The crisis explained

Substantial parts of this article are pillaged wholesale from Ryan Barne’s excellent account of the crisis, and Mortgage Guarantee Insurance’s colorful account of the crisis. I steal from the best. And thanks to the commenters that pointed out numerous errors.

In 2001, the Federal Reserve began cutting rates dramatically, dropping to 1% in 2003, in order to stimulate the economy.

This produced a boom, and especially a housing boom, in 2002.  A housing boom was a rational and appropriate response to the extraordinarily low  interest rate on a 30 year fixed rate mortgage, and no one was asking whether the extraordinarily low interest rates on 30 year fixed rate mortgages were rational and appropriate.

Interest rates on fixed rate mortgages were extraordinarily low thanks in part to Fannie and Freddie, which blessed mortgages with an implicit government guarantee, and resold them, making them very attractive to banks around the world under the Basel II rules.

So mortgages were being written by one bank, and sold to another bank or financial institution, far, far away, a bank with no idea of whether the house underlying the mortgage was worth what was claimed, or the borrower was solvent, or the borrower had a past history of paying his debts.

The US government, in particular George Bush, forcefully encouraged no money down loans, especially to non traditional borrowers, especially to members of non Asian minorities.  Banks had every incentive to lend irresponsibly, were encouraged to do so, and were under severe regulatory pressure to lend to groups that it was difficult to lend to responsibly.

No money down loans encouraged wild speculation.  If housing prices rise, you have free money, and if they fall, it is someone else’s problem – particularly if you have no credit rating to lose, as members of non Asian minorities usually don’t.

Wall street started to get into the business, competing with Fannie and Freddy, despite their lack of an implicit government guarantee.

The asset-backed security (ABS) has been around for decades, and at its core lies a simple investment principle: Take a bunch of assets that have predictable and similar cash flows, bundle them into one managed package that collects all of the individual payments (the mortgage payments), and use the money to pay investors a coupon on the managed package.  It is a good idea, provided the underlying assets really do have value and really do have regular and reliable payments.

The high implosive bomb that sunk the world financial system was Residential Mortgage Backed Securities (RMBS), a product created by Wall Street to weasel deadbeat loans into compliance with Basel II.  The underlying asset was wildly inflated, and the payments improbable because the people that were to make the payments were deadbeat speculators whose credit rating was frequently non existent.

Mortgage Guarantee Insurance Corporation gives us some colorful examples of loans that Countrywide bank made. Most of Countrywide’s loans wound up being made into RMBS. Mortgage Guarantee claims the following were typical of loans that went bad.

  • A stone broke female janitor earning $4000 per month purchased a $600,000 home no money down as a speculative investment.
  • A maid with erratic employment purchased a $360 000 home, for her sister and brother in law. She never made a payment, and shortly thereafter returned to her home country.
  • A milker who cannot read English and who earns $1000 per month purchased a $350 000 house no money down for his son.
  • A woman who has been unemployed since 1989, yet who somehow owned multiple houses, refinanced one of them for $400 000.
  • Someone borrowed $355 000 to buy a house. Supposedly he put $39 500 down payment, which, however, seems highly improbable since the house had recently sold for $127 500 and housing prices were not rising at the time.
  • A speculator owning multiple condos, with payments on the mortgages two and a half times his income, borrowed $187 400 to purchase a condo whose fair market value was $155 000.
  • Someone with no known income, no known assets, and no clear identity, borrowed $495 000 to purchase a house, no money down.
  • A front buyer (straw man purchaser) purchased a house for the loan officer who arranged the loan, for $205 000, no money down.
  • A woman with no savings earning $1 695 a month purchased a $100 000 home for $115 000 no money down.
  • A woman earning $2 500 a month refinanced her home for $231 000.

Somehow, residential mortgage backed securities based on such loans and collateralized debt obligations based on residential mortgage backed securities based on such loans got AAA or A+ ratings from Moody’s and Standard & Poor’s   These highly regulated credit agencies have a special privilege from the government to bless debt as low risk under Basel II, thereby entitling banks owning such debt to special regulatory treatment, making the debt highly attractive to financial entities subject to Basel II regulation.

Ginnie May, Freddie Mac, and Fannie May had long been engaged in this shady business, of making questionable loans into loans that supposedly met Basel II standards, but in their case the AAA ratings may have been justified by the implicit taxpayer guarantee.  The rationale for the high ratings given to RMBS is more complicated, and less clear.

The debt that went into the RMBS was often debt that even Ginnie May, Freddie Mac, and Fannie May would not touch, subprime. The ratings given to this low quality debt were justified by dividing the securities into tranches.  Upper tranches were able to receive ‘AAA’ ratings because these tranches were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk. All the way at the bottom, the “equity” tranche was a highly speculative investment.

Lehman Brothers purchased these mortgages, and made them into RMBS divided into tranches.  It was unable to sell the lowest tranches, so accumulated a large portfolio of these worthless mortgage backed securities.  It would borrow money against the highest tranches on the repo market. When the fat lady sang, the repo market went south, and the true value of these Residential Mortgage Backed Securities was revealed, Lehman went under.

Then then, to get part the middle level tranch up to the AAA, they made CDOs based on the mezzanine RMBS tranches based on rubbish mortgages, and divided the CDO into tranches, so that by this elaborate financial engineering, most the debt the rubbish mortgages were magically converted into debt deserving of favorable treatment under Basel II as very safe.

As a result of this activity, it became very profitable to originate mortgages, even mortgages as worthless as those described by Mortgage Guarantee Insurance Corporation

Record-low interest rates had combined with ever-loosening lending standards to push real estate prices to record highs across most of the United States. Existing homeowners were refinancing in record numbers, tapping into recently earned equity that could be had with a few hundred dollars spent on a home appraisal.

