Gary J Carter
2008-10-13 12:37:09 UTC
Financial Meltdown 101
By Arun Gupta, Indypendent. Posted October 13, 2008.
Everything you ever wanted to know about the biggest economic meltdown
since the Great Depression but were afraid to ask.
<posted as a service to those who support the free flow of information
some of which may not be sanctioned by US Right Wing Politico idiots
bordering on both nazi and communist principals - Remember it was the
internet, the one medium that communism was unable to control that
took down communism, and not Ronald Reagan, another right wing liar>
Er, excuse me Sam but try to pay attention to this paragraph as you go
off on your inane rants. Note the line above that begins with By:
Max Fraad Wolff consulted on and Michelle Fawcett contributed to this
article. This article relied on many sources, including "The Subprime
Debacle" by Karl Beitel, Monthly Review, May 2008. This essay was
printed in the Oct. 3, 2008, issue of The Indypendent, and the
November 2008 issue of Z Magazine.
From 1982 to 2000, the U.S. stock market went on the longest bull run
ever, as share prices rose to dizzying heights. In the late 1990s, a
combination of factors, which included the Federal Reserve lowering
interest rates, created a huge price bubble in Internet stocks. A
speculative bubble occurs when price far outstrips the fundamental
worth of the asset. Bubbles have occurred in everything from real
estate, stocks and railroads to tulips, beanie babies and comic books.
As with all bubbles, it took more and more money to make a return*.
This led to the Internet bubble popping in March 2000.
During this time of market mania, the Fed guts the Glass-Steagall Act,
which was enacted during the Great Depression to prevent the type of
banking activity that led to the 1929 stock market crash. In 1996, the
Fed allows regular banks to become heavily involved in investment
banking, which opens the door to conflicts of interest in banks
pushing sketchy financial products on customers who poorly understood
the risks. In 1999, under intense pressure from financial firms,
Congress overturns Glass-Steagall, allowing banks to engage in any
sort of activity from underwriting insurance to investment banking to
commercial banking (such as holding deposits).
*For instance, if you purchased 100 shares of Apple at $10 a share and
it rose to $20, it cost $1,000 to make $1,000 profit (a 100 percent
return), but if the shares were $100 each and rose to $110, it would
cost $10,000 to make $1,000 profit (a 10 percent return -- and the
loss potential would be much greater, too.
Many Americans joined the stock mania literally in the last days and
lost considerable wealth, and some, such as Enron employees, lost
their life savings. When the stock market bubble erupted, turbulence
rippled through the larger economy, causing investment and corporate
spending to sink and unemployment to rise. Then came the Sept. 11,
2001, attacks, generating a shock wave of fear and a drop in consumer
spending. Burned by the stock market, many people shifted to home
purchases as a more secure way to build wealth.
By 2002, with the economy already limping along, former Federal
Reserve Chairman Alan Greenspan and the Fed slashed interest rates to
historic lows of near 1 percent to avoid a severe economic downturn.
Low interest rates make borrowed money cheap for everyone from
homebuyers to banks. This ocean of credit was one factor that led to a
major shift in the home-lending industry -- from originate to own to
originate to distribute. Low interest rates also meant that homebuyers
could take on larger mortgages, which supported rising prices.
In the originate-to-own model, the mortgage lender -- which can be a
private mortgage company, bank, thrift or credit union -- holds the
mortgage for its term, usually 30 years. Every month the bank*
originating the mortgage receives a payment made of principal and
interest from the homeowner. If the buyer defaults on the mortgage,
that is, stops making monthly payments, then the bank can seize and
sell a valuable asset: the house. Given strict borrowing standards and
the long life of the loan, it's like the homebuyer is getting married
to the bank.
*Shorthand for any mortgage originator.
In the originate-to-distribute model, the banks sell the mortgage to
third parties, turning the loans into a commodity like widgets on a
conveyor belt. By selling the loan, the bank frees up its capital so
it can turn around and finance a new mortgage. Thus, the banks have an
incentive to sell (or distribute) mortgages fast so they can recoup
the funds to sell more mortgages. By selling the loan, the bank also
distributes the risk of default to others.
The banks made money off mortgage fees, perhaps only a few thousand
dollars per loan. Because they sold the loan, sometimes in just a few
days, they had no concern that the homebuyer might default. Banks
began using call centers and high-pressure tactics to mass-produce
mortgages because the profit was in volume--how many loans could be
approved how fast. This was complemented by fraud throughout the
realestate industry, in which appraisers over-valued homes and
mortgage brokers approved anyone with a pulse, not verifying assets,
job status or income. And the mushrooming housing industry distorted
the whole economy. Of all net job growth from 2002 to 2007, up to 40
percent was housing-sector related: mortgage brokers, appraisers,
real-estate agents, call-center employees, loan officers, construction
and home-improvement store workers, etc.
