Understanding the 2008 Financial Crisis, part 2

In 2005 and 2006, housing prices began to fall.  This, combined with the fact that the mortgages from 2003 and 2004 were reaching the end of their two-year fixed interest rate and spiking, led to defaults in record numbers.  The fuse had been lit, the dominoes began to fall; use whatever metaphor you want here, it was bad and only going to get worse. 

In March, 2007 Bear Stearns, the 5^th largest investment bank in the country, was unable to meet its financial obligations.  They had invested heavily in mortgage-backed securities and CDOs and had even sold some credit default swaps.  As their shares plummeted, the Treasury Department, led by Treasury Secretary Hank Paulson (the former CEO of Goldmann Sachs), took action to attempt to stabilize the financial sector.  They negotiated a merger in which Bear Stearns was bought by JP Morgan Chase for $2 a share with the government guaranteeing $30 billion in toxic assets. 

The markets stabilized for a time but the underlying problem of housing defaults continued.  The type of large-scale crisis that occurred in September 2008 was the result of these defaults combined with the shady bookkeeping of Wall Street firms.  The actual liquidity of investment banks like Lehman Brothers, financial conglomerates like CitiGroup, and insurance companies like AIG was relatively unknown. 

When Wall Street firms posted almost across the board losses in the 3^rd quarter of 2008 resulting from the investment in mortgage backed securities and CDOs all of the dominoes began to fall.  Lehman Brothers (the 4^th largest investment firm in the country), whose stock had been trading at $66 a share, plummeted to $2 a share in a matter of months (as pictured below).  While Lehman CEO Richard Fuld expected the Treasury Department to give them the same deal they gave Bear Stearns, Secretary Paulson sought a private sector solution (meaning rather than the government guaranteeing Lehman’s toxic assets, the other investment firms would). 

But after the deal with Bank of American fell through (they eventually bought Merrill Lynch) and British regulators killed the deal for Barclays to buy Lehman, Lehman was forced to declare bankruptcy on a Sunday night as an attempt to stabilize the markets opening on Monday.  It did not.  When Lehman declared bankruptcy, British regulations mandated that the personnel at Lehman’s London office leave the premises.  When this occurred, investors who sought to withdraw their money from Lehman’s accounts were not able creating panic and a run not only on that one bank but on every investment bank in the world. 

As a result, the world-wide credit market was frozen; investors could not get their money out of the banks and corporations, such as GE, could not get enough liquid capital to run their day to day operations.  After choosing not to take direct action for the sake of Lehman Brothers, the government realized that they had no other option in this case. 

First, they attempted to steady AIG by buying, originally, $85 billion in toxic assets (that number would later increase to about $160 billion).  When this failed to stabilize the market and various other financial institutions neared collapse the Treasury Department sought Congressional approval for larger-scale action. 

Led by Secretary Paulson and Federal Reserve Chairman Ben Bernanke, they sought $700 billion from Congress for two purposes: continuing to buy the toxic assets poisoning the market and injecting capital into the market to return it from the brink of collapse and unlock the credit market.  While Congress originally voted down the measure (which led to a 777 point drop in the stock market, the largest in history) they eventually agreed to and passed the Troubled Asset Relief Program (TARP). 

So after years of dubious financial management and economic finagling what was the final product?  Millions of Americans defaulted on their mortgages and went into foreclosure; millions of Americans lost their jobs; the American economy lost approximately $1 trillion in value. 

And the Wall Street firms?  Well the investment banks received $125 billion in TARP money which they were supposed to, but did not, lend out; AIG was given a total of $160 billion in taxpayer money to remain solvent; Fannie Mae and Freddie Mac were taken over by the government.  On top of these taxpayer bailouts, the Obama Administration spent almost $900 billion on a stimulus package in an attempt to repair the job market. 

We have learned about the dangers of the specific instruments at play during this crisis; sub-prime mortgages, bad; mortgage backed securities, bad; CDOs, bad; credit default swaps, bad.  But the realities of the financial system have not changed.  The incentive structure remains essentially the same, evident by the record bonuses given out after the financial crisis.  The securitization chain remains in effect for various other financial instruments.  And the government has not instituted any real financial reform; Dodd/Frank was a valiant effort but lacked teeth. 

