In case you’ve been asleep in a cave with your hands over your eyes and cotton in your ears for the past few weeks, the American economy has been in a world of hurt recently. US Treasury Henry Paulson has put forward a far-reaching plan to deal with this crisis. As it turns out there are indeed a lot of things not to like about it, but in order to see what’s wrong with it we need to take a look at how the American economy got itself into this mess in the first place. This will tell us what’s wrong with the economy and whether the bailout plan will address that.
To recap, last week saw the end of one investment bank (Lehman Brothers), the acquisition of another (Merrill Lynch) at a heavily discounted price, and serious financial problems at one of the world’s largest insurance company (AIG). All these were related to the American mortgage crisis which started last August. In the case of Lehman and Merrill, the troubles were rooted in the amount of collateralized debt obligations (CDOs) they held, whereas with AIG the problem was the number of obligations which they had insured through a process known as credit default swaps (CDSs). With a CDS a bank or insurance company insures a bond by offering to buy it from its owner at a set price if the original lender defaults on it. This is what’s known as a derivative product (its value is dependent on the value of something else).
The way CDOs work is rather complicated, but aptly described in this little montage. If you have more time, check out these videos: Mortgage-backed securities, part I; Mortgage-backed securities, part II; Collateralized Debt Obligations.
CDOs and the Mortgage Crisis
We know exactly what happened that made the 2007 troubles so significant. In the years leading up to the explosion of the mortgage crisis bankers came to see CDOs as a way to print money based on the mortgages that they held, and the more mortgages you held the more money you could print. For those in the mortgage game quantity quickly trumped quantity; after all, as the conventional thinking went, the more you lent out the more CDOs you could sell. This came about largely because of a change in the banking laws that was signed in 1999 called the Gramm-Leach-Bliley Act and which blurred the line differentiating banks from brokers and insurance companies (in case you’re wondering, the Gramm referred to here is Phil Gramm, who is the senior economic advisor and campaign co-chair for John McCain). After Gramm-Leach-Bliley investment banks, ordinary banks and insurance companies were basically free to play on each others’ turf, which is why ordinary banks were able to offer CDOs as investment vehicles (and insure them through CDSs, but that’s another story).
The push to sell mortgages resulted in two trends which I saw as fairly catastrophic the moment I heard about them:
- the quality of the borrower no longer mattered, and
- cashing out on equity
It doesn’t take a genius to see how lowering the bar for borrowing is an awful idea, yet it was sold as a sort of “democratization of home-ownership”.Â In the late 90s there was an explosion in the growth of mortgage brokers, or people (or companies, it doesn’t really matter) who sold mortgages without being the lenders. In essence a mortgage broker is not really any different from an insurance broker: the broker works for you and examines the offerings of several mortgage lenders, then (in theory) directs you to the best one. In theory the broker has, to use the colloquialism, no skin in the game — but in reality this isn’t true. The broker gets a commission for his troubles from the lender, and since the commission is always based on the amount of business generated it’s necessarily much higher when you’re dealing in mortgages than when you’re dealing in insurance policies. Since the broker isn’t lending the money himself, you’ve created a situation where he (or she) has a huge incentive to sell to anyone. Once your sale is done, you cash in your commission, you move on to the next sale.
And that’s where we get the idea behind some of the risk-oriented mortgage practices of the early 2000s. For a start the capital requirements for getting a mortgage, though not abandoned outright, were halved (from 10% to 5%). Even if the buyer didn’t have 5%, the mortgage broker, as an independent agent, would easily figure out ways for the borrowers to borrow that 5% from another bank. That practice is known as a “jumbo loan”. And then it gets even better. You started seeing such things as “stated income” loans, which are known as (and this is a bit of a giveaway) “liar’s loans” or “NINJA loans”, where the borrower was not even asked for a proof of income or assets — just a statement that he was making X amount of money per year and had Y assets.
In retrospect it seems obvious that the market was headed for a trainwreck situation. Interest-only mortgages, introduced in the US only in 2003-2004, were in my view the ultimate illustration of banking excess. Originally intended only for junior executives who expected to rack up 6-figure bonuses within a few short years, they became the ultimate weapon of mass destruction for subprime lenders. Sure, you can afford a $500,000 home on a plumber’s salary… if you only pay the interest and accrue no equity. A lot of people were sold interest-only mortgages being told that they were getting a conventional mortgage; on the one hand they should have been more careful in reading the offer they ended up accepting, but on the other hand it’s also true that the brokers were signing people up for financing that was entirely inappropriate for their needs and means.
Adjustable-rate mortgages (ARMs) were another problem. Having originated as they did in the early 2000s, when interest rates were very low, they were sold without much warning that the attractive “introductory rate” could (and eventually did) triple after 3 to 4 years. When you’re talking about a 25-year mortgage the difference can be quite shocking.
Another aspect of the credit expansion has been the urge by existing homeowners to cash out their equity. Driven by soaring home prices, the remortgaging market has grown by leaps and bounds in the United States. Homeowners, used to seeing the value of their home grow from year to year, pursued mortgage loans in order to finance all sorts of things — renovation costs (which is somewhat logical), but also their children’s education, cars, home electronics and vacations. This type of loan is often known as HELOC: home equity line of credit. It’s not necessarily a bad idea when house prices are rising, but only as long as they are rising. These loans were also subject to the same factors as other loans, and like ordinary mortgages could end up “upside down” (with the owner owing more than the home is worth) if housing prices go down.