So the highest tranches got a AAA rating, qualifying institutions owning them for special regulatory treatment under Basel II.  No one would touch the lowest tranches.  What of the middle tranches, called the “Mezzanine” tranches?

AIG sold “Collateralized Debt Obligations” “Credit Default Swaps”, meaning that if the lower tranches went under, AIG would make it up.  AIG insured the mezzanine tranches. Thus even mezzanine tranches based on worthless mortgages became AAA equivalent, qualifying the owning institutions for special treatment under Basel II.

In 2005 November, an increasing number of people started to realize that all this was going to fall apart.  A mad stampede for the exits began.  The run on the repo market began.  (The repo market is where debt that meets Basel II’s high standards of safety is traded.) “Slapped in the face by the invisible hand” tells us that the panic began in August 2007. This may well be true if one defines “panic” as the shocking realization that there are no bigger idiots to unload your exposure onto, but the frantic search for the bigger idiot began in 2005.

Despite this, housing prices continued, supposedly, to rise until the middle of 2006, possibly due to straw man purchases and fake sales made by people getting the hell out.

By the middle of 2006 default rates began to rise sharply. making it obvious that prices were not rising, but falling, and obvious that the RMBS were going to implode.  The repo market collapsed, though regulators continued to deny it had collapsed until 2007.  Since Basel II ensured that the debt was extremely safe, markets must be irrational, so we were told.

In 2007 financial institutions started to collapse in large numbers.

Somehow, the market had created a flood of assets that received Basel II’s official blessing.  In 2007, most businesses still doing business in these assets, businesses who had not got out the exits in late 2005, early 2006,  imploded.

Observe that all the factors that caused this crisis are still in place.  The CRA is still in effect.  Basel II continues to provide special regulatory privilege for “safe” assets, meaning that regulators have to decide what is “safe”.  To the extent that they outsource this job to certain favored firms, such as Moody’s, we get crony capitalism, to the extent that the regulators decide what is safe, we get political allocation of debt to cronies, special interest groups, and favored voting blocks, such as non Asian minorities.  Either way, the “safe” assets are bound to be ruinously unsafe.

9 Responses to “The crisis explained”

  1. A banker says:

    Also, it wasn’t the lowest tranches that Lehman, Bear etc. got stuck with. Those “equity” securities were always seen as speculative investments, and were sold pretty cheap from the start. It was the highest tranches that stayed on the books – because of their ratings the models valued them as completely safe, so the structuring banks kept them, and used them as collateral to borrow more funds for more deals. Under Basel II that was perfectly OK, because, hey, they were AAA

    • jim says:

      When I saw your comment, I went looking for reliable information on what happened to the equity tranch. Could not find it. Could you point me to some?

      I initially assumed that people just forgot about the equity tranch, the point of the financial alchemy being to put all the crap in the equity branch, so that supposedly someone else was taking all the risk.

    • jim says:

      On further checking, it was not the equity tranch that took Lehman under, but the supposedly AAA tranch that it could no longer use to raise money on the repo market.

  2. Bill says:

    So the highest tranches got a AAA rating, qualifying institutions owning them for special regulatory treatment under Basel II. No one would touch the lowest tranches. What of the middle tranches, called the “Mezzanine” tranches?

    AIG sold “Collateralized Debt Obligations”, meaning that if the lower tranches went under, AIG would make it up. AIG insured the mezzanine tranches, giving them its AAA credit rating, a credit rating based on the government’s implicit guarantee of AIG.

    Thus even mezzanine tranches based on worthless mortgages became AAA, qualifying the owning institutions for special treatment under Basel II.

    This part is not exactly wrong, but kind of wrong. To make the mezzanine tranches into AAA securities, what the investment banks did was to create CDO^2 (CDO-squared) CDOs. They took the mezzanine tranches of a bunch of CDOs, made those tranches into a CDO, and then divided that CDO^2 itself into tranches. The senior tranche would again be AAA.

    AIG sold not CDOs but credit default swaps, CDSs. CDSs were, as you note, a way of providing extra assurance that highly-rated CDOs were safe to own since if the CDO senior (or even mezzanine) tranche failed to pay, AIG promised to pay. I’m not sure about this, but I think that insuring a CDO with a CDS from AIG did not actually increase the rating of the CDO, rather the regulations give favorable treatment to securities which are AAA or which are rated lower and insured by a highly rated insurer.

    The attitude of the people involved in all this is really interesting. They knew the loans were crap, but, because they are mortgages, they (and the models they used) expected to recover maybe 70 or 80% of the loan value on the loans that went bad. This is a reasonable assumption as long as prices don’t fall (much). The fraud would have been OK if prices had kept going up, and the fraud caused the prices to go up, and nobody involved really had an incentive to think properly about the mad circularity of it all.

    • jim says:

      This part is not exactly wrong, but kind of wrong.

      It is completely wrong, CDO was typo for CDS, typo for Credit Default Swap. Thanks for the correction. Fixing it.

      I intended to leave out the multi layer CDOs, because any sane person’s eyes should glaze over on reading about that stuff, but on reflection, should be in there. Inserting it.

      The distinction between AAA rating and treated as AAA rating was so subtle I overlooked it. That is indeed “kind of wrong”. All this stuff is complicated and confusing, partly because they were trying to fool themselves, and partly because they were gaming hideously complicated Basel II definitions of “safe”.

      • jim says:

        On further checking, it was not the equity tranch that took Lehman under, but the supposedly AAA tranch that it could no longer use to raise money on the repo market.

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