The Roots of the Crisis
How did Wall Street get into this mess?
Michael Flynn
October 1, 2008
The unexpected 228-205 defeat of the housing bailout in Congress yesterday threw a curveball across Wall Street. It contributed to a large sell-off on Wall Street, where the bailout had already been "priced" into the market. The Dow shed just over 6 percent, the 18th largest drop in its history. But given the dire warnings about financial chaos that would result unless there were a bailout, this seems fairly modest.
Let's be clear: This is a Wall Street crisis, not a national economic crisis. The overall economy, while a bit weak, is still growing. Some politicians are comparing the current environment to the Great Depression. But in 1932, when the federal government last moved to bail out the banking sector, economic output had fallen 45 percent and unemployment was a staggering 24 percent. Today, economic output is actually up and unemployment is a historically modest 6.1 percent.
The overall economy doesn't even face a liquidity crisis in the current turmoil. Consumer, commercial/industrial, and real estate loans are all up over last year. Main Street is doing fine. The liquidity crisis is confined to Wall Street, between and among investment banks, insurance and securities firms, and hedge funds. There is the possibility that the contagion could spread, but in a global capital market, this is hardly certain.
It is the intersection of several underlying trends that have brought us to this point, not a breakdown in any specific part of the financial sector. The fundamental flaw with the bailout approach is that it ignores these trends and simply seeks to shore up the finances of certain Wall Street institutions.
Mortgage-backed securities (MBSes) are the principal source of pain in the current environment. Investment houses would bundle individual mortgages from several banks together into a bond-like product that would be sold to individual investors. Mortgages have historically been seen as among the safest investments. In an era of rising house values, "safe" became "guaranteed returns."
One of the major factors pushing investors into these securities was the Federal Reserve's weak money policy. Immediately after the terrorist attacks of 2001, the Fed began a sustained period of easing interest rates. Its efforts went so far that, at one point in 2003, we had effectively negative interest rates. Institutional investments needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on treasury notes.
In the early years of this century, mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. There was a lot more money available to underwrite mortgages. At the same time, investment houses were looking to replace the healthy fees earned during the dot com bubble. MBSes had fat margins, so everyone jumped into the game.
The additional capital to underwrite mortgages was a good thing...up to a point. Homeownership expanded throughout the decade. Over the last few decades, the American homeownership rate has been around 60 to 62 percent. At the height of the bubble, homeownership was around 70 percent. It is clear now that many people who got mortgages at the height of the bubble should not have. But Wall Street needed to feed the MBS stream.
At the same time, Fannie Mae and Freddie Mac were going through a crisis. In 2003 and 2004, an accounting scandal was revealed. The two public-private partnerships were cooking the books to show phantom profits. The Bush administration and its allies on the Hill pushed a strong bill to reform how these institutions operated. The measure came very close to passing, but Fannie and Freddie cut a deal. They would refocus on expanding mortgages for low-income borrowers if the feds kept out of their operations. The bargain worked. Virtually all the Democrats and a few Republicans backed the two companies and the reform effort failed.
Fannie and Freddie then went on a subprime bender. They made it clear that they wanted to buy all the subprime or Alt-A mortgages that they could find, eventually acquiring around $1 trillion of the paper. The market responded. In 2003 subprime mortgages made up less than 8 percent of all mortgages. By 2006, they were over 20 percent. Banks knew they could sell subprime products to Fannie and Freddie. Investments banks realized that if they laced ever increasing amounts of subprime mortgages into the MBSes, they could juice the returns and so earn bigger fees. The rating agencies, thinking they were simply dealing with traditional mortgages, didn't look under the hood.
Unfortunately, after several years of a housing boom, the available pool of households who could responsibly use the more exotic financing products had dried up. In short, there were no more people who traditionally qualified for even a subprime mortgage. However, Fannie and Freddie were still signaling that they wanted to buy these products. At the same time, activist groups were agitating for more lending to low-income families. Banks realized they could make even more exotic loan products (e.g., interest-only loans), get the activists off their backs, and immediately diffuse their risk by selling the mortgages into MBSes. After all, Fannie and Freddie would buy anything.
Everything worked as long as housing prices continued to rise. The most pessimistic scenarios on Wall Street showed a leveling off of housing prices; no one foresaw an actual decline in prices. Suddenly, though, there weren't enough buyers. In hot real estate markets, builders raced to bring inventory to market that they thought was inexhaustible. But at this point everyone (essentially) who could possibly qualify for a mortgage had received one. At the same time, the first wave of the more exotic mortgages began to falter. Interest rates on adjustable rate mortgages moved higher"the Fed was finally tightening the money flow"and mortgages that were initially interest-only were close to resetting, with monthly payments jumping to include principal. A not insignificant number of these mortgages moved into default and foreclosure.
