10. The 2008 Financial Crisis“A business that makes nothing but money is a poor business.” -Henry Ford The U.S. government is using the 2008 Financial Crisis as a reason to take over the U.S. economy. The politicians and regulators are telling you that the free market failed and government must step in to fix it. Rampant, excessive greed at Wall Street put the whole country in jeopardy. The bankers and executives put making money before common sense and sound business decisions. The Wall Street bankers and executives did make poor decisions; they should be punished for it. However, the U.S. government may have planted the seeds that sprouted into the 2008 Financial Crisis. These seeds came from the American Dream where all American families must own their own home. Thus, the politicians and government officials help perpetuate this dream by passing favorable laws for homeownership. One law, the Community Reinvestment Act (CRA) of 1977, forces banks to grant loans to low-income households (DiLorenzo 2007). On the surface, this appears to be a good law, because banks are forced to grant mortgages to low-income households. Further, cities are teeming with poor neighborhoods and poor households; thus, this law could help banks invest in blighted neighborhoods and transform them into thriving neighborhoods. This investment is possible without using taxpayer money. Some community organizations like the Association of Community Organizations for Reform Now (ACORN) used the Community Reinvestment Act to strong arm banks into granting loans to low-income households. If a bank wanted to merge with another bank or open up a new bank branch, the U.S. government has to approve this activity. However, if these community organizations believed this bank did not grant enough loans to poor people, they could petition the U.S. government, claiming the bank is violating the Community Reinvestment Act. Thus, these organizations could delay bank mergers and bank branch expansions indefinitely with these petitions (DiLorenzo 2007). The banks are caught in a catch 22. Low-income households are more likely to default on loans than the middle and rich classes, but not making enough loans to poor people could jeopardize future business expansions. Further, banks could not charge higher interest rates to compensate for this higher risk of default. Some low-income households are minorities and charging a higher interest rate could be perceived as a racist policy. An ingenious innovation came along that allowed banks to grant mortgages to anyone. Moreover, this innovation allowed the banks to earn enormous (short-term) profits, and involved no risk to the banks. Thus, banks easily approved mortgage for low-income households. Banks removed their stringent loan guidelines, such as verifying borrowers’ income, ignoring employment history, and not requiring borrowers to put any money down. Banks granted 100% financing for homes to anyone with a heartbeat and paycheck stub. The families that banks would never approve for a mortgage before the 1990s could easily get financing, even though they are more likely to default. This class of loans evolved into the subprime loan market. With home foreclosures escalating from these subprime loans, these loans are now dubbed toxic mortgages. This chapter examines three types of financial innovation that led to the 2008 Financial Crisis. Banks used securitization and Collateralized Debt Obligations (CDOs) to finance mortgages to anyone with no risk to the banks and banks earned enormous short-run profits. Another innovation allowed some companies to reap large profits. This innovation was Credit Default Swaps (CDSs) and excessive greed and poor judgment caused several companies to over extend themselves. These companies were pursuing large profits without considering their financial exposure to changes in the economy. These financial securities are complicated and the author greatly simplified the analysis; thus, any knowledgeable person can make sense of them and see how foolish the bankers on Wall Street were, and more importantly, how government should by and let it happen. SecuritizationBanks can use securitization to package together in a fund any type of debt that generates cash flow. The cash flow results from debtors paying back their debts. However, this chapter focuses on securitization of mortgages. Once a bank grants a mortgage, the bank can use securitization to get rid of it. The bank packages these mortgages into a fund and allows investors to buy into it by purchasing the fund’s bonds. A fund may issue different types of bonds called tranches. A tranche is a French term meaning a portion or slice. Each tranche has a bond associated with a risk level and thus each tranche of bonds have different credit ratings. Some bonds are rated AAA, and will pay the lowest return to investors, but investors are first in line, if the fund goes bust. The fund also issues risky bonds, also called speculative grade, that pay a higher return, but investors can lose their investment if the fund bankrupts. The reason why securitization was not used on a large scale before the 1990s is banks had no easy way to quickly price the different tranches in the fund until a statistician, David Li, devised a method in 2000. Li’s method allows easy and quick pricing of these tranches. When the borrowers pay their mortgages, the payment goes into the fund and the fund pays a return to the investors. The bank gets backs its money from the mortgages