To make the loans easier to sell, the banks go to Fannie Mae or
Freddie Mac and get assurance for conforming (or prime mortgages*).
Assurance means one of the agencies certifies that the loans are
creditworthy; they also insure part of the loan in case the homeowner
defaults. Before their recent nationalization, Fannie and Freddie were
government-sponsored entities (GSEs). While anyone could buy shares in
the two companies, they were also subject to federal regulation and
congressional oversight. This federal role was seen as an implicit
guarantee: While there was no explicit guarantee, all parties believed
loans backed by Fannie and Freddie were absolutely safe because the
government would not let the two agencies fail. This allowed them to
borrow huge sums of money at extremely low rates.
*Prime refers to the credit score of the borrower.
Banks then sold their newly acquired assured prime mortgage loans to
bundlers, ranging from Fannie and Freddie to private labels, such as
investment banks, hedge funds and money banks (ones that hold deposits
like savings and checking accounts. Bundlers pooled many mortgages
with the intention of selling the payment rights to others, that is,
someone else pays to receive your monthly mortgage payments.
The next step was to securitize the bundle (a security is a tradable
asset. Much of the financial wizardry of Wall Street involves turning
debts into assets. Say you're Bank of America and you sell 200
mortgages in a day. Lehman Brothers buys the loans after they are
assured and bundles them by depositing the mortgages in a bank account
-- that's where the monthly payments from the 200 homeowners go. Then,
a mortgage-backed security (MBS) is created from this bundle. An MBS
is a financial product that pays a yield to the purchaser, such as a
hedge fund, pension fund, investment bank, money bank, central bank
and especially Fannie and Freddie. The yield, essentially an interest
payment, comes from the mortgage payments.
How does it work? The homeowner keeps making monthly mortgage payments
to Bank of America, which makes money from the fees from the original
mortgage and gets a cut for servicing the mortgage payments, passing
them on to Lehman Brothers. Lehman makes money as a bundler of the
mortgages and underwriter of the mortgage-backed security. The
purchaser of the mortgage-backed security, say, Fannie Mae, then gets
paid from the bank account holding the mortgage payments.
At first, this process covered only prime mortgages because Fannie and
Freddie could not assure subprime loans. To address low rates of home
ownership among low-income populations and communities of color,
around 2004 Congress began encouraging Fannie and Freddie to start
assuring subprime mortgages on a wide scale. And easy credit fed
investors' appetite for more and more mortgage-backed securities,
which provided funding for new mortgages.
One definition of subprime loans is any loan at an interest rate that
is at least 3 percentage points more than a prime loan. Many of these
loans were adjustable-rate mortgages (ARMs) with teaser rates. The
rate was low for the first few years, but then it would reset, causing
monthly payments to leap dramatically, sometimes to two or three times
the original amount. Subprime borrowers are considered riskier to lend
to because of low credit scores. Subprime borrowers are concentrated
among people of color and immigrant and low-income communities, partly
because racial and class disparities result in less access to banking
services such as credit cards, online billing and checking and saving
accounts. Bill paying becomes a labor-intensive process, making it
much more likely that payments will be late or missed, driving down
credit scores. With mortgage brokers and lenders pushing loans on
anyone and everyone, those with less financial acumen --
disproportionately low-income people, immigrants, the elderly and
communities of color -- often found themselves with mortgages that
became unaffordable.
With the surge in mortgage loans, around 2004, banks started
extensively using financial products called collateralized debt
obligations (CDOs). The banks would either combine mortgage-backed
securities they already owned or bundle large pools of high-interest
subprime mortgages. CDOs were sliced into tranches -- think of them as
cuts of meat -- that paid a yield according to risk of default: The
best cuts, the filet mignon, had the lowest risk and hence paid the
lowest yield. The riskiest tranches, the mystery-meat hotdogs that
paid the highest yield, would default first if homebuyers stopped
making payments. This was seen as a way to distribute risk across the
markets. The notion of distributing risk means all the market players
take a little risk, so if something goes bad, everyone suffers but no
one dies.
