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.
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