The International Monetary Fund (IMF) calculated that the global financial crisis would produce $3.4 trillion in losses for financial institutions around the world by 2010. 

The crisis caused recession and a worldwide economic decline.  It was the worst in the last eighty years. November 2008 saw 533,000 jobs disappear in the worst one-month decline in 34 years. As of 2013, there were still 4 million fewer jobs in the U.S. than in 2008.  This is in spite of a $5 trillion in Federal stimulus spending.

 “U.S. households lost on average nearly $5,800 in income due to reduced economic growth during the acute stage of the financial crisis from September 2008 through the end of 2009. Costs to the federal government due to its interventions to mitigate the financial crisis amounted to $2,050, on average, for each U.S. household. Also, the combined peak loss from declining stock and home values totalled nearly $100,000, on average per U.S. household, during the July 2008 to March 2009 period”, says one of the studies undertaken on the consequences of the 2008 crash.

Huffington Post says in an article written by Eleazar David Melendez that according to a study by the Government Accountability Office (GAO), the 2008 financial crisis cost the U.S. economy more than $22 trillion.  “The 2007-2009 financial crisis, like past financial crises, was associated with not only a steep decline in output but also the most severe economic downturn since the Great Depression of the 1930s”. The agency said the financial crisis toll on economic output might be as much as $13 trillion; Paper wealth lost by U.S. homeowners totalled $9.1 billion. Economic losses associated with increased mortgage foreclosures and higher unemployment since 2008 need to be considered as additional costs.

Let Us Summarize

The US financial system crash was building up for a long time before it actually struck. With the Federal Reserve maintaining the interest rates unacceptably low for an unduly long period, investors looked for securities with better returns. Certain government policies to improve the housing situation in the US encouraged people, who had no capacity to repay, go for housing mortgages. These mortgages were converted into Mortgage Backed Securities that promised returns much higher in comparison to the ruling interest rates.  The assumption of ever-rising real estate prices provided the assurance to all that mortgage backed securities could never fail. Investors considered MBS an absolutely riskless investment option.

A subprime mortgage market evolved when people who had low credit scores had to be made eligible for housing loans. But the lenders charged higher processing fees, interest rates and applied risky interest schemes. When these mortgages were securitized in to MBSs it seemed to offer better returns with very low risks. Such higher returns increased the demand for subprime MBS. The existent system had to be tweaked to make ineligible borrowers eligible for housing mortgages so that enough subprime mortgage based securities could be created to meet the burgeoning demand for it in the market. More and more mortgages were produced by progressively diluting lending standards. People were often lured into debt traps through promises of easy and innovative means of repayment. The government and the public sector systems went more liberal to fuel the burning greed.  Lenders doled out loans to all and sundry. Junk securities were created and put into the market. Credit Rating Agencies put their stamp of high safety on these worthless papers. Drooling investors lapped it up with ecstasy.

Government and private institutions went merry providing guarantees and insurances with blissful abandonment. The whole euphoria was an unsustainable bubble. But everyone was on cloud nine and did not care. Many who realised the danger kept quiet since their own profits depended on it. A few called foul. They were crushed. It was big time for all. Home prices soared. Cash-out refinancing scaled new heights. Institutions in the financial sector were making gigantic killings on the Wall Street. As an article on the topic says,  “In a bid to drive revenues and stock prices higher, many financial institutions went on lending binges – reducing loan standards excessively and rewarding executives for closing deals without regard for how the transaction worked out in the long-run.”

But the happy days did not last long. “The predictable longer-term result was too many bad loans and record defaults by a wide range of borrowers – from individual homeowners to market speculators and even governments – who had taken on more debt than they could.”  Eventually defaults and foreclosures started. It started as trickle and soon turned a deluge. Millions of houses were put for sale. House prices plummeted. The housing mortgage bubble went bust. The securities that investors held became worthless. They ran to their insurers and guarantors who had no means of honouring their commitments. It set off a chain reaction. Several companies went bankrupt. Other teetered on the brink of annihilation. It was blood and mayhem on the Wall Street.  Government pumped public money in trillions in to the system to prevent a complete and calamitous washout of the global financial system. And its aftershocks are yet to die down. And in the end, plain citizens paid for the greed and folly of a gang of marauding corporate honchos and a governmental system that danced to their beguiling tunes.

Conclusion

There were many actors playing their parts in contributing to the catastrophe. Some of these came from the public sector and others belonged to the private sector. But it often appeared that the public sector was actually acting at the behest of the private sector rather than keeping vigilance over public funds and citizen’s interests. They went ahead relaxing rules, diluting standards and pushing lending to a level that ripped the entire financial system apart. They acted deaf and blind in spite of the clear warning signs of an impending disaster. It is obvious that there was hard lobbying and the insatiable greed for quick and colossal gains. And everyone seemed to be insanely scrambling for a piece of the delectable housing mortgage pie.