Ultimately, the crux of the issue is that a lot of people were issued mortgages that they should not have obtained. So a lot of them started defaulting on those mortgages. Because there were default on the mortgages, there were defaults on the bonds that were made of those mortgages (CDOs), and insurance companies like AIG were forced to pay out on credit default swaps (CDSs) on assets that were previously considered too safe to fail. This is only a small part of the problem, the part known as “subprime mortgages”. This crisis is extremely complicated! We haven’t quite gotten to the really badÂ part yet!
So a bunch of people have lost their homes (which shouldn’t have been theirs to start with). Big deal, right? Well, actually it is a big deal. Lending practices became more restricted as a result of the mortgage crisis in 2007, so borrowers now had to face more hurdles and more requirements before a lender would lend them money. This represented a significant change from previous practices that kept the money flowing.
Many people with interest-only and adjustable-rate mortgages ended up in default, much more than the usual rate. At the same time those people who were not yet in default with interest-only and ARMs faced their mortgage resets. What happens then is that the borrower must negociate a new, conventional multi-year mortgage with a borrower. Many of them were simply unable to find a borrower in the new tight-credit times in which they found themselves. Additionally a lot of people who had defaulted found themselves foreclosed on, and had to leave their homes. In normal times this is no big deal, but after 7 years of limitless borrowing the number of foreclosures reached record highs. Banks ended up getting stuck with a lot of houses.
How Prime Became The New Subprime
Banks are not terribly good landlords, nor should they be really; but the point here is that you have a lot of houses which now sit unoccupied in the United States, and these houses are everywhere — in all sorts of neighborhoods. But while an occupied house can be assumed to be maintained relatively regularly, this is not the case of an empty house. The lawn will grow will and disorderly. The pool will quickly grow green with algae. Broken windows will go unrepaired and let in the elements. Pipes will freeze. Dust will accumulate. And this is assuming that the house was left in good condition in the first place; in many cases it was not. Many borrowers, angry at the fact that they were being kicked out of “their” home, decided to take that anger out on the house.
So what, you ask? The unoccupied house that’s become an eyesore has started to affect the neighborhood. On top of having a glut of homes that are available for sale, unoccupied homes have definitely started affecting the value of homes in the immediate vicinity. And because these houses, as I’ve previously mentioned, are everywhere, home values across the United States have been on the decline. Houses are depreciating, and this is a phenomenon that Americans are simply not used to dealing with. There are exceptions of course — New York City, for one, and rural areas in general, but in most urban and suburban areas a house is worth less now than it was in 2006.
This causes an additional problem for people facing mortgage resets. Even if they are “prime” borrowers and have good credit histories, they now find themselves unable to refinance their home because they owe more on it than it is worth (“upside down mortgage”). This lead to a round of defaults which is occurring currently. Now whereas one could predict higher-than-average defaults among subprime borrowers, it used to be very rare to see prime borrowers in default or foreclosure. Not anymore, and it’s a direct result of the subprime troubles.
The Subpriming of the Financial Markets
Then there’s the commoditization of mortgage debt (see above) which ensured that the banks’ losses would have a ripple effect through bond markets. Suddenly a bunch of foreclosed mortgages aren’t just a local problem — there’s little bits of mortgages hidden away in a lot of securities that are still being traded out there, and this is where the investment banks step in, Bear Stearns and Lehman in particular: by investing heavily in CDOs as investment vehicles — most probably attracted by the high rates of return promised by the riskier but higher-yielding slices — they effectively contaminated their own holdings and investors lost faith in the financial products that were their bread and butter.
AIG was a different, but related matter. AIG is an insurance company that insured bonds through credit default swaps (CDSs). As mentioned above CDSs are agreements by which an insurer (which, since 1999, can also be a bank) agrees that if a certain bond defaults, they will buy it from its holder at a previously-agreed price. Now many banks issue CDSs, but in AIG’s case the insurer had an inflated view of the viability of the bonds they insured. Indeed as recently as 6 months ago the bonds insured by AIG were widely seen as too secure to fail. Typically CDS issuers hedge their bets by also buying CDSs. AIG did not. Its problem was not strictly speaking one of solvency, but lack of liquidity: a credit downgrade on AIG meant that it had to have more cash on hand as reserve to back its oustanding debt.
The Big Issue
The really detrimental long-term effect of the 2007 mortgage crisis has been the long-term tightening of credit by banks. It’s now a great deal harder to get a mortgage in the USA than it was just a year and a half ago, and house prices have plummeted as a result (by as much as 25% in the hardest-hit areas). Because of the peculiar way in which the American economy has taken to function since the 1990s, that’s a very bad thing not only for the American economy, but for the world economy.
The American economy has essentially grown very dependent on consumption, and that consumption, in recent years, has been essentially driven by credit. Add to this that the US doesn’t really manufacture anymore, and you can see the world exposure to the American credit crisis. If Americans aren’t spending foolishly, then your country ends up suffering.
So in theory I should be in favor of the United States Treasury spending a trillion dollars to restore the credit markets. As a Canadian my country is dependent on US-bound exports, and anyway foreign banks will be eligible for relief from the US government. So I like this plan, right?
No. Not by a long shot. I’ll explain why in Part II.