Tranches were given ratings by services like Standard & Poor's,
Moody's and Fitch. The highest rating, AAA, meant there was virtually
no risk of default. The perceived safety of AAA meant a broad variety
of financial institutions could buy them. And because tranches were
marketed as a tool to fine-tune risk and return, this spurred a big
demand. There was a conflict of interest, however, because the rating
services earned huge fees from the investment banks. Moody's earned
nearly $850 million from such structured finance products in 2006
alone. The investment bank also bundled lower-rated mortgage backed
securities, like BBB -rated ones, and then sliced them to create new
tranches rated from AAA to junk. This was like turning the hotdogs
into steaks.
Furthermore, the banks would hedge the tranches, another way of
distributing risk, by purchasing credit default swaps (CDSs) sold by
companies like AIG and MBIA. The swaps were a form of insurance. This
was seen as a way to make tranches more secure and hence higher rated.
For instance, say you're Goldman Sachs and you have $10 million in AAA
tranches. You go to AIG to insure it, and the company determines that
the risk of default is extremely low so the premium is 1 percent. So
you pay AIG $100,000 a year and if the tranche defaults, the company
pays you $10 million. But CDSs started getting brought and sold all
over the world based on perceived risk. The market grew so large that
the underlying debt being insured was $45 trillion -- nearly the same
size as the annual global economy!
Also around 2004, things began to get even trickier when investment
banks set up entities known as structured investment vehicles (SIVs).
The SIVs would purchase subprime MBSs from their sponsoring banks. But
to purchase these MBSs, the structured investment vehicles needed
funds of their own. So the SIVs created products called asset-backed
commercial paper (short-term debt of 1 to 90 days). Asset-backed means
it is backed by credit from the sponsoring bank. The SIVs then sold
the paper, mainly to money market funds. In this way, the SIVs
generated money to purchase the mortgage-backed securities from their
bank. The SIVs made money by getting high yields from the subprime
MBSs they brought, while paying out low yields to the money markets
that purchased the commercial paper (profiting from a spread like this
is known as arbitrage).
Wall Street's goal was to conjure up ways to make money while not
encountering any liability. It was moving everything off-book to the
SIVs to get around rules about leveraging. Banks, hedge funds and
others leverage by taking their capital reserves -- actual cash or
assets that can be easily turned into cash -- and borrowing many times
against it. For instance, Merrill Lynch had a leverage ratio of 45.8
on Sept. 26. That means that if Merrill had $10 billion in the bank,
it was playing around with $458 billion. The Federal Reserve is
supposed to regulate reserves to limit the growth of credit, but the
SIVs were one method to get around this rule. More leverage also meant
more risk for the bank, however, because funds could disappear quickly
if a few bets went bad. This is all part of what's called the Shadow
Banking System, meaning it gets around existing regulations.
It was deregulation that led to the huge growth of the shadow banking
system. In 2004 Wall Street successfully lobbied the Securities and
Exchange Commission to loosen regulations on how much they could
leverage against their capital reserves. This allowed the companies
"to invest in the fast-growing but opaque world of mortgage-backed
securities; credit derivatives, a form of insurance for bond holders;
and other exotic instruments," according to the New York Times. The
only real oversight left in place was self-policing by the investment
banks themselves to determine if they were putting investors at risk.
The whole process worked as long as everyone believed housing prices
would go up endlessly. This is a form of perceptual economics, one
principle of which is that any widely held belief in the market tends
to become a self-fulfilling prophecy. In the case of housing,
homeowners took on ever-larger mortgages in the belief that prices
would keep rising rapidly. Mortgage lenders believed the loans were
safe because even if the homeowner defaulted, the mortgage holder
would be left with a house that was increasing in price. Confidence in
rising prices led the creators and purchasers of mortgage-backed
securities to think these investments were virtually risk-free. This
also applied to over-leveraging -- as long as there was easy credit
and quick returns to be made, investors clamored for more
mortgage-backed securities. And this applied to the money market funds
that brought the paper from structured investment vehicles. As long as
the money market funds had confidence in the system, they didn't cash
out the commercial paper when it came due, but rolled it over at the
same interest rates. This allowed the SIVs to mint money without
posing any liabilities for their sponsoring banks.
This system kept the U.S. economy chugging along for years. For some
35 years, real wages have been stagnant for most Americans, but as
house values skyrocketed over the last decade, many homeowners
refinanced and cashed out the equity -- turning their homes into ATMs.
For example, if you owed $200,000 on a mortgage but the house value
rose to $300,000, you could potentially turn the $100,000 difference
into cash by refinancing. By 2004, Americans were using home equity to
finance as much $310 billion a year in personal consumption. This
debt-driven consumption was the engine of growth.