and can use this money to grant new mortgages. As long as most borrowers are paying back their mortgages, these funds remain solvent and investors earn a return on their investment. Banks earn short-term profits from the closing cost fees when they granted a mortgage and then earn fees for managing the fund. (Also, attorneys can earn legal fees from the fund setup). Of course, the banks do not earn the cash flow from a mortgage; the fund investors do. For example, if a family bought a $100,000 home at 7% interest rate, as a 30-year mortgage, then their monthly payment is $665 per month. This does not include property taxes, homeowner’s insurance, and other fees. However, the homeowner pays a total of $139,509 of interest to the investors’ fund over the life of the loan. Further, banks persuaded homeowners to accept adjustable rate mortgages (ARMs). Thus, a mortgage payment can change as interest rates change. At the beginning, homeowners paid low mortgage payments, but payments exploded in size as interest rates reset to higher levels. Using the same example with a $100,000 mortgage with no principal paid, and the interest rate climbs to 10%, then the homeowner’s monthly payment climbs to $878 per month, increasing by $213. Thus, they pay a total interest of $215,925 to the investor fund. With home prices in California averaging $500,000, these numbers become much more extreme. Some of the largest players in securitization were Countrywide Financial, Lehman Brothers, and Wells Fargo. Two public companies were also heavily involved which were Fannie Mae and Freddie Mac. President Franklin D. Roosevelt created the Federal National Mortgage Association (i.e. Fannie Mae) in 1938. The President gave two Fannie Mae two functions: provide mortgages to low-income households and make the mortgage market liquid. Investors prefer liquid assets because they can be sold quickly with little transaction costs. On the other hand, mortgages used to be illiquid assets. Once a bank granted a mortgage, the bank was stuck with the mortgage until either the bank foreclosed on the home or the homeowner paid off the mortgage. No investors wanted to buy these mortgages because mortgages are long-term loans lasting up to 30 years and mortgages are high risk. If a homeowner stops paying his mortgage, investors can incur large losses, even with a very low default rate and the ability to foreclose on the home. The U.S. government transformed Fannie Mae in 1968 into a private corporation, taking Fannie Mae out of the government budget. Also the U.S. government created the Federal Home Loan Mortgage Corporation (i.e. Freddie Mac) in 1970, because the U.S. government wanted more competition in the mortgage market. Freddie Mac performs the same functions as Fannie Mae. President Clinton used the Community Reinvestment Act during the 1990s to pressure Fannie Mae and Freddie Mac to expand loans to low-income households, especially black and Hispanic households. Thus, both Fannie Mae and Freddie Mac expanded mortgages to low income households until it comprised at least 42% of their loans (Lotterman 2008; Schulzke 2008). Further, Fannie Mae and Freddie Mac were also purchasing mortgages from the banks, heavily using securitization to package mortgages. Nothing is wrong with securitization. The only problem was the banks, Fannie Mae, and Freddie Mac extended too much credit to poor people. Poor people may be more vulnerable to downturns in the economy. A downturn in an economy causes layoffs to increase, jobs become scarce, and people have more trouble paying back their debt. Furthermore, homeowners cannot pay their mortgages if they lose their job and cannot find a new one. Consequently, bankruptcies and foreclosures increase, putting severe financial strain on the mortgage companies. The 2007 Recession meted out severe punishment to Fannie Mae and Freddie Mac. Both of them hold approximately $6 trillion in mortgages and loan default rates started at 5% and quickly shot up to 20% in 2009. The U.S. federal government nationalized both agencies in September 2008 by annexing them to the federal government. The U.S. Treasury Secretary became the CEO of these two companies, eliminated dividends, and bought $100 million of preferred stock in both companies (Swann and Fox 2008). Preferred stock elevates investors higher up on the ladder when it comes to liquidating a bankrupt company, but these investors give up their right to vote for corporate officers. However, both Fannie and Freddie are hemorrhaging large losses daily. David Kellermann, former Chief Financial Officer of Freddie Mac, committed suicide in April 2009 (Charles 2009). Collateralized Debt Obligations (CDOs)The story continues with securitization, and here is where it gets crazy. The investment banks also wanted to get into the short-run profits of securitization. An investment bank helps corporations issue new stocks or bonds, and also help city, county, and state governments to issue new bonds. They are really marketing agents for new financial securities, whereas a commercial bank is a traditional bank that accepts deposits and makes loans. The U.S. government split the functions of investment and commercial banking during the Great Depression using the Glass-Steagall Act of 1933. The federal government split these two functions because it believed banks assumed too much risk that led to the massive bank failures during the Great Depression. For instance, if a bank helped a company issue new bonds, then the bank