In the early 2000s the US stock market experienced two economic downturns: The 9/11 terrorist attacks and the popping of the dotcom bubble. On Tuesday 11th September 2001, at least 2,996 people lost their lives in the deadliest terrorist attack in history. The effect on the stock market was drastic. The Dow Jones Industrial Average dropped 14% by the end of the week (the largest weekly loss in its history). The other major downturn was the popping of the dotcom bubble, which saw investors abandoning traditional valuation techniques and investing money into high risk internet start-ups, many of these companies went bankrupt and investors lost their shirts.
These two events combined created an anxiety in the market, professionally managed funds and retail investors alike withdrew from the conventional markets in search of safer returns. To avoid recession, the Federal Reserves decreased the cost associated with borrowing money thus increasing spending and investment. By the end of 2001 the Federal Reserves dropped interest rates to 1.75%, which at the time was on par with inflation 1.6%. This was the lowest interest rates had been since the late 1950s. Interest rates at this level led average people to become avid property investors. Taking out loans and investing in real estate appeared to be low risk as property prices were constantly rising.
Mortgage backed securities
Anyone who has seen The Big Short will know that Lewis Ranieri is the father of the Mortgage Backed Security. Ranieri is said to have coined the term securitization, and BusinessWeek have referred to him as one of the greatest investors of the past 75 years. Interesting note: he started his banking career in the mailroom of Salomon Brothers.
What made Ranieri famous was his idea of securitizing mortgages. The process goes like this: A mortgage broker will lend money out to a person buying a house, the borrower (called a mortgagor) gives the broker a mortgage note. This document obligates the mortgagor to pay back the loan plus interest to whoever holds the mortgage note. The mortgage broker can sell the mortgage note to anybody, for example an investment bank. The investment bank assigns the mortgage note to a Special Purpose Entity (SPE). The SPE is simply a company created for a very narrow purpose, usually companies will set them up to avoid tax, or enhance their balance sheet by hiding toxic assets. In this case the SPE is assigned the mortgage notes, meaning when people pay their mortgages, they are giving this SPE their money. Investors can buy shares of the SPE like any other company. The shares are known as Mortgage Backed Securities. The SPE issues dividends which are roughly equal to the mortgage payments coming in. The investment bank profits by selling shares in their newly created SPE on the open market. Mortgage Backed Securities offer investors a reasonable return on investment, but their real attraction is their low risk profile.
Collateralized Debt Obligation (CDO) is a derivative of the above process. Like a Mortgage Backed Security, the bank sets up a SPE and assigns it mortgages. The bank will divide the mortgages into different tranches based on the risk of the mortgagor defaulting. The investment bank then markets these different tranches to investors based on their risk preferences. For example, pension funds are heavily regulated with regard to the amount of risk they can take. CDOs give pensions funds a way to invest in mortgages without buying risky Mortgage Backed Securities.
Upon closer inspection, a dangerous feature of the securitization of mortgages becomes apparent. The mortgage broker has little incentive to ensure that the person who is applying for the mortgage is capable of paying it back. If the mortgage holder defaults, then the pension fund (or anyone else who bought MBSs or CDOs) is left holding the bag. Taking this idea to its logical extreme; mortgage brokers will give loans to people with no jobs, no stable income and even engage in predatory lending practices, such as luring people into loans with a teaser interest rate which will then be increased dramatically in the future.
The investment banks also have no incentive to ensure that the mortgage sold to them is going to be paid back, as they can sell the mortgage on once it has been securitized. The investment bank’s sell side analysts advise customers to buy these Mortgage Backed Securities and CDOs. In some cases investment banks knowingly sold CDOs which they knew were bad investments. During an investigation into Goldman Sachs after the 2008 financial crisis, internal emails were uncovered about their top selling priority being “one shitty deal.” When David Vanier, CFO of Goldman Sachs was asked about this by the US Governmental Affairs Subcommittee on Investigations, he testified “that’s very unfortunate to have on email.”