U.S. over-consumption was balanced by over-production in many Asian
countries. Countries like China, India, Taiwan and South Korea run
large trade surpluses with the United States, which speeds their
economic development. They invest excess cash in U.S. credit
instruments ranging from corporate debt and MBSs to government bonds
and bills. It's what economists call a virtuous cycle: we buy their
goods, helping them develop, while they use the profits to buy our
credit, allowing us to purchase more of their goods. But it's also
unsustainable. A country cannot over-consume forever.
In the final stage of the housing bubble, fewer first-time buyers
could afford traditional mortgages. Rising house prices required
ever-larger down payments so subprime mortgages multiplied, as they
often required little or no money down. From 2004 to 2006, nearly 20
percent of all mortgage loans were subprime loans. As the vast
majority were adjustable-rate mortgages (ARMs), this created a time
bomb. The minute interest rates went up, the rates reset, and
homeowners with ARMs were saddled with larger monthly payments.
Various factors combined to slow real-estate prices and deflate the
bubble. Rising prices led to a building boom and oversupply of houses,
everaccelerating prices meant more money brought smaller returns and,
once again, the Fed played a role by raising interest rates. It was
trying to stave off inflation, but given the proliferation of
adjustablerate mortgages, it led to higher mortgage payments, pushing
hundreds of thousands of homeowners into foreclosure.
Once the bubble started to leak, the process accelerated, turning the
mania into a panic. First, the default spread to the structured debt
instruments like collateralized debt obligations and mortgage-backed
securities. The system of distributing risk failed. Securitization had
spread across the entire financial system -- investment and money
banks, pension funds, central banks, insurance companies -- putting
everyone at risk. Because the finance sector had lobbied aggressively
for decades to slash regulation, the lack of oversight amplified risk.
As mortgage holders defaulted, mortgage-backed securities also began
to default. The subprime funding conduit from Wall Street froze up,
which led big mortgage lenders like Countrywide, New Century Financial
and American Home Mortgage to go belly-up.
As panic set in, money market funds began to stop rolling over the
commercial paper -- they wanted to cash it out. So SIVs now had to
either call on their credit line from their sponsoring banks or sell
assets such as the mortgage-backed securities to raise money. Mortgage
defaults and forced sales of the MBSs began to push prices down even
further. This forced banks to book losses, requiring some to sell more
assets to cover the losses, further lowering prices, forcing them to
book more losses, creating a vicious cycle. This is known as a
liquidation trap. Since no one was sure about the size of the losses,
banks began to hoard funds, which caused the credit markets to dry up.
Over the last year, the Federal Reserve and U.S. Treasury have taken
increasingly drastic measures -- lowering interest rates, pumping cash
into the banking sector, allowing investment banks to borrow funds
while putting up low-valued securities as collateral. This then
proceeded to financing takeovers, such as the Fed providing a $29
billion credit line for JP Morgan to take over Bear Stearns in March.
Then it nationalized Fannie Mae and Freddie Mac; this was followed by
the federal takeover of AIG, which was done in by its gambling with
credit default swaps. In the end, the legendary Wall Street banks
disappeared in a fortnight -- bankrupt, acquired or converted into
bank holding companies like Citigroup.
But the contagion has not been contained. Whether the bailout plan can
succeed is highly questionable. Many are skeptical as to whether the
bailout will even restore confidence -- and credit -- to the banking
system. As Reuters stated recently, "Doubts remain as to how it [the
bailout plan] could immediately thaw the frozen money and credit
market." Even if the bailout revives the banking sector, few
economists think it will jumpstart the consumer credit machine. For
one, over-leveraged, money-strapped banks will eagerly dump
nearworthless securities on taxpayers in exchange for cash to bulk up
their reserves. Plus, with working hours and wages declining and
unemployment, home foreclosures and inflation surging, banks are in no
mood to give consumers more credit, so consumption -- and hence the
economy -- will continue to contract.
There are many other, better options that were proposed: avoiding the
poisonous mortgage-backed securities and buying equity stakes directly
in troubled banks, re-regulating the industry, sending in teams of
government auditors to decide the real worth of financial companies
and which should live and die, creating a Home Owners' Loan
Corporation to allow the government to buy troubled mortgages
directly, allowing local governments to seize foreclosed homes and
turn them into subsidized housing to minimize abandonment (which
creates ghost neighborhoods, driving down the price of still-occupied
homes), public works program, alternative energy investments, a Green
New Deal. But these are political questions that depend on organizing
and political power to propose, legislate, fund and enact. That's what
will determine if there is a 21st-century New Deal or if Wall Street
will get away with the biggest financial crime in world history.