could push these bonds onto its customers. Since the Great Depression, insider trading, conflicts of interest, and excessive greed have perpetually plagued investment bankers. The investment banks created Collateralized Debt Obligations (CDOs). They purchased bonds from already established securitized mortgages or included other types of debt. This is really like re-securitization, creating new bonds from the already securitized debt and packaging these bonds into a new fund pool. Then investors can buy into this fund. Thus, investment banks were stacking securitization upon securitization. Like securitization, the investment banks earned origination and management fees. The CDOs were highly profitable and low risk to the investment banks. The investors who purchased the bonds to the CDOs, assumed all the risk. The investment banks got their money back and could use it to setup another CDO. The main players of CDOs were Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities (Rosen 2007). CDOs are similar to the standard securitization. The fund contains different tranches and thus, each tranche has a different bond, risk level, and credit rating. Further, CDOs were formed outside the United States to avoid U.S. taxes and regulations. The U.S. government assesses taxes on foreign companies if they are involved in a trade or business with the United States. However, if a foreign company invests in stocks and bonds, then they are exempt from U.S. taxes. Foreign companies purchasing securities is not considered a trade or business. This loophole probably exists because the U.S. government wants international investors to buy U.S. Treasury bonds. Some experts believe the rating agencies participated in fraud, were inept, or had trouble accurately assessing the true risk of CDOs. The reason is investment bankers packaged CDOs to always have an AAA rating (Rozeff 2008). Thus, subprime mortgages were blended with high quality mortgage pools to obtain this AAA grade. Then international investors started to invest in CDOs only because of the AAA rating. Estimates of the global market ranged from $552 billion to $2 trillion in 2006. The investment banks went into overdrive. Foreign investors were pouring money into these CDOs, causing indirectly a large flow of money into the U.S. housing market. Thus, investment and commercial banks needed to grant more mortgages to keep this system going. Banks and mortgage companies kept lowering their lending standards and granted anyone a loan. The joke among Houston realtors was if a homebuyer has a heartbeat and a paycheck stub in his pocket, then he had himself a mortgage loan. A large infusion of money into the housing market caused property values to quickly rise. Some states like California, Florida, and Nevada experienced double-digit growth in housing values. Of course, the U.S. politicians did nothing to stem this. The politicians were happy that everyone and anyone were granted mortgages. Unfortunately, affordable housing remained far from their minds or worse yet, how poor homeowners could afford to pay higher mortgage payments when they reset to higher interest rates. Furthermore, many homeowners cashed out their equity from the higher property values; they paid off credit card debt, planned exotic vacations, or bought new cars or appliances. All states tie property taxes to property values. With property values quickly rising, local governments experienced surges in property tax revenue. Local governments used these taxes to expand police and fire departments; to build new jails, libraries, and schools; and to hire more teachers. The U.S. mortgage party unfortunately ended in 2007. Some international investors started to question the financial health of their CDOs and the spigot of mortgage funding was turned off in August 2007. Then the United States entered a recession in December 2007. The 2007 Recession started the hemorrhaging of jobs. Furthermore, homeowners with ARMS were paying higher monthly payments that they could not afford. Thus, more homeowners are declaring bankruptcy and foreclosures are climbing. A glut of homes on the market is causing house values to fall. Some people are even fleeing from their homes, because their mortgages became worth more than the home’s value. Consequently, neighborhoods are becoming infested with deserted, boarded up houses. These abandoned homes are attracting squatters and squatting is leading to the growth of a new industry. Squatting companies patrol neighborhoods and prevent squatters from moving in. The bankruptcy and foreclosure rates continue to soar during 2009. Unfortunately, securitization and CDOs create several legal problems for foreclosures. The most important question is who has a legal right to foreclose on a home if the borrower defaults? The bank sold the mortgage to the fund and gave up ownership to the mortgage. Technically, the fund investors own the home, even though the bank manages the fund. Further, who has the legal right to renegotiate the terms of a mortgage? Some homeowners thought they successfully re-negotiated lower mortgage payments to the bank and then the investors foreclosed on their homes. The investors did not agree to the new mortgage terms. Further, the bank sometimes misplaced or lost the mortgage paperwork. Thus, some homeowners have challenged banks in court and made the banks prove they own the mortgages. Some homeowners used this technique to delay foreclosure or if the homeowners are lucky and the bank