The financial crisis of 2007-2008 is complex. This article will explain the most important concepts, such as the financial context prior to the crisis, the housing bubble, the different players involved, and the nature of MBSs and CDOs.
I was impressed by Michael Lewis’s ‘The Big Short’ (2015). Put simply, I like the idea of a few independent thinkers refusing to naïvely trust the integrity and sustainability of Wall Street’s latest profit generators. However, I found that I wanted to know more about the crisis; the movie’s short explainers provided by celebrities just didn’t cut it for me. In particular, I didn’t understand how to connect the dots. What was the financial context prior to the onset of the crisis and how did this lead to a housing bubble? Additionally, how were all of the different players involved in the crisis linked? This article will attempt to answer these questions and provide a chronological explanation of the crisis.
Before I dive in, I would suggest watching the below video by Ray Dalio to gain an understanding of basic economic principles. You don’t need to watch all of it; what matters is that you grasp the cyclical nature of economic growth and the importance of credit.
As a result of the dot-com bubble bursting in 2000 and the terrorist attacks of 9/11, investors and banks had become risk-averse. This resulted in low economic growth. In response, the U.S. central bank – the Federal Reserve – lowered interest rates. This is a type of monetary policy that typically has the effect of stimulating the economy. Let me explain why. Leverage/debt has the effect of multiplying the returns of an investment or a business deal. If you buy a car for €10,000 and sell it for €12,500, you have made a 25% profit, or €2,500. However, if you take on €40,000 in debt, buy five cars instead, and sell these for the same 25% profit, you make €12,500 which is five times as much! Banks always use leverage/debt to conduct their business operations and if this is available cheaply (i.e., at a low interest rate) from the central bank, they will borrow more to make more. Lower central bank rates, which dropped from 5-6% in 2000 to 1% in 2003 have the effect of flooding the economy with money, which typically leads to inflation (increasing prices) and growth. Vice-versa, investors such as pension funds, hedge funds, banks and other institutions can also lend money to the central bank or government to make a return. Specifically, they can buy treasury bills (short-term loans) or treasury bonds (long-term, multi-year loans) that pay interest. These investments are not always attractive because they typically offer low albeit safe yields: in 2003, T-Bills with a 26-week maturity yielded about 1%. This meant that investors were sitting on mountains of cash and grumbling over a lack of enticing investments.
The availability of cheap credit also led many aspiring home owners to purchase houses since they could capitalise on the low interest rates they would have to pay on their mortgages. The process of buying a house typically works like this: you save for a downpayment and contact a mortgage broker, who in turn pairs you with a lender who creates a mortgage for you. The mortgage broker receives a commission for his services and the lender retains the right to seize your house in the event of default. The lender can also sell your mortgage to another financial entity for a fee, which is often the case. Although house prices tend to rise consistently in the long-term, the 2003 buying frenzy accelerated this trend strongly. Investment banks saw an opportunity to profit from this booming market by using significant leverage to buy up thousands of mortgages and packaging them into mortgage-backed securities (MBSs). Securitisation refers to the practice of turning a group of illiquid assets such as mortgages into a liquid and easily marketable financial instrument like the shares of a company. In this case, they were being marketed to salivating investors who were ‘starved for yield’ (a return which exceeded that of T-Bills). In practice, a MBS was created in the form of a special purpose company. The shares of this company could be bought by investors and they yielded the interest payments made by a group of homeowners on their mortgages. Shares of the company were also split into different tranches according to their risk, which was based on the underlying homeowners’ probability of defaulting on their mortgages. The riskiest tranches were called ‘equity tranches’, mid-risk tranches were labeled ‘mezzanine’, and the safest tranches were described as ‘senior’. The risk-rated nature of these MBSs made them an excellent product because they could be tailored to an investor’s risk tolerance. For instance, hedge funds would often buy the equity tranches, whereas pensions funds would purchase safer tranches.
The MBSs sold well. So well in fact, that the investment banks were running out of prime (i.e., high-quality mortgages with a low default risk) mortgages to package into the MBSs. Everybody, from the mortgage broker to the investors was eating from this pie and so they all had an interest in keeping the profit engine running. The pressure began to mount on the brokers and lenders to create and pass on new mortgages, which in turn led to increasingly risky and predatory lending practices. Enticed by adjustable and teaser rates, which lenders figured were minor concessions considering that they could always seize the houses and sell them in a booming market, families and individuals who had no verifiable income or immigrants with no documentation were targeted for high-risk subprime mortgages. The influx of more and more subprime mortgages was reflected in the degrading composition and increased risk of the MBSs and the creation of even riskier collateralised debt obligations (CDOs) which housed the riskiest mortgage bonds in addition to other asset classes.