Arun Gupta is the editor of the Indypendent.
By Arun Gupta, Indypendent. Posted October 13, 2008.
Everything you ever wanted to know about the biggest economic meltdown
since the Great Depression but were afraid to ask.
<posted as a service to those who support the free flow of information
some of which may not be sanctioned by US Right Wing Politico idiots
bordering on both nazi and communist principals - Remember it was the
internet, the one medium that communism was unable to control that
took down communism, and not Ronald Reagan, another right wing liar>
Er, excuse me Sam but try to pay attention to this paragraph as you go
off on your inane rants. Note the line above that begins with By:
Max Fraad Wolff consulted on and Michelle Fawcett contributed to this
article. This article relied on many sources, including "The Subprime
Debacle" by Karl Beitel, Monthly Review, May 2008. This essay was
printed in the Oct. 3, 2008, issue of The Indypendent, and the
November 2008 issue of Z Magazine.
From 1982 to 2000, the U.S. stock market went on the longest bull run
ever, as share prices rose to dizzying heights. In the late 1990s, a
combination of factors, which included the Federal Reserve lowering
interest rates, created a huge price bubble in Internet stocks. A
speculative bubble occurs when price far outstrips the fundamental
worth of the asset. Bubbles have occurred in everything from real
estate, stocks and railroads to tulips, beanie babies and comic books.
As with all bubbles, it took more and more money to make a return*.
This led to the Internet bubble popping in March 2000.
During this time of market mania, the Fed guts the Glass-Steagall Act,
which was enacted during the Great Depression to prevent the type of
banking activity that led to the 1929 stock market crash. In 1996, the
Fed allows regular banks to become heavily involved in investment
banking, which opens the door to conflicts of interest in banks
pushing sketchy financial products on customers who poorly understood
the risks. In 1999, under intense pressure from financial firms,
Congress overturns Glass-Steagall, allowing banks to engage in any
sort of activity from underwriting insurance to investment banking to
commercial banking (such as holding deposits).
*For instance, if you purchased 100 shares of Apple at $10 a share and
it rose to $20, it cost $1,000 to make $1,000 profit (a 100 percent
return), but if the shares were $100 each and rose to $110, it would
cost $10,000 to make $1,000 profit (a 10 percent return -- and the
loss potential would be much greater, too.
Many Americans joined the stock mania literally in the last days and
lost considerable wealth, and some, such as Enron employees, lost
their life savings. When the stock market bubble erupted, turbulence
rippled through the larger economy, causing investment and corporate
spending to sink and unemployment to rise. Then came the Sept. 11,
2001, attacks, generating a shock wave of fear and a drop in consumer
spending. Burned by the stock market, many people shifted to home
purchases as a more secure way to build wealth.
By 2002, with the economy already limping along, former Federal
Reserve Chairman Alan Greenspan and the Fed slashed interest rates to
historic lows of near 1 percent to avoid a severe economic downturn.
Low interest rates make borrowed money cheap for everyone from
homebuyers to banks. This ocean of credit was one factor that led to a
major shift in the home-lending industry -- from originate to own to
originate to distribute. Low interest rates also meant that homebuyers
could take on larger mortgages, which supported rising prices.
In the originate-to-own model, the mortgage lender -- which can be a
private mortgage company, bank, thrift or credit union -- holds the
mortgage for its term, usually 30 years. Every month the bank*
originating the mortgage receives a payment made of principal and
interest from the homeowner. If the buyer defaults on the mortgage,
that is, stops making monthly payments, then the bank can seize and
sell a valuable asset: the house. Given strict borrowing standards and
the long life of the loan, it's like the homebuyer is getting married
to the bank.
*Shorthand for any mortgage originator.
In the originate-to-distribute model, the banks sell the mortgage to
third parties, turning the loans into a commodity like widgets on a
conveyor belt. By selling the loan, the bank frees up its capital so
it can turn around and finance a new mortgage. Thus, the banks have an
incentive to sell (or distribute) mortgages fast so they can recoup
the funds to sell more mortgages. By selling the loan, the bank also
distributes the risk of default to others.
The banks made money off mortgage fees, perhaps only a few thousand
dollars per loan. Because they sold the loan, sometimes in just a few
days, they had no concern that the homebuyer might default. Banks
began using call centers and high-pressure tactics to mass-produce
mortgages because the profit was in volume--how many loans could be
approved how fast. This was complemented by fraud throughout the
realestate industry, in which appraisers over-valued homes and
mortgage brokers approved anyone with a pulse, not verifying assets,
job status or income. And the mushrooming housing industry distorted
the whole economy. Of all net job growth from 2002 to 2007, up to 40
percent was housing-sector related: mortgage brokers, appraisers,
real-estate agents, call-center employees, loan officers, construction
and home-improvement store workers, etc.