Investors may be sceptical of an investment bank’s sell side analysts but would feel confident in investing in a CDO because a reputable ratings agencies (such as Fitch), had rated the mortgage backed security AA. As the 3 main credit ratings agencies are competing with one another, there is an incentive to keep their customers (investment banks) happy by giving their products (MBS and CDOs) positive, potentially exaggerated ratings. It’s interesting to note that Moody’s (the largest of the big three ratings agencies) quadrupled their profits between 2000 and 2007.
Betting against the housing market
Derivatives are simply financial contracts that are derived from an underlying asset. A forward contract is the simplest derivative to understand: A forward contract is an agreement between two people to trade an asset at a certain price on a specified date in the future. Forwards have been around for millennia; the ancient Greek philosopher Thallus would purchase the rights to use an olive press weeks before harvest. The contract itself cost him far less than buying a physical olive press. If the olive harvest was good that year, he could sell his right to use the olive press for a higher value than what he bought it for. If the harvest was poor, then he could not sell his contract, but he would only be down a small amount of money. Now fast forward to the present day and financial derivative products can be incredibly complex. For example; Knock in Bermudian options, which is an option that can only be activated on certain days, and the price of the underlying asset must be trading above a certain price on that day.
There are 2 main derivatives which brought the financial crisis to a catastrophic level. Synthetic CDOs and Credit Default Swaps:
Firstly, Credit Default Swaps were first devised by Blythe Masters in 1994 while she was working at JP Morgan. Credit Default Swaps are simply an agreement between two counterparties where, in exchange for a premium, one party will guarantee any loss in value of an underlying asset, called the reference obligation. It’s helpful to draw comparisons between Credit Defaults Swaps and home insurance. In exchange for a yearly premium, an insurance company covers your loss if your house (the reference obligation) burns down. The key difference is that anyone can buy a Credit Default Swap, essentially buying insurance on a house they don’t own. Credit Default Swaps are traded Over the Counter (i.e. they’re not openly traded on exchanges), this makes it extremely difficult to regulate or even estimate the total value of CDS in the economy.
The second derivative are Synthetic CDOs. Synthetic CDOs are CDOs of Credit Default Swaps. The process is similar to how a bank normally creates a CDO but instead of buying mortgage notes from mortgage brokers and assigning them to a SPE, they buy the rights to collect premiums on Credit Default Swaps from insurance companies, they then assign these rights to a Special Purpose Entity.
Essentially, Synthetic CDOs offer investors a way to act as an insurance company and profit from premiums coming in. In doing so, investors are liable if the underlying asset insured by the Credit Default Swaps decreases in value. The riskiest tranche is known as the Equity tranche, which will usually be bought by hedge funds. The least risky is known as the senior tranche, which is marketed towards pension funds. Senior tranches were often rated triple A, the same risk rating assigned to US treasury bills, which the United States has never defaulted on.
Why it collapsed when it did
The Federal Reserves raised interest rates in 2006 to 5%. Those who were on tracker mortgages, where the interest rate on their mortgage is simply the Federal Reserve interest rate, plus a fixed amount, found themselves unable to pay their mortgage and defaulted. Similarly, people who had been on a teaser rate were now having to pay a higher interest rate, so they too defaulted. Due to reckless lending practices there were people with no stable income who had multiple mortgages, as such many homes went up for sale simultaneously. The market was flooded with supply driving the price of real estate down. Even people who could afford to pay their mortgage defaulted, asking “what’s the point in paying a $1 million mortgage when the house is now only worth $650,000?”
When foreclosures began increasing, banks ramped up selling Mortgage Backed Securities and buying Credit Default Swaps to clear their balance sheets of these now toxic assets. On the stock market, investors played hot-potato with each other, selling off their MBS and CDOs at a large discount in order to recoup their losses.