The bubble was built up on the belief that real estate prices could never fall. Consequently, bundled subprime mortgages were overvalued. There were questionable trading practices. Corporate compensation structures were skewed for short-term gains over long-term value creation. An abundance of mortgage based securities unsustainable for the financial system. And banks, security dealers and insurance companies were rushing after debt without bothering about liquidity to back their commitments. Everyone was excited, everyone was turning adventurous and everyone was walking on air. That included the government, the legislature and the regulator.

There are no two opinions on the fact that the whole calamity was the consequence of the rabid hunger for making more money and making it easier and faster. In other words, the entire subprime mortgage euphoria and the huge bubble it had created were simply the product of the ‘get rich quick my any means’ philosophy of the twenty first century.

The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that “the crisis was avoidable and was caused by: widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; an explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels”.

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Introduction to Mortgage Backed Securities

ANNEXURE

Mortgage

Assume that you wish to buy a house and do not have enough money to make the purchase. You approach an institution like a bank, for a home loan. Your plan is to borrow money, buy the house and repay the loan (principal) along with its interest in instalments in the long term in future. The person taking the loan is the ‘borrower’. The entity granting the loan is the ‘lender’.

The borrower enters into a contract with the lender to obtain the loan. The basic goal of the contract is ensuring that the borrower repays the loan strictly in accordance with the prescribed repayment schedule.  If the borrower fails in his repayment (defaults), the lender can seek legal remedies for breach of contract. But the lender has little desire to spend time and energy fighting court cases. So, the lender requires that some asset of value corresponding to the loan be pledged to the lender as security.  In the case of housing loan, the asset pledged is generally the house procured by the borrower using the loan. This is termed the collateral.

So, collateral is an asset belonging to the borrower over which the borrower gives control to the lender as a security against defaults by the borrower.  And a loan given on the strength of collateral is a ‘mortgage’Thus, a mortgage is a loan given by a lender to a borrower on the security of collateral. 

Classification of Mortgages

As we all know, lenders have to ensure that the sum they give out as loan is repaid along with interest by the borrower. Of course, the lender can always use the collateral to recover its loan. But the lender would like to avoid default situations and the complications arising out of it. So, before the loan is granted, the lender would ensure that the borrower has the capacity to repay the loan as per the terms of the mortgage. The evaluation of the borrower’s capacity to repay is done by obtaining the details of the borrowers’ wealth, employment, income, other loans and liabilities, credit histories etc. Often such assessments are done by independent professionals or institutions who give a credit score (as a number value) for the borrower. Higher the credit score, better the assurance on repayments. Based on the borrowers’ credit scores, mortgages are classified into three groups as Prime, Subprime and Alt-A mortgages.

Prime Mortgage

A mortgage classified as Prime Mortgage indicates that the borrower is financially sound and holds a clean credit history (no defaults on earlier loans, if any). Thus, in the case of prime mortgages, the risks are negligible for the lender. Therefore, terms and conditions applicable to such mortgages are comparatively liberal. The interest rates and interest options too are easier and more attractive. (Prime mortgage interest rates are often the rates at which banks and other mortgage lenders lend money to customers with the best credit histories). The other costs applicable for the mortgage would be lower and foreclosure penalties (charges for closing the loan before it runs its term as per the agreement) lighter.

Subprime Mortgage

Subprime mortgages are offered to borrowers whose capacity to repay the loan is unsatisfactory because of the financial background and credit history of the borrowers.  Their credit scores are poor. The risk profile of the mortgage is high.  Subprime mortgages carry higher interest rates to compensate for the higher risks involved. These are mostly adjustable rate mortgages (ARMs) where interest rate on the mortgage will change corresponding to changes in the market rates. ARM may significantly increase the interest burden on the borrower over time.

‘Alt-A’ Mortgage

These are mortgages where the risk profile lies between that of prime and subprime mortgages. The borrowers generally have clean credit histories.  But the mortgage itself may have some problems like a higher loan-to-value ratio (say a loan exceeding 100% of the value of the asset) or debt-to-income ratios (say, an annual repayment liability of 50,000 against an established annual income of 50,000),that aggravate the risk profile of the loan. Such mortgages are attractive for lenders since they can levy higher interest rates and other charges, although the risk profiles of the borrowers are often better compared to subprime mortgages.

