23 October 2009

A Brief History of the Crash of 2008

There are a number of contributing factors to our present financial crisis but the biggest issue (and the catalyst that set it off) is the collapse of the financial derivatives market. My friend, Paul B. Allen, has started Crashopedia.com to document the causes of the crash in detail but it can get pretty thick. Here’s my simplified summary of what happened:
1970GNMA "Ginny Mae" issues the first Mortgage Backed Security (MBS). A MBS is a way of collecting money to lend out in the form of mortgages. Bonds in the MBS are sold and the resulting cash is invested into a pool of mortgages. FNMA "Fannie Mae" and FHLMC "Freddie Mac" follow suit.
1977Under pressure from the Community Reinvestment Act banks and other mortgage vendors begin issuing high-risk (also known as sub-prime) mortgages with correspondingly higher interest rates.
Early 1980sIncentivized by the government and attracted by the high interest rates of these mortgages, bankers begin seeking a way to attract capital to invest in high-risk mortgages. Unfortunately, the market for high-risk investments is relatively small and interest rates are high.
1983Bankers invent the Collateralized Mortgage Obligation (CMO) which is a type of MBS in which shares are divided into risk "tranches." The idea is that if a lot of high-risk mortgages are pooled together the risk is reduced because only a fraction are likely to default. Risk can be further reduced for some investors by dividing the bond pool – decreasing the risk for premium tranches and increasing it in lower tranches. Bond rating organizations like Standard & Poors agree with this theory and offer high ratings.
1987Realizing that splitting risk into packages can work for more than just mortgages, bankers invent the Collateralized Debt Obligation (CDO) which is just like a CMO except that it may be backed by corporate bonds, commercial paper or other kinds of loans.
Early 1990sIn pursuit of ever higher interest rates (from higher-risk mortgages) but having trouble placing the higher-risk tranches of CMOs and CDOs, bankers find ways of enhancing the ratings of these tranches by using Credit Default Swaps. This is just a fancy name for an insurance policy. The bankers pay an insurance premium and the insurer pays up if the underlying asset (mortgage or bond) fails to make payments. Bankers can afford the insurance premiums because they collect more interest from the high-risk loan than they have to pay to the low-risk bond. AIG becomes one of the leading insurers of these obligations.
1990s and 2000sBankers come up with all kinds of new derivative instruments such as CDOs that invest in other CDOs (CDO squared), Single-Tranche CDOs in which insurance is used to raise the rating of the entire package, Strips, REMICs, PACs, Floaters and more. The tantalizing returns of these investments cause people to ignore Warren Buffet’s advice to invest only in things you understand.
2001Driven largely by growth in financial derivatives, the Financial sector surpasses Information Technology to become the largest sector in the S&P 500 as measured by market capitalization.
2002-2005Continuation of the longest sustained growth period in U.S. history masks the real problem with derivative instruments. That problem is that an overall decline in the housing sector or in the economy as a whole would cause simultaneous defaults – something that diversity and insurance don’t account for. Unencumbered by hidden risks, derivatives continue to offer stable income to investors and while enriching the investment banks that handle them.
2006The housing bubble bursts. Due to the ease of obtaining mortgages and the recent history of good real estate performance, a great deal of speculative building occurred in the early 2000s. By 2006 there was a surplus of homes in key markets like the West Coast, the Southwest, the Northeast Corridor and Florida. A mild recession at the time coincided with interest rate increases on Adjustable Rate Mortgages. The result was a wave of mortgage defaults.
2007The mortgage crisis cascades into the whole economy. Rumors grow that we may be in for a recession. Mortgages become increasingly difficult to get as investors pull out of the mortgage market.
2008Derivatives turn out to much riskier than their ratings indicated. AIG becomes insolvent as large numbers of CDOs default and they are required to pay up. Only a bailout by the Federal Reserve prevents it from going under. Credit markets freeze because bankers can no longer reliably determine the value of derivates which now account for an enormous part of the financial market. A new tern, Toxic Asset, is used to describe these because not only can they not be valued but neither can any institution that owns a substantial portfolio of them. Hundreds of banks with large portfolios of toxic assets fail and are taken over by the FDIC. The First Bailout Act including the Troubled Asset Relief Program is passed allowing the Treasury and the buy up toxic assets in an effort to relieve the credit markets.
2009As of this writing, the bailouts have had little success except to protect the profits made by irresponsible financiers. Credit markets are still extremely tight, the country is in a full recession, and unemployment is approaching 10% with certain markets well into double digits. Despite this, Congress and the White House have focused efforts on Healthcare Reform rather than considering regulations that might prevent irresponsible use of financial derivatives in the future.
Missing from this history are all of the forewarnings. For example, the General Accounting Office warned in 1994 that regulation of the market was warranted. Congress held hearings on the subject multiple times in the 1990s and 2000s and Warren Buffet famously wrote in 2002 that derivatives are "time bombs." There were many opportunities to prevent the train wreck before it happened. Unfortunately, the financial lobby was strong enough to prevent any meaningful reform.

I have some thoughts on how reform can be achieved without government intervention but those will have to wait for a future blog post. Meanwhile, this is yet another example of how government seems to be immune to forewarning. Action, if taken at all, occurs after the crash.

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