Lehman Brothers, which was the leading investment bank in underwriting of Mortgage Backed Securities, made history on the 15thSeptember 2008 with the largest bankruptcy ever. For context Lehman Brothers, was a 158-year-old bank with over 26,000 employees. As of late 2018, Facebook has 30,000 employees.
People who bought shares in Lehman, which was rated AA by Moody’s in the months leading up to their bankruptcy, lost their entire investment.
Where were all the economists?
UCD Professor of Economics Morgan Kelly, correctly predicted the Irish property bubble in his 2006 Irish Times article. Professor Kelly noted how rents had been in decline since 2000, but house prices were still on the rise, demonstrating that people were not buying for the purpose of living in the house, but to profit from the capital gain of selling the house later for a higher price.
With all due respect to Professor Kelly, it’s incredulous to believe that he was the only economist to see this coming. This begs the question: Why did many academics choose to stay silent? Harvard Economics Professor Martin Feldstein (once considered the favourite to succeed Alan Greenspan as Chairman of the Federal Reserve) chose not to make any publications about the 2008 crisis. It is worth noting, he was a member of the board at AIG Financial Products. Many other academics were either directly employed by, or on the board of various investment banks, which raises questions of conflict of interest between their professional lives and their academic research?
Certain members of academia may have been chosen to stay silent, but there were plenty of others who warned of the impending crisis. In 2004, the FBI reported that there was an epidemic of fraudulent mortgages. In May 2007, hedge fund manager Bill Ackman published a presentation called “Who is holding the bag?”
It would be remiss not to mention “The Greatest Trade Ever”, where John Paulson made $15 billion over the course of the crisis, $1.25 billion of which in just one day! Other hedge funds that profited from the crisis include: Front Point, Scion Capital and Cornwall Capital.
When it’s all said and done.
Who is to blame for all of this? Strong arguments have been made that various institutions bear the blame for the 2008 crisis.
Many will blame lending firms such as Countrywide (the largest subprime mortgage broker during the crisis) arguing that they are the root cause of the crisis. If it weren’t for their reckless lending practises, which allowed for people with no proof of income to own multiple properties then the 2008 crisis would’ve never happened. An additional point being made against these firms; by giving out mortgages with little to no customer due diligence, lending companies created opportunities for criminals to launder money through property.
Some will argue that investment banks have no regard for ethics, when they knowingly sell investors “shitty deals”. Although some have rebutted this argument, highlighting that investment banks work as market makers, and market makers simply act as a medium for supply and demand, regardless of what the underlying trade is.
Others still, will blame ratings agencies for giving favourable ratings to undeserving products. Investors would have never wanted to buy these products if they had been rated correctly.
The US government (namely the Clinton administration) get their share of the blame for repealing the Glass Steagall Act, which was enacted after The Great Depression to stop banks from speculating on markets with customer deposits.
The Securities Exchange commission lifted legislation on the maximum leverage banks could have. Some believe this was a recipe for disaster. However, these arguments face opposition from those who say the government was being lobbied heavily by investment banks.
Blame has been put on the Chairman of the Federal Reserve; Alan Greenspan. Greenspan was an admirer of Ayn Rand’s libertarian philosophy and strongly opposed regulation of financial markets. Perhaps if he had been more proactive in his role as Head of the Central Bank, the crisis could have been less severe, if not avoided entirely.
It is easy to get caught up in laying blame, but I think it’s important to commit to memory the effect this crisis had on average people. To quote a 2009 study entitled Losing Life and Livelihood: A Systematic Review and Meta-Analysis of Unemployment and All-Cause Mortality; “unemployment is associated with a 63% higher risk of mortality in studies controlling for covariates”. With that in mind, the unemployment rate went from 4.4% in 2006 to 10% in 2010. As US consumers stop spending the crisis spreads across the world. Over ten million workers in China lost their jobs. Even more concerning, according to The Centre on Budget and Politics Priorities; compared with 2007, the number of families entering New York City homeless shelters in late 2008 jumped by 40 percent. In Connecticut, family homeless shelters turned away 30 percent more families due to lack of bed space.