The overall numbers moving into foreclosure were small. Someone simply looking at housing stats could be forgiven for wondering what all the fuss is about. Nationally, the number of mortgages moving into foreclosure is just around 1 to 2 percent, suggesting that 98 to 99 percent of mortgages are sound. But the foreclosed mortgages punched way above their weight class; they were laced throughout the MBS market.
Then the MBS market collapsed. The complexity of these financial products cannot be overstated. They usually had two or three "tranches," different baskets of mortgages that paid out in different ways. Worse, as they moved through the system"being bought and sold by different firms"they were sliced and diced in varying ways. A MBS owned by one firm could be very different when it was sold to another.
No one fully understood how exposed the MBS were to the rising foreclosures. The market for them dried up. No one traded them. The market became effectively "illiquid." American accounting standards, however, required firms to use "mark-to-market" to value their assets. This means that you value your assets based on what you could sell them for today. Because no one would trade MBSes, most had to be "marked" at something close to zero.
This threw off banks' capital requirements. Under U.S. regulations, banks have to have a certain percentage of assets to back up the loans they make. Lots of banks and financial institutions had MBS assets on their books. With these moving to zero, they didn't have enough capital on hand for the loans that were outstanding. They rushed to raise capital, which raised fears about their solvency and compounded into a self-fulfilling prophecy.
We should pause here to note that two simple regulatory tweaks could have prevented much of the carnage. Suspending mark-to-market accounting rules (you could use a 5-year rolling average instead, for example) would have shored up the balance sheets. And a temporary easing of capital requirements would have provided banks breathing room to sort out the MBS mess. Although it is hard to fix an exact price for these in this market, they aren't worth zero.
Alas, the Fed and the Treasury decided simply to provide the capital to meet the regulatory requirements. They moved into crisis mode, making a series of tactical moves to deal with specific, present challenges. The first misstep, in March, was to force a hostile takeover of Bears Stearns. The Fed put up $30-40 billion to back JP Morgan's takeover of the investment bank. In the long term, it probably would have been better to let the bank fail and go into bankruptcy. That would have set in motion legal proceedings that would have established a baseline price for MBSes. From this established price, banks could sort out their balance sheets.
It is worth noting that immediately after the collapse of Bears Stearns, rumors quickly circulated on the Street of trouble at Lehman Brothers. Lehman went on a PR offensive to beat back those rumors. The company was successful, but then did nothing over the next several months to shore up its balance sheet. Their recent demise was largely their own doing.
The collapse of the MBS market now started to pollute other financial products. (The Fed moves did nothing to deal with the MBS market, but simply provided temporary means to cope with it.) Credit default swaps and derivatives, both of which amount to hedges against the risk of bonds defaulting, came due. Suddenly, stable firms like AIG were overexposed. Insurance companies regularly sell these swaps, as an insurance policy against bonds defaulting. Traditionally they are fairly conservative investment products. These developments threw off the accounting in one division of AIG, threatening the rest of the firm. Given a few days, AIG could have sold enough assets to cover the spread, but iron-clad accounting regulations precluded this. So the government stepped in.
The one-two punch of Lehman's failure and the government's $85 billion bailout of AIG on September 16 seriously spooked the Street and the Bush administration. With Fannie Mae and Freddie Mac already in government receivership, there were fears that the MBS weakness would spread through the entire financial system. There was a big sell-off on the Dow. The next day, the government announced there would be a bold rescue plan. The market rebounded. Details emerged over the weekend. On Monday, the Dow had another sell-off. But, the most important signal was the rise of oil. The spot price for October delivery of oil jumped $25 a barrel. Some of this was covering trades, but a sizable amount of this appreciation was probably a "flight to quality," a place to park money while everything was sorted out. It was also a signal that the government's plan might not work.
The original plan crafted by Treasury would authorize the department to spend up to $700 billion to buy MBSes and other "toxic" debt and thereby remove them from banks' balance sheets. With the "bad loans" off the books, the banks would become sound. Because it was assumed that the MBS market was "illiquid," the government would become the buyer of last resort for these products. There is a certain simple elegance to the plan.
Except that no market is truly illiquid. It just isn't liquid at the price you want to sell. This summer, Merrill Lynch unloaded a bunch of bad debt at 22 cents on the dollar. There are likely plenty of buyers for the banks' bad debt, just not at the price the banks would prefer. Enter the government, which clearly intends to purchase MBSes at some premium above the market price. That was the nature of the bailout that failed on Monday.
Congressional leaders have vowed to bring a new proposal for a vote, possibly as soon as Thursday, proving yet again that Washington is fertile ground for really bad ideas. But with the market rebounding"as of this writing the Dow was up almost 300 points"and public opposition hardening, signs are emerging that banks are starting to clean house. The crisis may have already peaked. Of course, Congress' ability to further screw this up can't be overstated.
Mike Flynn is director of government affairs at the Reason Foundation.