To make the loans easier to sell, the banks go to Fannie Mae or
Freddie Mac and get assurance for conforming (or prime mortgages*).
Assurance means one of the agencies certifies that the loans are
creditworthy; they also insure part of the loan in case the homeowner
defaults. Before their recent nationalization, Fannie and Freddie were
government-sponsored entities (GSEs). While anyone could buy shares in
the two companies, they were also subject to federal regulation and
congressional oversight. This federal role was seen as an implicit
guarantee: While there was no explicit guarantee, all parties believed
loans backed by Fannie and Freddie were absolutely safe because the
government would not let the two agencies fail. This allowed them to
borrow huge sums of money at extremely low rates.
*Prime refers to the credit score of the borrower.
Banks then sold their newly acquired assured prime mortgage loans to
bundlers, ranging from Fannie and Freddie to private labels, such as
investment banks, hedge funds and money banks (ones that hold deposits
like savings and checking accounts. Bundlers pooled many mortgages
with the intention of selling the payment rights to others, that is,
someone else pays to receive your monthly mortgage payments.
The next step was to securitize the bundle (a security is a tradable
asset. Much of the financial wizardry of Wall Street involves turning
debts into assets. Say you're Bank of America and you sell 200
mortgages in a day. Lehman Brothers buys the loans after they are
assured and bundles them by depositing the mortgages in a bank account
-- that's where the monthly payments from the 200 homeowners go. Then,
a mortgage-backed security (MBS) is created from this bundle. An MBS
is a financial product that pays a yield to the purchaser, such as a
hedge fund, pension fund, investment bank, money bank, central bank
and especially Fannie and Freddie. The yield, essentially an interest
payment, comes from the mortgage payments.
How does it work? The homeowner keeps making monthly mortgage payments
to Bank of America, which makes money from the fees from the original
mortgage and gets a cut for servicing the mortgage payments, passing
them on to Lehman Brothers. Lehman makes money as a bundler of the
mortgages and underwriter of the mortgage-backed security. The
purchaser of the mortgage-backed security, say, Fannie Mae, then gets
paid from the bank account holding the mortgage payments.
At first, this process covered only prime mortgages because Fannie and
Freddie could not assure subprime loans. To address low rates of home
ownership among low-income populations and communities of color,
around 2004 Congress began encouraging Fannie and Freddie to start
assuring subprime mortgages on a wide scale. And easy credit fed
investors' appetite for more and more mortgage-backed securities,
which provided funding for new mortgages.
One definition of subprime loans is any loan at an interest rate that
is at least 3 percentage points more than a prime loan. Many of these
loans were adjustable-rate mortgages (ARMs) with teaser rates. The
rate was low for the first few years, but then it would reset, causing
monthly payments to leap dramatically, sometimes to two or three times
the original amount. Subprime borrowers are considered riskier to lend
to because of low credit scores. Subprime borrowers are concentrated
among people of color and immigrant and low-income communities, partly
because racial and class disparities result in less access to banking
services such as credit cards, online billing and checking and saving
accounts. Bill paying becomes a labor-intensive process, making it
much more likely that payments will be late or missed, driving down
credit scores. With mortgage brokers and lenders pushing loans on
anyone and everyone, those with less financial acumen --
disproportionately low-income people, immigrants, the elderly and
communities of color -- often found themselves with mortgages that
became unaffordable.
With the surge in mortgage loans, around 2004, banks started
extensively using financial products called collateralized debt
obligations (CDOs). The banks would either combine mortgage-backed
securities they already owned or bundle large pools of high-interest
subprime mortgages. CDOs were sliced into tranches -- think of them as
cuts of meat -- that paid a yield according to risk of default: The
best cuts, the filet mignon, had the lowest risk and hence paid the
lowest yield. The riskiest tranches, the mystery-meat hotdogs that
paid the highest yield, would default first if homebuyers stopped
making payments. This was seen as a way to distribute risk across the
markets. The notion of distributing risk means all the market players
take a little risk, so if something goes bad, everyone suffers but no
one dies.