So now we wait; wait and see if Wall Street has learned its lesson.  I for one would feel better if the future of the American economy was not in the hands of those who most recently brought it to the brink of collapse.  

Understanding the 2008 Financial Crisis, part 1

If you’re like me, you have a vague understanding of what occurred in 2008 to bring the United States’ economy to the brink of ruin.  The terms subprime mortgages, mortgage-backed securities, collateralized debt obligations (CDOs) and credit default swaps were continuously thrown around on cable television and the pages of our newspapers.  But what does it all mean, and what exactly happened?  Here’s a quick (and not at all expert) explanation.

There were four main parties involved; the consumers, the mortgage lenders, the government, and Wall Street.  All bear some responsibility, to varying degrees.

Consumers, in unprecedented numbers, sought the quintessential American dream, a house of their own with a yard and probably a fountain with some odd gargoyle-like statues.  In and of itself, this was not problematic; the housing, construction and insurance industry became a booming part of the American economy and housing prices continued to rise making real estate a positive investment. 

But many Americans got greedy.  With low interest rates (the Alan Greenspan-led Federal Reserve reduced interest rates to their lowest level since World War II in the years following 9/11) and the continued rise in the value of real estate, people began refinancing their mortgages and using the extra money to buy a boat, or a car, or in some cases another house.   

Then there was the mortgage lenders.  Due to low interest rates, mortgages being guaranteed on a large scale by quasi-government agencies Fannie Mae and Freddie Mac, and the appetite of Wall Street investment banks for more mortgages to finagle into investment grade bonds, it became more profitable to sign as many subprime mortgages as possible.  Because of this, mortgage lenders such as Countrywide began lowering their lender criteria.  While, before, you needed a FICO score of 615 to get a loan, people could now get one with a score as low as 500; additionally, lenders stopped requiring down payments or occupational information.

Because the lenders sold the mortgages to Wall Street firms to be packaged into bonds, they had no incentive to be cautious.  They began creating mortgages that were almost made to default.  Many had a two-year fixed rate at 5% or 6% which would then jump after the second year to 12% and continue at a “floating rate” for the rest of the term.  Predatory lending was rampant during this period as people like a strawberry farmer Michael Lewis mentions in his book The Big Short—a fantastic read by the way—who made $15,000 a year and paid no money down on a $750,000 mortgage with a two-year fixed rate. 

If housing prices continued to rise, as they had almost uninterrupted for the previous 40 years (as seen in the graph below), people could continue to refinance their mortgage.  But, as we know, that did not happen.  Around 2005, housing prices began to fall and consumers began to default on their mortgages.  The factors discussed explain the crash in the housing market, but why did that lead to a crash in the entire financial sector?  That’s where Wall Street comes in.

Since the end of the Cold War, physicists, mathematicians and other intellectuals have been looking for a new avenue to use their skills.  Rather than creating new weapons systems and satellites, many ventured into financial markets creating complex instruments such as derivatives and securities.

In the early 1980s, Larry Flink invented Collateralized Mortgage Obligations (CMOs) as a means of creating more value in the mortgage industry.  Charles Morris, in his book The Trillion Dollar Meltdown—also a fantastic read and a great summary of the contributing factors—says that the CMO was a “genuinely important invention and had a profound impact on the mortgage industry.”  A study in the mid-1990s concluded that CMOs saved homeowners $17 billion a year. 

As the mortgage industry became less and less conscientious in their standards, the loans packaged into CMOs became more and more risky.  So-called “subprime loans” increased at an alarming rate and the financial instrument evolved from CMOs to mortgage-backed securities, to Collateralized Debt Obligations (CDOs) which packaged subprime mortgages together with credit card debt, student loans, car loans and anything else they could find.  The value of these securities was dependent on one very important assumption, that housing prices would continue to rise…forever.