Mortgage Backed Securities

Let us remember that a mortgage is essentially a loan that gives a right to the lender over the asset pledged as collateral. The mortgage is represented by the contract (Mortgage Deed) between the borrower and the lender. A mortgage has a value defined by the future instalments of repayment to be received from the borrower. In the event of default, this value of the mortgage shifts to the collateral.  Thus, a mortgage has a value that is finally determined by the collateral.

The process of originating a mortgage may be summarised as follows:

A mortgage deal is executed, the lender pays money to the borrower, the borrower buys the house using the money and pledges it to the lender, and in due course, the borrower repays loan in instalments along with interest. The mortgage is released.  The house now becomes the exclusive property of the borrower.

Now, there are at least two options before the lender with regard to the mortgages it creates. One is that the lender keeps the mortgage and recovers the loan through the repayments made by the borrower in the long term. This would mean that the lenders’ money (funds) remains locked up in the mortgage and would come back to it only in instalments in the course of the next 20-30 years. But no business would like to keep money so locked up, if it can help it.  So, the second choice for the lender is to sell the mortgage so that it can receive the value of the mortgage immediately and use that money to create new mortgages. And there are institutions operating in the mortgage market that buy mortgages.  Let us call them as Securitizing Institutions (SIs).  The SI may be a government, quasi-government or private entity.

What does the SI do with the mortgages it buys? One option for the SI is to keep the mortgages and collect the repayments routed to it by the originators of the mortgages (lenders) in the long term. But the SIs too would not relish waiting for their money to come trickling to them in the next 20-30 years. Just as the lenders, the SIs too would like to exchange the mortgages for recovering their investments immediately. Obviously, they cannot sell it in its original shape. It has to be reshaped. The reshaping of the mortgages is carried out using what is considered the greatest financial innovation in the 20th century called securitization.

The securitization process runs something like this.  To start with, the SIs pool the mortgages they have purchased by putting together mortgages having identical features like interest rates, maturity periods etc. into groups. The pooling is expected to bring down the risks inherent in individual mortgage since the pool is the aggregate of a large number of mortgages originated by multiple lenders with multiple classes of borrowers from various geographic locations. The mortgage pools so created are then (theoretically) sliced into pieces. Each of these pieces represents a corresponding value of the principal and interest payments due on the mortgages forming part of the pool. These pieces are fashioned as securities and sold in the market. This process of converting the pools of mortgages into marketable pieces is called securitization of the pool. Those investing in these securities are promised periodic returns that are based on the repayments made on the mortgages by the borrowers. People invest in such securities since the returns are much higher than what can be earned through other investments.

The process securitization is a purely theoretical exercise. It does not directly change anything about the mortgages purchased by the SIs.  The SIs may simply issue a certificate against each hypothetical slice of the mortgage pool evidencing the participation of the investors in the returns from the pool. (There are more complex ways of securitization, a discussion on which is beyond our scope.  Each (participation) certificate so issued and sold represents the value of a piece of the pool to which it belongs.  Using the sales proceeds of the securitized mortgages, the SIs buy more mortgages, pool them, securitize them and sell them… and the cycle continues.

The reader may see that the value of the securities created out of mortgage pools lies in the mortgages.  The value of the mortgages lies in the repayment instalments to be received from the original borrower, in the long term. The assurance on the repayments related to the mortgage lies in the collateral.  Thus, the securitization of the mortgage pools creates a marketable financial instrument (like a Participation Certificate), the value of which is derived from the underlying collection of mortgages.  The technical term used to denote a marketable financial instrument that derives its value from its underlying asset is derivative.  Since the value for these securities (derivatives) arise from its underlying mortgages, these securities are called Mortgage Backed Securities (MBSs)

The borrower does not know or concern himself with the sales or securitization of his mortgage. His deal is with the lender. So, the borrower pays his mortgage instalments to the lender. The lender keeps a small part of the instalment payments as compensation for its services as the originator of the mortgage.  The sum so deducted is termed as fee or spread.  The balance sum is transferred by the lender to the SI to whom the mortgage was sold.  But the value in the mortgage is no more held by the SI since it has been securitized and sold to investors.  The SI keeps a part of what it receives from the lender as its own spread and transfers the balance to the credit of the investors participating in the MBS.

The ultimate outcome of all these operations is that the loan given to the borrower comes neither from the originator of the mortgage (lender) nor from the buyer of the mortgage (SI).  The money comes out of the pockets of investors in the MBS. The lender and the SI collect a sum as fee for their services. The assurance for the investor for the safety of the money invested in MBS comes either from government guarantees in the case securities issued by GSEs.  In the case of Securitizing Institutions in the private sector, the guarantee comes from underwriting/insurance institutions. The credibility of private label securities is evidenced by the rating given to it by the Credit Rating Agencies.
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