lost the paperwork, they can renegotiate a more favorable mortgage. Finally, some homeowners bought investment homes with mortgages and rented these properties to tenants. All states differ about eviction procedures when the renters paid their rent in full, but the landlords defaulted on their mortgages. CDOs have a severe flaw and could be used for fraudulent purposes. Companies can use CDOs to convert their debt into assets. For example, a company’s financial statements are not looking too great. The company may have too much debt on the books, so the company sells its debt and allows it to be packaged into these CDOs along with debt from other companies. Now the debt is removed from the books, but the company has to make payments on the debt. Then the company acts like an investor and buys into the CDOs, converting a debt into an asset. Thus, companies could legally improve their financial statements even though this is smoke and mirrors. At this point in time, it is not known how many companies used CDOs to artificially inflate their financial statements. Credit Default Swaps (CDS)Here is where the story gets even crazier. Some insurance companies and investment banks created Credit Default Swaps (CDS). The best way to describe this financial instrument is a type of insurance. Some investors would like to purchase speculative grade (i.e. risky) bonds, because these bonds pay higher interest rates. This also includes the CDOs. However, if the business bankrupts, then these bonds become worthless and the investors lose their money. Thus, CDSs were born. Investors could buy these risky bonds and also buy CDS contracts. Investors would pay premiums on CDSs as if it were insurance to investment banks. If the company bankrupts and its risky bonds collapse in value, the investment bank would pay the investors their loss that is specified in the CDS contract. If the company with risky bonds did not bankrupt, then the investment bank kept the premium payments as profits. CDSs have a severe drawback. Investors are not likely to buy CDS for bonds or other debt from financially strong companies with AAA ratings. These companies are not likely to bankrupt and why purchase insurance for an unlikely event? Investors are only likely to purchase insurance for probable events. Thus, investors are more likely to purchase CDSs for speculative grade bonds or debt. During good times, companies rarely file for bankruptcy, even risky businesses that issued risky bonds. Thus, the investment banks would collect CDS premiums as almost pure profit. During good times, AAA rated companies have a zero default rate while speculative grade bonds have a default rating less than 4%. However, during the 2001 recession, AAA rated companies still had close to a zero default rate while the default rate shot up to 10% for speculative investments (Hamilton et al. 2004). As bankruptcies climb, losses can be staggering during a downturn in the economy. The largest players of CDSs were American International Group (AIG), Bank of America, Citibank, Countrywide Home Loans, GMAC (i.e subsidiary of General Motors), General Electric Capital, Goldman Sachs, JP Morgan Chase, Merrill Lynch, Morgan Stanley, and Wachovia (Bajaj 2008; Morrissey 2008). CDSs are contracts and are traded in the financial markets. Anyone can buy them, even if the investors do not own the risky bonds that are specified in the CDS contract. Therefore, speculators can enter the market and gamble on outcomes. For example, a gambler believes Company XYZ is going to bankrupt. This gambler does not hold any stock or bonds for this company, but can buy a CDS contract. The gambler only has to pay the CDS premiums. However, if this company does indeed bankrupts, then the gambler gets a payout from the issuer of the CDS contract. If Company XYZ does not bankrupt, then the gambler lost his bet, which is the CDS premiums. Imagine how much money someone could make if he/she had inside information about a company’s finances. Some investors even bet the housing market would collapse and bought CDS contracts on CDOs (Morrissey 2008). If you are having trouble understanding them, then think of this analogy. It is as if you are buying insurance on your neighbor’s house and praying for the house to burn down and collect the insurance. The CDS contracts have a similar feature to CDOs. CDS contracts can be stacked upon CDS contracts. For example, Company X buys a CDS contract from an insurance company and pays 2% of the contract’s value as a premium. Now the financial health of the company, specified in the CDS contract, deteriorates, increasing the risk on its bonds. Company X can exploit this situation, and create and sell a new CDS contract to Company Y for a 6% premium, earning 4% commission on the deal. If that company does indeed bankrupt, then the insurance company pays Company X its CDS insurance, and in turn, Company X pays Company Y the same insurance money, earning a quick 4% commission on the deal. Thus, multiple CDS contracts can apply to the same debt. Unfortunately, the CDS contracts depend on one important assumption. The issuing companies can indeed payoff the CDS contracts if the companies fail. The CDS market in the United States quickly grew into $47 trillion market by June 2008, covering a debt of approximately $34 trillion (Bajaj 2008). To put this number into perspective, the U.S. economy in terms of Gross Domestic Product (GDP) is approximately $14 trillion. Consequently, the potential losses if all CDS