To understand why this financial structure was created and allowed to exist we must understand the securitization chain.  Businesses and financial firms such as investment banks seek at all times to maximize profits while limiting their risk.  The securitization chain accomplished this goal for almost all the parties involved: it goes like this.

A consumer gets a mortgage on their home from one of the mortgage brokers like Countrywide.  Countrywide then sells the mortgage to a financial institution like an investment bank thus passing off the risk in the case of default.  Investment banks (Goldmann Sachs, Lehman Brothers, Merrill Lynch, etc.) would then package these mortgages, along with some other goodies, into mortgage-backed securities and CDOs and sell them to investors, thus limiting their risk. 

All the while, the rating agencies (Standard & Poor’s, Moody’s, Fitch) rated many of these mortgage-backed securities and CDOs as AAA—in financial terms an almost riskless investment—because they were either duped by the opaque nature of the security or were corrupted by the fees they were paid to rate instruments.  This was especially harmful because many investors, such as pension funds and endowments, were limited in their investments to AAA rated securities since they are “safest.”  Thus in the end, it was these pension funds and endowments that lost millions of dollars while the rating agencies explained to Congress that their ratings are “merely our opinions.” 

Investors, who were banking on a continued increase in housing value, were then most vulnerable to the risk of the market.  In order to offset their risk, some invested in another financial innovation called credit default swaps.  This is, in essence, an insurance policy.  While their mortgage-backed securities increase in value as the housing market booms, the credit default swaps pay off if the housing market busts.

Insurance companies, such as American Insurance Group (AIG), sold credit default swaps because they too were working under the assumption that a large-scale drop in the housing market was next to impossible.  They received hundreds of millions of dollars in premiums from various investors and investment banks prior to the crash and owed hundreds of billions of dollars in CDS payments after.  The whole securitization chain is pictured below.

All of these factors—the desire for home ownership, low interest rates, reduced credit standards, the securitization chain—combined with a Wall Street incentive structure which rewarded high risk/high reward behavior, created a ticking time-bomb with a single fuse: housing prices.  

What Did the Ames Straw Poll Accomplish?

On Saturday, a small percentage of the Republican electorate in Iowa flocked to the little town of  Ames for an event with no real meaning but for which candidates have spent many millions of dollars.  Only once in the last thirty years—George W. Bush in 1999—has the winner of the Ames Straw Poll gone on to win the Republican nomination and the White House.

Some candidates, such as John McCain in 2007, skipped the Iowa Caucus altogether because of its reputation as an Evangelical litmus test.  McCain had also opposed the Ethanol Tax Credit during his career in the Senate which would have killed any chance he had in the Caucus.  Mitt Romney is at least partially following this path due to the fact that his New England persona and Mormon religion do not necessarily play well in Iowa. 

While the Straw Poll has very little substantive meaning, it did help to clarify and simplify the Republican primary race which can now be viewed in three tiers. 

The top tier of candidates is now made up of Romney, Michelle Bachmann and, as of his entrance into the race on Saturday, Texas Governor Rick Perry.  This is where the real action of the Republican primary will occur.  Perry and Bachmann will now compete for the votes of the ultra-conservative, evangelical, Tea-Party types while Romney will seek to portray himself as the businessman with a plan to fix the economy and a mainstream electability. 

The second tier of candidates will now look to either increase their exposure in Iowa, working towards the Caucus in February, or focus their attention on New Hampshire and South Carolina.  In reality, these candidates—Ron Paul, Newt Gingrich, and Jon Huntsman—have little chance of making much headway in the primary, although some, such as Jon Stewart, believe Paul should be getting more press.  Huntsman, due to his strategy from the beginning of focusing on New Hampshire and South Carolina plus his financial backing has the greatest chance of becoming a spoiler but that chance is still slim. 

Herman Cain, Rick Santorum, and Thaddeus McCotter round out the Republican candidates as the third-tier.  With little support and limited funds, these candidates will likely remain in the race through the Iowa Caucus in order to “get their message out” but with little chance of making any electoral headway. 

