Financial crisis of 2008 - Business in United States of America

The Event: Throughout 2008, declining prices for houses and increasing defaults on home mortgage loans led to a wave of failures involving banks and other mortgage-market participants. The crisis phase crested in mid-October after the U.S. Congress authorized the Treasury Department to use up to $700 billion to buy troubled assets or inject capital into banks.
Date: September-October, 2008
Place: United States, also Europe and Asia
Significance: The crisis disrupted housing markets, mortgage markets, and finance and credit markets generally. These developments reduced aggregate demand and brought on an economic recession that adversely affected most businesses and shook public confidence in financial institutions and government.
Beginning during the summer of 2007, worsening conditions in the United States housing and home finance sectors led to an escalation of financial distress. Average house prices had doubled between 1997 and 2005, and many people expected the increases to continue. Then the market for houses turned around, and house prices declined by 18 percent from mid-2006 to mid-2008. An increasing number of borrowers could not meet their mortgage payments—or chose not to. Major financial institutions with hundreds of billions of assets and liabilities became insolvent, unable to pay their debts. Federal government agencies, notably the Federal Reserve and the Treasury, intervened at many points to try to prevent matters from getting worse. At the same time, stock prices were falling rapidly. By then the panic had spread to Europe.
Government intervention was not primarily motivated by concern for the failing institutions. Rather, it was undertaken in an effort to prevent a decrease in aggregate demand (as measured by gross domestic product—GDP) that would cause a decrease in production and employment. There was fear that loans would not be available for business spending for new capital equipment. More specifically, government interventions sought to prevent a serious decrease in the construction and sale of new homes—an important component of GDP. Surprisingly, even by mid-2008, GDP was still increasing. Another objective was to prevent foreign investors from selling off their holdings of American securities, which would increase interest rates in the U.S. and drive down the international value of the dollar. This objective was achieved.

Fannie and Freddie

At the center of financial turmoil were two giant financial firms. The Federal National Mortgage Association (“Fannie Mae”) had been created in 1938 as a government enterprise. It was privatized in 1968, meaning it had private stockholders and very highly paid executives. To create competition, the federal government established the Federal National Mortgage Corporation (“Freddie Mac”) in 1970. Both institutions operated by borrowing money and using it to buy home mortgages from the grassroots lenders. Although technically private, they were able to borrow on favorable terms because investors believed their debts were guaranteed by the federal government. From 1970, they increasingly raised money by issuing mortgage-backed bonds.
In 1977, Congress passed the Community Reinvestment Act, which put pressure on banks and other lenders to expand loans to racial minorities and low-income borrowers. In 1995 the Department of Housing and Urban Development (HUD), required banks to meet numerical quotas in lending and provide evidence of the diversity of their borrowers. By 2005, HUD required that 22 percent of all mortgages bought by Fannie and Freddie represent borrowers with incomes below those of 60 percent of their area’s median income.
Traditionally, mortgage lenders wanted to be sure the loans that they made would be repaid and evaluated loan applicants on the basis of their incomes, wealth, and credit experience. Now those standards were increasingly set aside, particularly in view of the rapid increase in house prices that was raising the market value of borrowers’ collateral. In 2007, 45 percent of first-time home buyers made no down payments; they were thus borrowing the entire prices of their houses. The rapid rise in house prices generated demand for houses by speculators who expected to be able to resell the houses at still higher prices.

Collateralized Debt Obligations

The expansion of subprime lending was financed in large degree by the creation of collateralized debt obligations (CDOs). Invented in 1987, mortgage-backed collateralized debt obligations were issued by Fannie, Freddie, and a number of private investment firms. A pool of mortgages worth $10 million could be the basis for issuing a stratified mix of securities with different levels of priority. The issuer might create $8 million of bonds with top priority claims for principal and interest. Credit risk for these bonds would be much lower than the average for the entire mortgage pool. Consequently, they could carry a very high rating and be purchased by conservative investors such as insurance companies, foreign governments and central banks, which would be willing to buy them at relatively low interest rates. Perhaps $1 million of additional bonds (“mezzanine tranche”) would be sold with second priority. Investors in this bond would receive payment only after the first bonds were paid in full. The risk would be substantial and thus a higher interest rate would need to be paid. The securities in the third layer (“equity tranche”) would receive payment only after both the others were paid in full. The equity level appealed to hedge funds and other investors who sought high returns from high risk.
The opportunity to issue low-interest CDOs to finance high-interest mortgages created large profit opportunities, and private firms flocked to the field in the new millennium. Whereas in 2003, Fannie and Freddie accounted for three fourths of collateralized debt obligation issues, by mid-2006 their share had fallen to 43 percent. In 2003, prime (top-grade) mortgages were half the basis for collateralized debt obligations, but by 2006, they were down to one fourth.