Tranches were given ratings by services like Standard & Poor's,
Moody's and Fitch. The highest rating, AAA, meant there was virtually
no risk of default. The perceived safety of AAA meant a broad variety
of financial institutions could buy them. And because tranches were
marketed as a tool to fine-tune risk and return, this spurred a big
demand. There was a conflict of interest, however, because the rating
services earned huge fees from the investment banks. Moody's earned
nearly $850 million from such structured finance products in 2006
alone. The investment bank also bundled lower-rated mortgage backed
securities, like BBB -rated ones, and then sliced them to create new
tranches rated from AAA to junk. This was like turning the hotdogs
into steaks.
Furthermore, the banks would hedge the tranches, another way of
distributing risk, by purchasing credit default swaps (CDSs) sold by
companies like AIG and MBIA. The swaps were a form of insurance. This
was seen as a way to make tranches more secure and hence higher rated.
For instance, say you're Goldman Sachs and you have $10 million in AAA
tranches. You go to AIG to insure it, and the company determines that
the risk of default is extremely low so the premium is 1 percent. So
you pay AIG $100,000 a year and if the tranche defaults, the company
pays you $10 million. But CDSs started getting brought and sold all
over the world based on perceived risk. The market grew so large that
the underlying debt being insured was $45 trillion -- nearly the same
size as the annual global economy!
Also around 2004, things began to get even trickier when investment
banks set up entities known as structured investment vehicles (SIVs).
The SIVs would purchase subprime MBSs from their sponsoring banks. But
to purchase these MBSs, the structured investment vehicles needed
funds of their own. So the SIVs created products called asset-backed
commercial paper (short-term debt of 1 to 90 days). Asset-backed means
it is backed by credit from the sponsoring bank. The SIVs then sold
the paper, mainly to money market funds. In this way, the SIVs
generated money to purchase the mortgage-backed securities from their
bank. The SIVs made money by getting high yields from the subprime
MBSs they brought, while paying out low yields to the money markets
that purchased the commercial paper (profiting from a spread like this
is known as arbitrage).
Wall Street's goal was to conjure up ways to make money while not
encountering any liability. It was moving everything off-book to the
SIVs to get around rules about leveraging. Banks, hedge funds and
others leverage by taking their capital reserves -- actual cash or
assets that can be easily turned into cash -- and borrowing many times
against it. For instance, Merrill Lynch had a leverage ratio of 45.8
on Sept. 26. That means that if Merrill had $10 billion in the bank,
it was playing around with $458 billion. The Federal Reserve is
supposed to regulate reserves to limit the growth of credit, but the
SIVs were one method to get around this rule. More leverage also meant
more risk for the bank, however, because funds could disappear quickly
if a few bets went bad. This is all part of what's called the Shadow
Banking System, meaning it gets around existing regulations.
It was deregulation that led to the huge growth of the shadow banking
system. In 2004 Wall Street successfully lobbied the Securities and
Exchange Commission to loosen regulations on how much they could
leverage against their capital reserves. This allowed the companies
"to invest in the fast-growing but opaque world of mortgage-backed
securities; credit derivatives, a form of insurance for bond holders;
and other exotic instruments," according to the New York Times. The
only real oversight left in place was self-policing by the investment
banks themselves to determine if they were putting investors at risk.
The whole process worked as long as everyone believed housing prices
would go up endlessly. This is a form of perceptual economics, one
principle of which is that any widely held belief in the market tends
to become a self-fulfilling prophecy. In the case of housing,
homeowners took on ever-larger mortgages in the belief that prices
would keep rising rapidly. Mortgage lenders believed the loans were
safe because even if the homeowner defaulted, the mortgage holder
would be left with a house that was increasing in price. Confidence in
rising prices led the creators and purchasers of mortgage-backed
securities to think these investments were virtually risk-free. This
also applied to over-leveraging -- as long as there was easy credit
and quick returns to be made, investors clamored for more
mortgage-backed securities. And this applied to the money market funds
that brought the paper from structured investment vehicles. As long as
the money market funds had confidence in the system, they didn't cash
out the commercial paper when it came due, but rolled it over at the
same interest rates. This allowed the SIVs to mint money without
posing any liabilities for their sponsoring banks.
This system kept the U.S. economy chugging along for years. For some
35 years, real wages have been stagnant for most Americans, but as
house values skyrocketed over the last decade, many homeowners
refinanced and cashed out the equity -- turning their homes into ATMs.
For example, if you owed $200,000 on a mortgage but the house value
rose to $300,000, you could potentially turn the $100,000 difference
into cash by refinancing. By 2004, Americans were using home equity to
finance as much $310 billion a year in personal consumption. This
debt-driven consumption was the engine of growth.