At the behest of the investment banks and in return for hefty fees, ratings agencies such as Standard & Poor’s and Moody’s marked many of these MBSs and CDOs as ‘AAA’ – the safest possible credit rating. This would allow the products to be sold more easily. The ratings agencies gave the superficial explanation that, because of the number of mortgages these products contained, they were diversified – the effect of a single default could be cushioned by all the other healthy mortgages. This was true in theory, but dead wrong in practice. In reality, MBSs and especially CDOs were filling up with very low quality subprime mortgage bonds that were virtually guaranteed to enter default. For example, at the peak of the bubble, the ‘interest-only, negatively-amortising, adjustable-rate subprime mortgage’ emerged, which was essentially a large loan that didn’t require the borrower to make interest payments. In other words, this loan catered to people with no income. The entire business of creating mortgage bonds, selling them, repackaging them and selling them again had turned into a game of hot potato, in which the actors breathed sighs of relief as soon as these products were off their books. The game was incentivised at every single stage by fees and commissions, which kept the process running. In 2004, U.S. home ownership peaked at 69.2% and the Federal Reserve raised rates by a full 1% that same year. An initial trickle of mortgage defaults turned into a river, causing lenders to put more and more houses up for sale. The supply of houses quickly exceeded demand and beginning in August 2006, home prices began to fall for a six year period, bottoming out in 2012. Sinking home prices led owners to ponder the wisdom of paying for a $300,000 mortgage when their house was now worth only $80,000, leading them to also abandon their houses and accelerating the downward spiral of house prices.
Like a domino-effect, the crash of the U.S. housing market initiated the wider financial meltdown of 2007-2008. Falling prices and people walking away from or defaulting on their mortgages meant that the MBSs, CDOs, and a host of other far more exotic products (such as CDOs squared) held on the books of lenders, investment banks, pension funds, hedge funds, and many others now became worthless. Nobody traded these assets anymore and the market for them completely evaporated. Financial institutions’ exposure to credit default swaps (CDSs) further amplified the already dire situation. Investment banks and other vendors that sold MBSs and CDOs also dispensed CDSs to buyers as a form of insurance in the event of homeowners defaulting on their mortgages. CDSs had a protective effect because they allowed one to short (bets against) the MBS and CDO markets: in the event of default and the MBSs/CDOs losing value, the CDSs would increase in value, thereby limiting the downside. Since the riskiest equity tranches of CDOs had the greatest exposure to possible defaults, the CDSs for these high-risk products were more expensive than those which insured the lower-risk mezzanine and senior tranches. Driven by their unwavering faith in the stability of the housing market, investment banks had eagerly sold these CDSs to buyers which led them to rake in profits. Indeed, as portrayed in the ‘The Big Short’ (2015), when Michael Burry of Scion Capital initially asked for the CDSs to be created for him in 2003-2004, the banks felt that he was literally throwing free money at them. Additionally, in 2008, it was made possible to buy CDSs even if you didn’t actually own the underlying assets i.e., the MBSs and CDOs that they were designed to insure. This was fantastic news for short-sellers: they could purely bet against the housing market without even owning any of these dangerous assets themselves.
Economic growth is driven in large part by the availability of credit and U.S. banks’ struggle to remain solvent led them to restrict lending and freeze business transactions. This incited an economic recession which ricocheted internationally as a result of the interconnectedness of the world’s economies and financial systems. Worldwide, banks teetered on the edge of bankruptcy as a result of their massive exposure to MBSs and CDOs that were losing value and their obligation to meet the claims that the owners of CDSs were not entitled to. The very banks that had sold CDSs as insurance with the absolute confidence that they would never have to meet the claims now scrambled to buy them to protect themselves and limit their losses, resulting in windfall profits for short sellers who had foreseen the destruction. Infamously, governments and central banks bailed out many of the institutions that had caused the crisis, such as American International Group in the U.S. and UBS AG in Switzerland, to name but a few. Relative to some other countries, the U.S. got off lightly. Indeed, in a large-scale bailout, the Icelandic government nationalised its three largest banks. These banks had comprised the majority of the Icelandic stock market’s value, which caused the Icelandic All-Share Index to crumple roughly 95% between July 2007 and March 2009, triggering riots that toppled the government in January 2009. The meltdown also precipitated the Eurozone Crisis which hit Greece hardest of all, in part because of the quantitative easing policies implemented by central banks to reboot economies.
A common element of financial crises is their unlimited complexity, which means that even the best of explanations can’t cover everything. If I were to summarise the causes of the crisis, I would name the following factors: a lack of regulation and oversight, predatory lending practices, increasing financial complexity, misjudgement of risk, and outright greed. I believe that the last cause is easily overlooked. Every single institution involved in the MBS and CDO fest was incentivised in the form of fees and commissions, from the brokers to banks, to the ratings agencies and investors, leading everyone to put aside their concerns and morals in order to maximise profits. It’s doubtful that nobody saw the crisis coming: the very nature of asset bubbles is that they are temporary phenomena which always burst and I think that the hot potato analogy is an excellent way of visualising how these institutions conducted transactions at the time. Learning about the crisis convinced me of three things. The first is that we will likely experience another crisis of a similar magnitude in the future. That crisis might follow a similar pattern which is hard to notice in the midst of it all but easily identifiable in retrospect. The second is that irrational greed is inevitable and that its degree correlates positively with the amount of money involved. The third is that being a contrarian and independent thinker – like those who shorted the housing market via CDSs – must be painful and challenging. Even the people who had doubts about the sustainability of the housing bubble probably put aside their concerns when they saw how much faith ‘reputable organisations’ such as Lehman Brothers placed in the housing market. The simple truth is that Lehman Brothers went bankrupt – that’s why you only trust your own due diligence.
Johan Lunau – 28/05/21
Want to learn earn more? You can purchase Michael Lewis’s original book ‘The Big Short: Inside the Doomsday Machine’ via my Amazon-affiliate link: https://amzn.to/3x5PU4F
I would also recommend watching Michael Burry’s presentation at Vanderbilt University: