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How We Were Ruined & What We Can Do

The Reckoning

a series of articles by Gretchen Morgenson et al.
The New York Times, September 28–December 28, 2008

Charles Morris’s informed and unusual book, The Trillion Dollar Meltdown, provides a decisive rebuttal to all such excuse-making and blame of “government.” Morris makes it clear that it was an unquenchable thirst for easy profits that led commercial and investment banks in the US and around the world—as well as hedge funds, insurance companies, private equity firms, and other financial institutions—to take unjustifiable risks for their own gain, and in so doing jeopardize the future of the nation’s credit system and now the economy itself. In fact, government-sponsored entities, Fannie Mae and Freddie Mac, did have a part in the crisis, but not because they were principally trying to help the poor buy homes. Rather, they were also trying to maximize their profits and justify large salaries and bonuses for their executives. They had been made into publicly traded companies in 1989.

It would be wrong to conclude, however, that the new investment vehicles and intricate strategies for “securitization” that developed in the last thirty years had no value. Beginning in the late 1970s, the practice of packaging mortgages together and marketing them as so-called “collateralized debt obligations” was initially designed with the sensible aim of spreading the risk of making loans, particularly residential mortgages, by selling them to many kinds of investors throughout the US and eventually around the world. If many parties share the risk, this lowers the cost of borrowing and enables more people to buy homes and businesses to invest more in research, plants, and equipment.

But over the last two decades, this innovative system was exploited to stunning excess. Charles Morris is one of the observers who, contrary to Rubin’s claim that no one foresaw the current crisis, anticipated that the increasing gathering of mortgages into highly attractive investment devices had made the financial system dangerously vulnerable. A former banker himself, and author of several excellent books on finance over the past thirty years, Morris has described the intricacies of the American investment world as clearly as anyone. At the time of his latest book’s publication at the start of 2008, it seemed far-fetched for him to say that the cost of the financial meltdown throughout the world was a trillion dollars. In fact, Morris may have underestimated the amount of financial damage. Estimates of losses by financial institutions now range between $1 trillion and $2 trillion.

Morris starts his account of the unwinding of the markets with the collapse of the housing market, as does Mark Zandi, a respected Wall Street economist, whose book Financial Shock is intelligent, useful, and a more recent if less detailed book on the crisis. But the crisis cannot be understood without looking back a couple of decades to the development and rapid spread of the investment technique on Wall Street of packaging loans, principally mortgages made by banks and savings and loan associations, into an investment vehicle in which pension funds, money managers, foreign governments, hedge funds, and others could invest. Securitizing residential mortgages in this way was especially appealing, in view of the size of the US mortgage market, which runs into the trillions of dollars.

There was a strong precedent. The Federal National Mortgage Association, or Fannie Mae, established in 1938, had been packaging federally insured mortgages since the 1970s and selling them to investors. It was joined by the Federal Home Loan Mortgage Corporation, Freddie Mac, started in 1970. The two government-sponsored organizations bought up many of the mortgages on the books of commercial banks and savings and loans, allowing them to write more such mortgages, thus making home ownership more widely available to Americans. Owning a home in America is an integral part of the nation’s promise. Even in the revolutionary years a far higher proportion of colonialists owned property than in the Old World. And today no transaction is more favored by income tax advantages, including the deductibility of mortgage interest, than the purchase of a home. Home ownership is the principal source of the typical American’s wealth.

But in the late 1970s, investment banks—Salomon Brothers in particular—discovered a profitable new source of business in these mortgage-backed securities and began packaging them in a way that made them more like conventional bonds, except that they paid higher interest. The most important breakthrough, says Morris, came in 1983, when an innovative banker at First Boston, Larry Fink, divided packages of mortgages into several different tiers of risk with appropriately graduated interest rates. These tiers are now called “tranches,” the French word for “portion” or “slice.” Fink’s innovation attracted many more clients, including pension funds and major money market institutions, to invest in mortgage-backed securities, and eventually the private market accounted for substantially more such securities than did the government.

The first tier—or some 60 percent of all the investors in a mortgage-backed security—was to be paid interest and principal fully from the monthly cash flows of the mortgage holders and was therefore best protected. But these investors received the lowest interest rate. The more subordinate tiers were paid off after this senior tier received its payments, and thus earned higher interest because of the higher risk of nonpayment. The lowest tiers were the riskiest, the so-called toxic waste, which would get money last, and therefore lose money first if there were unanticipated defaults. But these investors were paid two to three percentage points more in interest to take the risk. This toxic waste was typically bought by hedge funds, the aggressive investment vehicles that took higher risks to earn higher returns for their investors, and often borrowed liberally to increase their returns on capital even further.

For the banks and mortgage brokers who wrote the mortgage loans, the financial advantage was significant. They could now sell the mortgages they wrote almost immediately to packagers, often investment banks, earning a quick and very handsome fee—one half to 1 percent of the value of the mortgage—in the process. By selling the mortgage loans, the banks did not have to maintain capital requirements for those loans, requirements that were imposed internationally by the Bank for International Settlements in the 1990s. The banks and mortgage brokers were then free to make still more loans with the cash they got back from selling the packaged mortgages and quickly to earn another round of fees.

Homeowners also benefited significantly from the securitization. In response to the demand for mortgages by pension funds, investment managers, banks, hedge funds, and others across the globe, mortgages were easily granted; banks and mortgage brokers lowered the interest rates on mortgages charged to home buyers in order to attract more customers. It was principally the investor appetite for the mortgage-based securities and the easy profits made by the banks and mortgage brokers that led to the mortgage-writing frenzy in the 2000s, not encouragement by the federal government to lend to low-income home buyers.

Securitization of mortgages was not all. In the 1990s, commercial and investment bankers expanded the market for new forms of insurance, called credit default swaps, which would supposedly guarantee holders of mortgage-backed securities against losses incurred by defaults. These were complex transactions involving derivatives—investment vehicles such as options or futures contracts based on traditional stocks, bonds, and averages or indices of stocks or bonds. Such insurance protection encouraged investors, including hedge funds and commercial and investment banks, to be still more bold in packaging and investing in mortgage-backed securities. Now that many of these mortgages have in fact defaulted, whether most of the insurance claims on them will be met is still an open question. AIG, the giant insurance company that was rescued by the federal government in September, for example, backed many of these insurance products and may not be able to meet its obligations.

By the late 1990s, America’s credit system had changed radically. Enormous numbers of loans were held, not on the balance sheets of commercial banks or thrift institutions, which are regulated by the federal government, but in a rapidly growing “shadow” banking system of hedge funds and other unregulated investors in New York, London, and around the world. This shadow banking system in effect made the loans, but unlike commercial banks, which have reserve and capital requirements legally imposed upon them for activities on their balance sheets, and are also subject to Federal Reserve scrutiny, its capacity to borrow was by and large unrestricted. By the 1990s, securitizers, often investment banks and even commercial banks, were packaging not only residential mortgages but also equipment loans, commercial mortgages, credit card debt, and even student loans—known in general as collateralized debt obligations (CDOs)—and the shadow banking system was buying them. Morris writes that 80 percent of all lending by 2006 occurred in unregulated sectors of the economy, compared to only 25 percent in the mid-1980s.

The mortgages traveled such a long distance from institution to investor that no one was in personal touch with the actual mortgage holder any longer. Now, the likelihood of defaults was assessed not by someone who tracked a specific mortgage holder but by complex, computer-generated statistical models of the entire portfolio of mortgages. Like all such models, no matter how mathematically intricate, they required an estimate about the future based on the past—an estimate that was inherently incapable of adequately taking into account the consequences of a historically rare and therefore seemingly unlikely crash in housing prices.

In addition, the ratings agencies used these statistical models to award ratings to the mortgage-backed obligations sold to investors. The ratings agencies were paid by the commercial and investment banks, who sold the packages of mortgages according to their rating, and who invariably benefited more the higher the rating. The agencies now have much to answer for.

The recession of 2000 and the World Trade Center attacks of September 11 led the Federal Reserve under Alan Greenspan to cut its target interest rate, the federal funds rate, from 6.5 percent at the end of 2000 to 1 percent in 2003, the lowest since the 1960s. For major institutions borrowing was now almost free, but there was no commensurate increase in the federal scrutiny of the loans being made, a power the Federal Reserve had but that Greenspan foreswore. And investment banks, hedge funds, and even commercial banks through off-balance-sheet subsidiaries known as structured investment vehicles borrowed aggressively to invest in the mortgage-backed securities—sometimes their borrowings amounted to thirty or forty times capital. The structured investment vehicles, typically domiciled in the Cayman Islands, enabled the banks to avoid higher capital requirements placed on balance sheet loans and closer scrutiny by the Federal Reserve and other federal watchdogs.

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