Some say the worst is over and it’s on to happy days for the US Economy. We all hope the happy days do come around for this country because its fortunes are inexorably linked to the financial health of the rest of the globe. The financial crisis that started in 2006 led to a recession which was the worst seen since the Great Depression of 1929. Everyone knows where the storm hit hardest: subprime mortgage. Was it the cause? Or was it just the result of factors with darker shadows and deeper roots?
Lest we forget, let’s revisit events and mileposts of the recent past to better understand how a lofty ideal like home ownership could produce such dire consequences.
Subprime mortgage defined
This type of mortgage is normally made out to borrowers with lower credit ratings. Conventional mortgage is not offered to these borrowers because they have a higher risk of not being able to repay a loan. The rate charged is often higher to compensate for carrying more risk. In plain language it’s lending to people who can barely pay, and making it difficult for them to actually pay. Strange but true.
The boom years
Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis. This fueled a housing market boom and encouraged debt-financed consumption. Home ownership rate increased from 64% in 1994 (a rate which held steady since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Everyone was in denial about the housing bubble. Fed chair Alan Greenspan called it impossible (he later retracted).
Home ownership mania
Americans have an inordinate appetite for home ownership, even when rental rates were much cheaper than mortgage premiums. Some blame the Bush-era mantra of an “ownership society.” The Wall Street Journal maintains that this mania was fueled by political interests. Beginning in 1992, and for many years thereafter, Congress pushed Fannie Mae and Freddie Mac (government sponsored enterprises GSE that purchase mortgages, buy and sell mortgage-backed securities, and guarantee nearly half of the mortgages in the U.S.) to increase their purchases of mortgages going to low and moderate income borrowers. In compliance, both funded hundreds of billions of dollars of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.
Big spenders, big debt
As housing prices increased, consumers were saving less while borrowing and spending more. Household debt grew from $705 billion in 1974 (60% of disposable personal income), to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, which was unbelievably 134% of disposable personal income. Fareed Zakaria narrates: “Two decades of easy money and innovative financial products meant that virtually anyone could borrow any amount of money for any purpose. If we wanted a bigger house, a better TV or a faster car, and we didn”t actually have the money to pay for it, no problem.”
Lenders stalk limping prey
All the excitement caused by rising home prices set the ordinary consumer up for exploitation by predatory lenders. The most likely targets of predatory lenders are the less educated, the poor, racial minorities, and the elderly – people who are already disadvantaged to begin with and are pushed into graver circumstances by subprime mortgages. Credit ratings were ignored. People who could ill-afford it were enticed to buy homes, and were charged exorbitant rates because of the risk involved.
How the stage was set
Barry Ritholtz of Washington Post presents several events the contributed to the crisis. The Glass-Steagall legislation, which separated regular banks and investment banks was repealed in 1998. This allowed banks, whose deposits were guaranteed by the FDIC, i.e. the government, to engage in highly risky business. In 2000, the Federal Reserve dropped rates to 1% and kept them there for an extended period. Low rates meant asset managers could no longer get decent yields from municipal or treasury bonds. Instead, they turned to high-yield mortgage-backed securities – assets based on claims to the expected cash flow from the payment of mortgage loans.
Shadow banking system bets on debt derivatives
In plain language, debts (mortgages) were bought and sold as derivatives — complicated financial products that derive their value by reference to an underlying asset or index. Kimberly Amadeo of About.com explains how it works.
- A bank makes an interest-only loan to a homeowner.
- The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.
- Fannie Mae resells the mortgage in a package of other interest-only mortgages on the secondary market. This is a mortgage-backed security (MBS), which has a value that is derived by value of the mortgages in the bundle.
- Often the MBS is bought by a hedge fund, which then slices out portions of the MBS, for example the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
In fact, very few people really understand the intricacies of derivatives, and to what extent the slicing and dicing goes inside the shadow banking system (SBS) – a collection of non-bank financial intermediaries that provide services similar to traditional commercial banks. The SBS includes entities such as hedge funds, money market funds and structured investment vehicles. Investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), but most are generally not classed as SBS institutions themselves.
Out of the shadows and into the spotlight
Ritholtz proceeds to detail the events surrounding the decision by fund managers to cash in on MBS. Credit ratings agencies gave an AAA rating on these junk mortgage-backed securities, claiming they were as safe as U.S. treasury bonds. Fund managers relied on these ratings, failed to do adequate due diligence before buying them, and did not understand these instruments or the risk involved. The demand for higher-yields led Wall Street to begin bundling mortgages of which the highest yielding were subprime mortgages. This market was dominated by non-bank entities exempt from most regulations. Private lenders started ignoring traditional lending metrics such as income, credit rating, debt-service history and loan-to-value. Innovative mortgage instruments designed to capture the subprime prospects soon flooded the market — adjustable rate mortgages, negative amortization, interest-only loans, and piggyback loans. All of these were extremely difficult to honor, and had vastly disproportionate default rates compared to traditional mortgages. Banks wanted in on the action, too, and employees were compensated on the basis of loan volumes closed, not quality.
Real estate downturn sends early warning signals
In December of 2006, the Commerce Department reported that permits to build new homes were down 28% from the previous year. The real estate industry is a leading indicator of the US Economy and contributes about 10% to the gross domestic product. It is a major source of employment and, consequently, consumption. Any movement in the real estate industry will have repercussions for the rest of the economy. The figures were alarming, but no fingers were pointing to subprime mortgages at that time. The major concern was that the decline in real estate sales could lead to a decline in home prices. However, the defaults on mortgages had already begun.
Hedge funds take a hard blow
In March of 2007, Bloomberg reported that “the subprime lending industry is getting hammered, and hedge funds and investment banks are feeling the pain.” The crisis was on, and recession was not far behind. “The $1.3 trillion subprime mortgage industry has taken a violent turn: At least 25 subprime lenders, which issue mortgages to borrowers with poor credit histories, have exited the business, declared bankruptcy, announced significant losses, or put themselves up for sale.”
The downward spiral
Real estate prices began to drop steadily and by January of 2011, the Globe and Mail reported that the “plunge in U.S. home values reached 26 per cent in November, down from the June 2006 high. That”s a shade more than the 25.9-per-cent drop between 1928 and 1933,” the period covered by the Great Depression. As housing prices dropped, so did stock market prices. Retirement savings were hit hard, the auto industry suffered, and unemployment reached alarming levels.
As America sneezes
The impact was, of course, global because financial institutions with worldwide presence had huge exposures in the hedge funds that gambled on derivatives in the US subprime market. The International Monetary Fund estimated global losses resulting from the crisis at US$4 trillion.
Solutions to prevent a similar crisis from happening again are still being debated. Solutions to put America back on track were the pivot points in the 2012 elections. Clearly, the crisis was the result of an unfortunate confluence of factors whetted by greed and abetted by irresponsibility. Few escaped unhurt.
How were you affected by the crisis? Did you change saving and spending habits to cope? Share your story with us.
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