By Brian | October 7, 2008 | Share on Facebook
UPDATE: Those who find this post informative should also check out What Happened? A Summary of the Homeowner Affordability and Stability Plan, a similar analysis of President Obama’s plan to re-stabilize the mortgage market
When I was growing up, I remember being told that The New York Times was written at an elementary school reading level, so that any reader could understand it’s content. Now, living in the information age, where The New York Times has morphed into a plethora of newspapers, wire services, aggregation portals, blogs, 24-hour news channels and pundits, it occurs to me that they really do treat us like elementary school children – they speak in simple words, and they lie to us about complex subjects (the storks bring babies, Santa brings presents, stop that or you’ll go blind…) in order to hide the fact that they don’t know the real answer or to save themselves the trouble of explaining a series of uncomfortable details.
I say this as a 15-year veteran of the capital markets industry, an active investor, and an avid consumer of current events news. I say it today, in particular, because we’re going through one of those periods in history that my kids and grandkids will ask me about when they read about it in their textbooks (or whatever textbooks have become when they reach that age). I say it because the information coming from my commonly-used information sources has been so scrubbed, so watered down, so sanitized, and so reduced to inaccurate sound bytes and oft-repeated tag lines that I literally can’t watch it anymore. I’ve resigned myself to learning a college course’s worth of material during each eight hour workday, and then surfing the internet for Hollywood gossip and watching TV for sitcoms and cartoons. In times like this, one struggles to keep one’s sanity.
As you might expect, my friends and family have come to me frequently over the past few weeks with questions about what’s going on at work, and what’s going on in the financial sector in general. I’ve probably written around 5,000 words on the subject in the last couple of weeks, explaining basic terminology, squashing rumors, and reassuring people who are understandably flummoxed by the amazingly complex problem we’re all facing. I don’t claim to understand it all (people much smarter than I have, in the recent past, successfully proven that they don’t understand it all themselves), but I hope I can provide a basic primer to help navigate this ever-changing drama.
This lengthy post is intended to be that primer – a place I can refer people to rather than typing it over and over again in response to frequently asked questions. If you’re interested, I encourage you to click through and read it, and then e-mail me with questions or comments. As time permits, I’ll update it as we go with new information and correct errors that others find in my analysis.
Two warnings, though: first, this comes from me and from me alone. While I’ll do my best to remain factually accurate and politically dispassionate, no one should take this as a statement made by or on behalf of my employer. I haven’t vetted it with anyone at work, and I can’t say with any certainty that some of my colleagues wouldn’t disagree with all or part of it. Second, it’s rather long. I mention this not as an apology, but to reinforce what should be an obvious fact – complex situations require a lot of words to explain them. Our news media, pundits, and politicians have repeatedly tried to violate this basic axiom, and have failed repeatedly. There are no shortcuts here. Get comfy and read awhile. And when we’re done, maybe we’ll talk a bit about the Tooth Fairy and the Easter Bunny…
Background: The Housing Bubble
Where to begin? To understand how we got here, we need to review a little history. I’m going to start in the mid-90s with the economic boom we now know as the “dotcom bubble.” This is a fairly arbitrary decision since everything that happens in the world is influenced by what happened just prior to it (another fact that should be self-evident). Various politicians, past, present and future, will try to convince you that this whole thing started in 2001 or 2004 or 2006 or whenever. They are being just as arbitrary as I am, typically to serve their own purposes. I choose the mid-90s because you’ve got to start somewhere. No other reason.
In the mid-90s, the economic, political and technological stars aligned to produce an economic transformation like nothing this country has seen since we made the move from agriculture to industrial assembly lines. New companies were forming almost daily, and growing at unbelievable (and as was eventually proven, unsustainable) rates. Tens of millions of new jobs were created, inflation and unemployment remained low, and personal wealth swelled for many Americans. In record numbers, people with new-found cash began investing in ways they never had before. When Bill Clinton left office in January of 2001, he cited, among his major accomplishments, the highest percentage of stock ownership in our nation’s history as well as the highest percentage of home ownership.