U.S. over-consumption was balanced by over-production in many Asian
countries. Countries like China, India, Taiwan and South Korea run
large trade surpluses with the United States, which speeds their
economic development. They invest excess cash in U.S. credit
instruments ranging from corporate debt and MBSs to government bonds
and bills. It's what economists call a virtuous cycle: we buy their
goods, helping them develop, while they use the profits to buy our
credit, allowing us to purchase more of their goods. But it's also
unsustainable. A country cannot over-consume forever.
In the final stage of the housing bubble, fewer first-time buyers
could afford traditional mortgages. Rising house prices required
ever-larger down payments so subprime mortgages multiplied, as they
often required little or no money down. From 2004 to 2006, nearly 20
percent of all mortgage loans were subprime loans. As the vast
majority were adjustable-rate mortgages (ARMs), this created a time
bomb. The minute interest rates went up, the rates reset, and
homeowners with ARMs were saddled with larger monthly payments.
Various factors combined to slow real-estate prices and deflate the
bubble. Rising prices led to a building boom and oversupply of houses,
everaccelerating prices meant more money brought smaller returns and,
once again, the Fed played a role by raising interest rates. It was
trying to stave off inflation, but given the proliferation of
adjustablerate mortgages, it led to higher mortgage payments, pushing
hundreds of thousands of homeowners into foreclosure.
Once the bubble started to leak, the process accelerated, turning the
mania into a panic. First, the default spread to the structured debt
instruments like collateralized debt obligations and mortgage-backed
securities. The system of distributing risk failed. Securitization had
spread across the entire financial system -- investment and money
banks, pension funds, central banks, insurance companies -- putting
everyone at risk. Because the finance sector had lobbied aggressively
for decades to slash regulation, the lack of oversight amplified risk.
As mortgage holders defaulted, mortgage-backed securities also began
to default. The subprime funding conduit from Wall Street froze up,
which led big mortgage lenders like Countrywide, New Century Financial
and American Home Mortgage to go belly-up.
As panic set in, money market funds began to stop rolling over the
commercial paper -- they wanted to cash it out. So SIVs now had to
either call on their credit line from their sponsoring banks or sell
assets such as the mortgage-backed securities to raise money. Mortgage
defaults and forced sales of the MBSs began to push prices down even
further. This forced banks to book losses, requiring some to sell more
assets to cover the losses, further lowering prices, forcing them to
book more losses, creating a vicious cycle. This is known as a
liquidation trap. Since no one was sure about the size of the losses,
banks began to hoard funds, which caused the credit markets to dry up.
Over the last year, the Federal Reserve and U.S. Treasury have taken
increasingly drastic measures -- lowering interest rates, pumping cash
into the banking sector, allowing investment banks to borrow funds
while putting up low-valued securities as collateral. This then
proceeded to financing takeovers, such as the Fed providing a $29
billion credit line for JP Morgan to take over Bear Stearns in March.
Then it nationalized Fannie Mae and Freddie Mac; this was followed by
the federal takeover of AIG, which was done in by its gambling with
credit default swaps. In the end, the legendary Wall Street banks
disappeared in a fortnight -- bankrupt, acquired or converted into
bank holding companies like Citigroup.
But the contagion has not been contained. Whether the bailout plan can
succeed is highly questionable. Many are skeptical as to whether the
bailout will even restore confidence -- and credit -- to the banking
system. As Reuters stated recently, "Doubts remain as to how it [the
bailout plan] could immediately thaw the frozen money and credit
market." Even if the bailout revives the banking sector, few
economists think it will jumpstart the consumer credit machine. For
one, over-leveraged, money-strapped banks will eagerly dump
nearworthless securities on taxpayers in exchange for cash to bulk up
their reserves. Plus, with working hours and wages declining and
unemployment, home foreclosures and inflation surging, banks are in no
mood to give consumers more credit, so consumption -- and hence the
economy -- will continue to contract.
There are many other, better options that were proposed: avoiding the
poisonous mortgage-backed securities and buying equity stakes directly
in troubled banks, re-regulating the industry, sending in teams of
government auditors to decide the real worth of financial companies
and which should live and die, creating a Home Owners' Loan
Corporation to allow the government to buy troubled mortgages
directly, allowing local governments to seize foreclosed homes and
turn them into subsidized housing to minimize abandonment (which
creates ghost neighborhoods, driving down the price of still-occupied
homes), public works program, alternative energy investments, a Green
New Deal. But these are political questions that depend on organizing
and political power to propose, legislate, fund and enact. That's what
will determine if there is a 21st-century New Deal or if Wall Street
will get away with the biggest financial crime in world history.
Arun Gupta is the editor of the Indypendent.