So what does this mean for the Republican Party and for the country?  With Bachmann and Perry jockeying for position as the Conservative thoroughbreds, the chances of unseating President Obama become slimmer and slimmer.  The majority of Republican Primary voters may agree wholeheartedly with the small-government, deregulatory, social conservatism of Perry and Bachmann but the majority of the American people do not—at least not to that extent. 

The further these candidates move to the right, the more difficult it will become for them to pivot naturally to the center in the general election making a general election victory all the more difficult. 

There is still a long way to go before the general election and circumstances can change drastically.  The economy and job market will be the major factor that decides the election of 2012 and Republican would do well to remember that.  A candidate’s perspective on the role and size of government or on abortion and gay rights can be important in a Republican Primary but will be dwarfed in the general election by the issue of jobs. 

The Straw Poll is over and there are now six months before the actual Iowa Caucus.  Anything can happen—maybe if we’re lucky Jon Huntsman can get a little more traction—but more likely the first tier candidates will continue in their barrage of Conservative talking points and anti-Obama rhetoric all the way to the Republican Convention in August.

Jobs Should Now Be the First Priority

In the past few weeks, the American political and economic infrastructure has experienced some serious blows.  Democrats and Republicans in the White House and Congress spent weeks debating a compromise on the defecit and debt ceiling.  In the end, they landed on a compromise that is neither substantial nor popular and was signed into law mere days before the impending default of the United States on its financial obligations.  

A few days after this compromise was reached, Standard & Poor's, a credit rating agency, announced that it had downgraded the United States' bond rating from AAA--the highest possible rating--to AA+.  S&P stated in their decision that they were "pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabalizes the government's debt dynamics anytime soon."  While S&P's credibility is in serious question due to their actions during the financial crisis of 2008--a story for another time--the effects of this downgrade have reverberated through the world economy.  In the last four days, the Dow Jones Industrial Average has wildly fluctuared from a high of 11,462 to a low of 10,687 with many peaks and valleys in between.

The question now becomes what is Congress and the president to do?  Both parties, and President Obama specifically, have announced a pivot from the debt debate to jobs, although this announcement has been made many times before.  While Obama will embark on a bus tour of the Midwest on Monday with stops in Minnesota, Iowa and Illinois, he will then begin a 10-day vacation in Martha's Vineyard with his family.  Congress meanwhile is out of session until September.  

Criticisms of Presidents for taking vacations and members of Congress for scheduled recesses are always overstated.  Political leaders--the president in particular--are never truly on vacation.  They have the technology and the wherewithal to conduct most items of business and make necessary contacts from any location.  That being said, our political leaders face two challanges resulting from this schedule.

First, there is an image problem.  Politicians came out publicly after finalizing the debt ceiling compromise and announced that jobs would be the new priority.  Members of Congress subsequently left Washington and returned to their district.  The reality of our political world is that little if anything could actually have been accomplished during the month of August had the members of Congress remained there; however the image of the recess is one of Congressmen and women exhausted from a self-inflicted conflict over the debt ceiling going on vacation while the unemployment rate remains above 9% and the stock market seemingly rises and falls on a whim.  Image may not be reality, but image is integral in the business of politics.

Second, there is an economic reality problem.  As I stated, theunemployment rate stands at 9.1% while the actual unemployment is upwards of 16%.  In real terms, approximately one in six Americans is out of work and as is often the case, the brunt of the burden has fallen on the most vulnerable.  Poor and lower-middle class families, African Americans, and even teenagers have had the most difficulty in finding employment.  

Government does not hold the silver bullet, the magic potion that can fix the economy and return unemployment to a more manageable level.  But it does have the ability to influence economic activity.  There are compromises on which Democrats and Republican could potentially agree; a great bargain of economic stability.  These could include the extension of the payroll tax cut, extension of unemployment benefits, tax reform, allowing corporations to bring overseas money back to the United States without a tax burden, and many other possible solutions.  

These may not solve the problem but they would be a step in the right direction.  Merely cutting government spending will not stabalize the economy and put us on a path towards consistent and substantial growth.  Our government must take further steps; all we need now is leaders who are actually in Washington and who have the political will to take a stand.