Many people, some of whom had never been able to afford a home before, used the proceeds from their dotcom investments to buy new, and often expensive, homes. As home prices continued to increase, homeowners would “flip” their properties – selling their current home at a huge profit, and using the cash as a down payment on a larger, more expensive home. Terms like “foreclosure” and “default” were hardly considered, since the constantly increasing value of the homes made it easy to pay off debt – either through flipping, or by securing larger credit lines based on the (now) more valuable homes.
In March of 2000, the dotcom bubble burst. As stock prices returned to earth and money flowed out of the stock market, investors went in search of a new investment vehicle, and the rapidly growing real estate market became the investment of choice. Entrepreneurial investors switched from buying high-flying dotcom stocks to buying multiple, high-flying real estate properties, which they would then sell to willing homeowners who wanted to flip their current property for something newer/nicer/better. And so, born of a stock market bubble and fueled by it’s collapse, a real estate bubble was born.
The Bubble Grows: Predatory Lending and Mortgage-Backed Securities
While consumer banks had little connection to the stock market bubble, the real estate boom was a different story altogether. The sudden rash of home purchases meant demand for thousands of new mortgages, touching off a period of fierce competition. As banks clamored to win market share in this target-rich environment, they began to offer incentives, principally reduced short-term interest rates and relaxed background checks. The result was the now famous “sub-prime” mortgage, in which the bank would lend money to someone who didn’t meet the standard, minimum requirements for a mortgage. The loan would be an “adjustable rate mortgage,” or ARM, which started off below the prime rate (typically, at a level the customer could afford to pay each month), and then increase to a much higher rate several years down the line. The consumer was happy to take such a deal because, as the story went, by the time the higher rate kicked in, the house would be worth significantly more money, and the owner could either re-finance the loan with another variable rate deal, or pay the loan outright by flipping the house, leaving him/her with the profits to use as a down payment on a new, larger home (with a new, larger, variable rate mortgage, no doubt).
I pause here to recognize the first of several controversies to come out of this whole affair. Are the mortgage bankers guilty of excessive greed (a.k.a., predatory lending) for offering these ARM’s to customers who could not afford to pay the future, higher rate? Or are the consumers guilty of excessive greed for taking money that they knew they could not afford to repay? Or were they both blinded by the false promise of an ever-growing housing market, where no one ever had to pay back any loan, because the underlying asset (the home) would perpetually increase in value? As I said in the introduction, I will stick to the facts here and leave those conclusions to the reader. I hope, though, that with this background, you can at least see both sides of the argument.
Alas, the banks had a problem. Despite what you are likely hearing from the media or the politicians these days, banking is a very highly regulated industry. In addition to due diligence requirements such as BASEL-II, Sarbanes-Oxley, OFAC Screening and the USA PATRIOT Act (particularly Title III), banks are also bound by law to maintain a certain ratio of liabilities to assets (also known as “leverage”), in order to ensure their ability to pay if a higher than expected percentage of customers come calling for their money simultaneously. As their mortgage volume increased, many banks, particularly the smaller regional banks, began finding it difficult to keep enough cash on hand to support these requirements. Faced with the prospect of passing up profitable mortgages (and, conversely, making it harder for an average citizen to secure a mortgage), the banks turned to the derivative markets for help.
Some definitions: a derivatives market is like the stock market, except that the securities traded in the derivative market are based on the value of other securities. The most common example is a stock option. The value of a stock option is entirely dependent on the value of the stock, whereas the value of the stock is dependent on the value of the underlying company. So, if you buy a “call” option (the right to buy a stock) at $10/share, and the stock drops to $8/share, then the value of your option (the right to buy at $10/share) is basically zero (it may be a little higher than zero, if someone out there expects the stock to rise above $10 in the future and is willing to buy the option from you).