contracts have to be paid would be over 3 times the size of the U.S. economy. With the downturn of the U.S. economy in December 2007, one company, AIG, quickly accumulated losses into the billions as investors requested the payouts from the CDS contracts. AIG’s current loss is $60 billion and growing by the day. The U.S. federal government owns 80% equity share (Karnitschnig et al. 2008) and has promised AIG four bailout loans worth a total of $163 billion (Dow Jones Newswires 2009). Unfortunately, AIG worked with several investment banks like Goldman Sachs and Lehman Brothers, which also had severe financial troubles. The U.S. government bailed everyone out, except Lehman Brothers. For some reason, the federal government refused to help or bailout Lehman Brothers[1]. Once the public learned that Lehman Brothers was insolvent and the government was not going to help it, the financial markets went into a nosedive in September 2008. Further, the credit markets froze as all financial institutions stop granting loans. About 350 banks and investors would lose their CDS insurance, because Lehman Brothers issued approximately $400 billion in CDSs on debt that was worth only $155 billion. Yes, Lehman Brothers issued more CDS contracts than the amount of debt by 2.5 times (Bawden and Jagger 2008). Lehman Brothers is bankrupted and is liquidating its assets. Lehman Brothers is the largest casualty of the 2008 Financial Crisis so far. Excessive greed brought the end to a 158-year-old company. The current status of some of the largest U.S. financial institutions is:
ConclusionThe securitization of mortgages, CDOs, and CDSs depend on a strong, growing U.S. economy. Mortgage default rates are low and very few companies file for bankruptcy. Thus, many U.S. financial companies reaped substantial short-term profits from these financial instruments. However, all market economies are plague by oscillations of the business cycle. The United States has had recessions approximately every 10 years. The United States had a recession in 2007, 2001, 1991, and 1981. The question is not whether the United States will have a recession, but when. These financial geniuses and Wall Street bankers ignored this simple fact, overextending themselves and their companies for short-term profits. Some fault must be laid at the feet of the Federal Reserve and U.S. government. The Federal Reserve and the U.S. federal government could have slowed down the housing bubble anytime. The Federal Reserve could have boosted interest rates, which would have slowed the growth of new mortgages. The federal government could have imposed regulations on the CDOs and CDSs, and tightened lending practices. Unfortunately, the federal government wanted universal homeownership for all Americans at any costs. Freddie Mac even paid $11.7 million to lobbyists, so they could persuade Congress not to impose stricter lending standards on the mortgage industry (SF Examiner 2008). Further, some believe a strong housing market coupled with appreciating home values was propping some state economies like California. In California, many industries were stagnant and not growing except the housing and financial industries. The growth of these two industries caused a surge in tax revenue, expanding the state and local governments in California. The U.S. government and the Federal Reserve are bailing out the financial
industry. President Bush offered a bailout package of $700 billion in October
2007 to the financial system, President Obama is offering a $900 billion to
jumpstart the U.S. economy, and the Federal Reserve has granted $2 trillion in
loans to the banking industry. The Federal Reserve does not publicly release
details, because it could cause investors to panic. Some financial institutions
changed their company status to a banking holding company as a way to ask the
Federal Reserve for emergency loans. GMAC and two investment banks, Goldman
Sachs and Morgan Stanley, became bank holding companies that became eligible for
loans from the Federal Reserve. It is debatable whether these companies can pay
these loans back. All of them are earning substantial losses. General Motors,
the parent company of GMAC, has already accumulated a loss of $9.6 billion
(Kaiser 2008) that is growing daily. Unfortunately, the public views the
government’s bailout package as free money, so everyone is getting in line. The
advantages of the bailout package are:
The problems of the bailout package are:
One bright spot is emerging through the stormy clouds of the 2007 Recession. The recession is bringing families back together. Kids are moving back in with their parents or parents are moving in with their kids. Further, some couples are postponing divorce, because they cannot sell the house and divide the marital assets. In addition, economic hard times like the Great Depression produced great leaders. Maybe the 2007 Recession will produce strong leaders that will lead the United States into the next century as a world power. Henry Paulson, Secretary of the U.S.Treasury in 2008, wanted to show that the U.S. government would not bail out all the financial institutions. At least one company had to fail. However, Lehman Brothers was financially connected to the other financial institutions. The Lehman Brothers collapse would spread to other financial institutions, like a contagion. Henry Paulson was a former CEO of Bears Sterns, which was a fierce competitor with Lehman Brothers. 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