CDO Problems

In retrospect, many problems can be identified in CDO issues. Often the issuers offered guarantees to persons buying their bonds. Such loan guarantees became a big business in themselves, in the form of “credit-default swaps.” Fannie and Freddie guaranteed many privately issued collateralized debt obligations. Both issuers and bond buyers lacked adequate information about the risk characteristics of the various CDO issues. Not only did the mortgage pools contain debts of persons of diverse credit standing, but the mortgages themselves were often loaded with complex provisions such as adjustable interest rates or interest-only payment schedules.
The national securities rating agencies, such as Moody’s or Standard and Poor’s, usually gave the high-priority bonds top investment grades—again without adequate information. The opportunity to purchase “insurance” against loan defaults, often at low cost, enabled many investors to ignore considerations of credit risk. The nominal value of credit default swaps reached $62 trillion by the end of 2007. Many of these were simple financial speculations, for the volume of corporate debt was only about $6 trillion. Some of these speculations were unbelievably profitable: According to Fortune magazine, “Hedge fund star John Paulson . . . made $15 billion in 2007, largely by using [credit-default swaps] to bet that other investors’ subprime mortgage bonds would default.”
The security issues arising from collateralized debt obligations were subject to surveillance by the Securities and Exchange Commission. However, this only involved confirming that issuers accurately described the new securities, not trying to assess their riskiness. In contrast, credit default swaps had been explicitly exempted from government regulation by federal legislation in 2000.

Institutional Failures

In March, 2008, Bear Stearns, a prominent investment banking firm, was rescued from imminent failure by being merged into JPMorgan Chase, a merger assisted by the Federal Reserve. In July, 2008, Countrywide, a major mortgage-lending bank, was taken over on the brink of collapse by Bank of America. The settlement was noteworthy for the fact that Bank of America agreed to offer many Countrywide borrowers improved terms on their loans. That same month the Federal Deposit Insurance Corporation (FDIC) supervised the closing of IndyMac, a large West Coast bank with heavy mortgage involvement.
On September 7, 2008, the federal government (through Treasury Secretary Henry Paulson) took control of Fannie and Freddie. The Treasury provided each with a $100 billion line of credit in exchange for an ownership share. Existing stockholders lost most of their investment. The two firms had liabilities exceeding $5 trillion and were providing as much as 80 percent of new mortgage financing. They continued operating under supervision from the Federal Housing Finance Agency. A week later, Lehman Brothers, a noted investment banking firm, filed for bankruptcy after efforts to arrange a rescue merger fell through. With total assets of $630 million, Lehman was the largest bankruptcy in U.S. history. Lehman had borrowed heavily by issuing short-term commercial paper. When these debts went into default, their market value fell by 80 percent. This spread crisis to money-market mutual funds (MMMFs) that held large amounts of commercial paper. When Reserve Primary Fund, a money-market mutual fund, found their net asset value per share falling below a dollar, most of their account holders demanded payment, and Reserve was unable to pay them. Federal authorities responded by extending deposit-insurance coverage to existing money-market mutual fund accounts, estimated at $3.4 trillion.
The Lehman failure led to an avalanche of security sales by financial firms desperate to raise cash, driving down stock prices and bond prices. Firms that had provided loan guarantees were under pressure to make good. One such troubled firm was AIG (American International Group), a large insurance company. On September 16, the Treasury agreed to lend AIG $85 billion, taking an 80 percent ownership interest in return. AIG’s stock had fallen from $37 to $3 a share in four months. Simultaneously, Merrill Lynch, an old and respected brokerage and investment-banking firm, was absorbed by Bank of America.
On September 25, 2008, the FDIC presided over the forced merging of Washington Mutual(WaMu), into JPMorgan Chase. With $300 billion in assets, WaMu represented the largest bank failure to date. Experts predicted its stockholders and some of its creditors would lose their investments.

Why the Collapse Was So Severe

One of the primary questions that this crisis raised is how a relatively minor increase in mortgage defaults—as measured by dollar magnitude—developed into a worldwide financial meltdown. One contributing factor was the layering of debts through several stages of financial intermediation. Grassroots lenders initiated mortgages, some of which they held pending resale, borrowing 80 to 90 percent of the value of their holdings. Fannie and Freddie bought mortgages using mostly borrowed money. They and other firms pooled some mortgages into CDOs, some of which they held pending resale, financed by borrowing. Hedge funds bought the high-risk equity tranches of collateralized debt obligations, financed by borrowing. For every $100 of underlying mortgage debt, there could easily be $500 or more of interlocking institutional debts. Interwoven with these were the debts implicit in the purchase and sale of credit-default swaps.
Firms that were deeply involved in collateralized debt obligations were most likely to experience a crisis. Relatively small increases in mortgage defaults became magnified for several reasons:

• Firms that made major investments in CDOs or in mortgages were heavily dependent on short-term loans that needed to be rolled over continuously. Inability to renew loans precipitated most of the firm closures.
  
• The firms did not have capital accounts sufficient to their risk exposure. The capital account shows the amount by which the value of assets exceeds the value of liabilities. Fannie and Freddie had capital accounts less than 2 percent of their assets. A decline of 2 percent in the value of their assets would make them technically insolvent. Government regulations establish minimum capital requirements, but in many cases, these were not large enough. Major reason was that many firms had extensive “off-balance-sheet” liabilities, such as loan guarantees. Firms like AIG had more liabilities than they acknowledged, and the rules for minimum capital failed to adjust for these invisible liabilities.
  
• Firms that sold large amounts of credit-default swaps, such as Fannie, Freddie, and AIG, believed they were providing “insurance.” They had elaborate computer algorithms to calculate probabilities of loss. The calculations were simply wrong, and the sellers did not have enough solid assets to cover their bad bets.