A mortgage-backed security works the same way, but is based on the value of a group of mortgages, rather than a single stock. Here’s how it works: a group of mortgages are bundled together and viewed as a portfolio. The monthly payments made by the mortgage holders reflect the monthly income expected from the portfolio (like a dividend on a stock). If one or more mortgage holders miss a payment in a given month, then the monthly income of the portfolio drops. If one or more mortgage holders declares bankruptcy, or otherwise defaults on their loan, then the monthly income of the portfolio drops even more (not just for the current month, but for every month left in the defaulted mortgage). A mortgage-backed security, or MBS, is the right to receive a share of this monthly income for a particular price. The price is determined, much like a stock option, on the value of the underlying assets. So, if a higher-than-expected percentage of mortgage owners miss a payment, for example, then the monthly disbursement is lower, and the right to receive that disbursement becomes less valuable (i.e., the price goes down). If, on the other hand, the default percentage is lower than expected, the right to receive that revenue stream becomes more desirable, and the price goes up.
So how does all of this help a bank that’s struggling to write more mortgages without becoming over leveraged? Simple – the bank bundles up a group of mortgages it’s already written, and sells them to an investment bank in the form of a mortgage-backed security. The cash the bank gets from the sale keeps it leveraged. In return for the cash, the investment bank gets it’s monthly disbursement in the form of the mortgage payments (or lack thereof). The investment bank can then sell shares of this security to clients who wish to invest in such things, or sell them on the open market to other investment banks. Believe it or not, it actually gets more complex than this, as the banks and investment banks start stratifying the mortgages into different risk profiles (sub-prime, standard, jumbo, etc.) and start assigning different risk ratings to each. But for our purposes, this is enough to move forward.
Before we do, though, let’s take a moment to ponder a major implication of this arrangement: once the bank sells a mortgage to an investment bank, it no longer cares if the loan is paid back or not. Like a salesman working for a commission, all the bank now cares about is whether or not it can sell the mortgage to the investment bank. The investment bank assumes that some percentage of the loans will default, and pays the bank a price based on that assumption. Trivial matters like which mortgages fail are irrelevant. If the percentage is lower than expected, the price of the security will rise, and if it’s higher than expected, the price will fall. Either way, though, the bank has already received payment for the mortgage which, depending on the specific rules and regulations, it may already be loaning to another customer in the form of yet another mortgage.
Once again, I pause for another “controversy break.” In the “good old days,” a regional banker would be very careful about who he/she would lend money to, because if they didn’t pay it back, then the banker could be stuck with the loss (or, in the worst case, a repossessed house). As a reseller to the derivatives market, though, the banker is no longer bound by this constraint. Each mortgage now represents raw material for him/her to package and re-sell to the investment bank at a small profit. Bankers become the middlemen, concerned only with moving product through the pipeline, not carefully evaluating each and every loan. Similarly, investment bankers aren’t buying an individual mortgage, but a bundle of thousands. If five out of a hundred mortgages default, the investment banker doesn’t care which five they are – the effect on his mortgage-backed security is the same. Does this system represent greed on the part of the mortgage banker? The investment banker? Does the lack of scrutiny on each loan represent a need for federal regulation to “protect the little guy,” or is it a glorious opportunity to expand the availability of affordable housing in America? Over the past decade or more, all of these arguments have been made by politicians and regulators alike, dependent mostly on whether the economy was doing well or poorly, and which message they were seeking to emphasize. As above, I leave it to you to adjust your level of outrage and then find a comfy home for it.
Crisis: The Credit Markets Run Dry
In the summer of 2007, the housing bubble burst. Much like the stock market of early 2000, investors began to believe that prices had gotten too high. As demand for new homes began to dry up, prices began to fall. People whose ARM’s were switching to the higher, long-term interest rate suddenly found themselves unable to secure additional credit or flip their homes to pay off the mortgage (the value of the home, in some cases, was now less than the value of the loan, so rather than selling it, paying off the loan and walking away with a tidy profit, the sale of the home became insufficient to pay off the loan itself). This led to record levels of mortgage defaults and home foreclosures, which further exacerbated the drop in housing prices, and also drove the price of mortgage-backed securities down dramatically.
This brings us to our first major misconception about the current financial crisis. Companies like Bear Stearns and Lehman Brothers did not get acquired or go out of business because they lost a lot of money in the markets. Market losses happen all the time, and those federally regulated leverage ratios help to minimize their impact. What brought down these and other firms was a combination of an accounting rule and a market function that exists in the stock market, but doesn’t exist in the derivatives market. Let’s look at these one at a time:
The accounting rule to which I refer is called “mark-to-market.” It says that when an institution buys an asset (in this case, a mortgage-backed security), they need to recognize it on their balance sheet at it’s market price, and that periodically, they need to adjust (or “mark”) the value of that balance sheet asset to reflect changes in the market. So, for example, let’s say that Lehman Brothers bought a particular mortgage-backed security for $1 million. This asset is now listed on their balance sheet at that price, and as per regulations, Lehman is now able to take on additional liabilities (e.g., borrowing money), essentially using that asset as collateral.
Now let’s assume that a month later, a surprisingly high number of the underlying mortgage holders miss their monthly payments, driving the price of the security down to $750,000. Without mark-to-market accounting, Lehman would still show a $1 million asset on it’s balance sheet, and could continue to use that asset as collateral for obtaining credit. With mark-to-market, though, Lehman must issue a “write-down” (careful observers of the recent press will recognize this term) and lower the value of the asset to $750,000. Now, their ability to secure credit is reduced by a proportionate amount. As write-downs continue and credit becomes harder and harder to obtain, liabilities begin to build up and eventually the firm can no longer survive. In Lehman’s case, when they filed bankruptcy, their balance sheet showed a whopping $639 billion in assets, with a corresponding $613 billion in liabilities.
Another “controversy break:” those who react to this rule harshly (either with “serves ‘em right for making bad investments” or “Unfair! They haven’t really lost the money until they sell – what if the market comes back?” should remember that in good times, mark-to-market can be used to increase a firm’s liquidity in much the same way. The rule is meant to create transparency in the marketplace, not to punish or reward any particular group. That said, abuse is certainly possible. We now return you to your regularly scheduled crisis…
At this point, some may be wondering, “If these securities kept dropping in price, why didn’t the banks just sell them and invest the cash in something more profitable?” It’s a good question. The answer lies in that mysterious market function I mentioned four paragraphs ago.
In the stock market, many of the large investment banks act as market makers for a given security. This means that if someone wants to sell shares of that security and there are no available buyers (at any price), the market maker agrees to buy the shares (at a price of its choosing). Conversely, if someone wants to buy shares of that security and no one is selling it, the market maker agrees to sell the shares (again, at a price of its choosing). Market makers are even allowed to naked short a stock (which is not as exciting as it sounds – it means they can sell the shares before they buy them). This creates liquidity in the marketplace, which means you’ll probably never find yourself in a situation where you want to buy/sell a stock and your broker tells you, “Sorry, it can’t be done.”
The derivatives markets have no market makers. As the prices of mortgage-backed securities began to free fall, we eventually reached a point of zero liquidity. In other words, no one would buy a mortgage-backed security at any price. This meant that companies like Lehman Brothers were stuck with these “toxic assets” (another term that’s been floating around the news lately) on their balance sheets with no way to get rid of them. The prices continued to drop, the mark-to-market rules made their balance sheets weaker, until eventually, they had to declare bankruptcy or agree to be acquired by another firm who had enough assets to cover their liabilities.
Still with me? If so, then congratulations. You now understand the crux of the financial crisis and how it occurred. Simply put, it’s a burst housing bubble causing a crash in the derivatives market which is enabled and sustained by a liquidity crisis that has frozen the credit markets, causing firms to build up debt that violates regulations and forces them to merge with other, more capitalized banks or declare bankruptcy. Clear as mud, right?
Controversy break: I hope you now understand my frustration with the media and the politicians who sum the whole thing up with “The fat cats on Wall Street destroyed the economy with their corruption and greed.” You may have concluded above that greed played a role on Wall Street or Main Street, or possibly both, as bankers and investment bankers painted themselves into a corner. But without all the facts described herein, I believe a statement like the above makes things sound a lot more sinister than they actually are. Your mileage, as they say, may vary.
The Aftermath: Bailouts and Buyouts and Bankruptcy, oh my!
From here, the dominos began to fall:
- March 17: Bear Stearns faces a liquidity problem when several large hedge funds lose confidence and pull their business simultaneously. JPMorganChase borrows money from the Federal Reserve to pay Bear Stearns’ clients, and eventually buys the company outright.
- July 12: IndyMac Bank is seized by federal regulators due to a “liquidity crisis” from issuing “Alt-A loans,” which are loans that don’t require documentation of the borrower’s income.
- September 7: The Federal Government bails out Fannie Mae and Freddie Mac, two institutions that were formed under government charter back in the days of FDR to be the “lender of last resort” for Americans who couldn’t otherwise buy homes.
- September 15: Lehman Brothers declares bankruptcy. The Fed chooses not to intervene with bailout funds this time, and the firm is eventually acquired by Barclays Capital.
- September 15: Bank of America acquires Merrill Lynch as Merrill faces liquidity problems.
- September 16: The Fed resumes it’s bailout activity by giving AIG an $85 billion loan. AIG was a special case; it’s an insurance company, not a bank. It had a big business insuring mortgage-backed securities, and their insurance policies had a clause in them that stipulated an additional cash reserve requirement if AIG’s credit rating was ever reduced. When other, unrelated investments declined, AIG’s credit rating was, in fact, reduced, causing the sudden appearance of an $85 billion debt, as stipulated by their policies.
- September 22: Morgan Stanley and Goldman Sachs, the only two remaining independent broker dealers, file to change their charters to bank holding companies, which means they can more easily borrow money from the Fed (the “lender of last resort”) and that they are willing to adhere to the more stringent leverage regulations placed on banks versus investment banks.
- September 25: The FDIC seizes Washington Mutual bank due to it’s high debt levels. JPMorgan Chase eventually buys the bank’s assets.
- September 29: The FDIC brokers a deal for Citigroup to acquire Wachovia Bank, so it can assume Wachovia’s debt.
- October 3: Wells Fargo makes a much higher bid for Wachovia, touching off a series of lawsuits that may result in Wachovia being split between it’s two potential suitors.
Then, there’s the stock market:
That’s a drop of 1,974.88 points (or 17%) in eighteen days. Ten of the eighteen days had a point change of three hundred or more. If you don’t follow the stock market regularly, trust me – these are truly historic levels of volatility. The list above explains most of this movement, of course, but there’s one other factor I haven’t covered yet – the much heralded $700 billion bailout package proposed by Treasury Secretary Hank Paulson, and (eventually) passed by both houses of Congress and signed by President Bush. First, let’s go through what happened when and then address some of the common misconceptions about this highly controversial, and political, piece of legislation:
- September 18/19: After roughly $300 billion in bailouts in less than a week, the federal government announces it will propose a plan to buy all of the “toxic” mortgage-backed securities from the banks that currently can’t find buyers. Essentially, the government agreed to be a market maker for MBS’s. The market reacts with a euphoria that wipes out almost all of the 1,000 points lost earlier in the week.
- September 29: After a week of deliberation, including involvement by both Presidential candidates and leaders of both houses, the House of Representatives votes down the bailout package. The market responds with the largest single-day point drop in it’s history.
- October 2-7: After a week of political rhetoric from the candidates, analysis by the media punditry, and pork-barrel spending by the Senate, a revised bill passes and is signed into law by the President. Despite the euphoria exhibited when the bill was announced, the market reacts to the passage of the bill with a 1,383.96 point drop over four days.
In keeping with my promise to stay accurate and dispassionate, I’ll note a few things about the bailout and then we’ll move on to the “Controversy Break” (you saw that coming, huh?) First, it’s important to understand that the government is not simply giving these firms $700 billion to do with as they wish. It is investing $700 billion in mortgage-backed securities, many of which are valued at historic lows. It is likely, though not guaranteed, that when liquidity returns to the market, and trading in MBS’s begin again, various companies will be very interested in trading these securities. It is also likely, though not guaranteed, that a significant percentage of the underlying mortgage owners will, in fact, pay their mortgages on time. Since the current estimate reflects that 0% of them will, this suggests that the prices for these securities will go up. If that happens, the government will be able to show a profit on it’s investment by selling the MBS’s for more than their purchase price. When the country saw a rash of Savings & Loan closures in the mid-90s, a similar institution was created (the Resolution Trust Corporation), which did, in fact, turn a profit selling off the assets it purchased under crisis conditions.
The other important thing to note about the bailout package is that the benefit derived from bailing out large investment banks is not relegated to the executives that run them. In addition to holding mortgage-backed securities, these banks also manage pension funds, retirement accounts, and mutual funds that are owned by millions of middle-income Americans. When these banks struggle or fail, these assets drop in value, sometimes very significantly. Incenting these markets to operate normally again benefits ordinary Americans by securing their financial holdings, regardless of their overall wealth.
Controversy break: A big part of why the liquidity markets dried up in the MBS market was a lack of investor confidence. Typically, assets that drop in price are more attractive to potential buyers. At some point, though, those buyers decide that the assets are never going to recover, and begin to fear the repercussions of owning them and not being able to sell them if they continue to decline. This creates a self-fulfilling prophecy that dries up the liquidity and makes it impossible to trade.
When the government announced it’s intention to inject liquidity in the markets, it made all of these nervous investors feel more confident, because it suggested that trading would begin again, and buying those cheap assets wouldn’t be such a risky proposition.
But then, a giant marketing campaign began. Emotions took over and hyperbole replaced rational thought. Media pundits began focusing on the compensation of the investment banks’ CEO’s, putting the need to punish someone – anyone – for what had happened above the need to solve it. Politicians seized the opportunity to tell part of this story, in order to blame the opposition party for causing the crisis when, as the above has hopefully demonstrated, it is only tangentially related to politics at all. And our leaders in the Senate, sensing a gravy train approaching, loaded down the revised bill with almost $200 million in unrelated, pork-barrel earmarks, taking the focus away from the benefits of the bill and placing it on one of John McCain’s pet campaign issues – the weeding out of pork-barrel spending.
This deluge of rhetoric and opportunism left most people with a bad taste in their mouth about the bill. The investor confidence that the original bill had inspired had completely dissipated, so that when the bill did pass, the general consensus was that it wouldn’t be enough, and that the economy was headed into a long and deep recession. As is typically the case with investor confidence, widely held beliefs like this one tend to become self-fulfilling prophecies, and all indications point to that occurring here.
Conclusion: Keep Your Eye on the Ball, but Make Sure It’s the Right Ball
In the coming days and weeks, it seems as though the stock market will produce the most fireworks. Watch what happens there with an eye toward what I’ve written above.
But more importantly, watch the credit markets. These are not nearly as widely reported, but if you read market commentary sites (like this one from Yahoo), it will almost always mention how well credit is flowing. Another under-reported item to watch is the LIBOR rate. LIBOR is the London Inter-Bank Offered Rate, or the rate at which banks will lend money to each other. Historically, this rate has served as a reliable barometer for international credit liquidity. When you see credit returning to the market place, that will be the first real sign that this crisis is coming to an end. Also, remember that it will be several weeks or months before the Treasury’s $700 billion starts to get spent. The markets will price it in from an expectations point of view today, but real buying power will not begin to materialize until this starts to happen.
Most of all, try to stay calm. I wouldn’t dare try to offer financial advice to a faceless mass of strangers, but I do suggest you keep a close eye on your investments and make trading decisions (both buy and sell) based on clear, rational thought. Panic and emotion most often lead to bad investment decisions, and the tendency to rely on those feelings these days is way too prevalent.
Good luck everyone, and thanks for reading.