I shall be posting one post a day this week as I take you through this Six Minute Strategist Guide to the 2008 Financial Crisis. Today I shall discuss the main Protagonists in the Crisis.
The Protagonists
The 2008 Crisis, as has already been stated was not just a banking crisis. The crisis was a financial crisis but it involved a range of participants all of whom share some level of responsibility for what happened. This post looks at who they were and explains how they came to be locked together in this macabre dance to the death!
1. Borrowers
The Main Street vs. Wall Street argument starts here. Did the borrowers defraud the investors by taking on loans they could never afford or did Wall Street set up the borrowers, tempting them with cheap deals and speculative profits on house price gains, while greatly enriching themselves by recognising all their profits upfront.
The initial impact of the looser interest rate policy affected not just mortgages but also credit cards and auto loans. The original phase of borrowing had its origins in the extension of house ownership but as the cycle developed the quality of the borrowers fell and the business became more speculative, based on the assumption that house prices would keep on rising.
Subprime borrowers came from the bottom 29% to bottom 5% of all lenders. Put another way 71% of US borrowers represented a better risk. It is also significant that house ownership has never exceeded 70% in the US market.
2. The Mortgage Originators
The capital markets provided the original capital for mortgage companies directly. Mortgage finance companies were floated on the market and used the capital raised to finance loans. In the mid and late 1990s this proved to be something of a merry-go-round. Despite high rates of default, these companies booked upfront fees (and therefore profits) on the back of these loans, announced great results (paper) and went back to the market for more capital (cash) part of which was used to pay themselves bonuses for their great performance. The failure of Long Term Capital Management (a massive hedge fund) in 1998 on the back of the sovereign capital crisis precipitated by Russia’s sovereign debt default, changed the market availability of capital for these companies and most of them lost money and many went bankrupt.
Despite the market difficulties, low interest rates, rising house prices kept the demand for mortgage finance high. A new source of capital was required. Step forward the Wall Street Investment banks.
3. Wall Street
Wall Street Investment Banks (and other banks globally) exist to organise capital and make it available for the economy. This purpose had arguably been forgotten and since the 1980s the main purpose of Wall Street seemed to exist to provide capital to enrich the bankers working there. An important change had happened in 1999 when Goldman Sachs floated. This change from a partnership to a public company – subsequently copied by other banks – was significant as the capital at risk was no longer directly that of the partners of the organisation but of the shareholders. Profits still provided large bonuses but the at risk nature of the business changed.
Wall Street had developed a profitable way of organising pools of corporate loans into bonds and selling them to investors as a more diversified (and therefore lower risk) investment opportunity. This was called Securitisation. The key argument was that if one company went bankrupt, it was not likely that the others would too. In other words the factors that caused the failure of one company were unconnected to the financial health of the other companies in the bond. This mirrors the later assumption that house prices could not fall nationally across the board – why? Because, it was argued this had never happened since the 1930s.
When the Securitisation model was extended to the housing market, groups of Mortgages, Wall Street investment banks were able to sell the mortgages and the default risk to investors through Mortgage Back Securities (MBS), Asset Backed Securities (ABS) and Collateralised Debt Obligations (CDOs). The sale, which booked up front arrangement fees also meant that the bank’s capital was freed up to issue more, loans and create more fees. This led to a focus on processing transactions with scant regard for the underlying quality of the loans in the bonds being issued. Between 1996 and 2007 $7.3 trillion of mortgage backed securities were issued.
4. The Ratings Agencies
The key to a successful bond issue was to get the bond AAA (Triple A) rated. This was important as it impacted the capital the bank needed to reserve against the bond and also made it much more attractive to investors and the implied default risk of the rating was very low.
There were several problems with the relationship between the Rating Agencies and the issuing Investment Banks. Firstly, the relatively quality of the people in the rating agencies were much lower than those in the investment banks. This enabled the Banks to game the models used by the rating agencies.
Secondly, the Rating Agencies became very dependent for their revenues and profits on the investment banks and this conflict of interest (moral hazard) was exacerbated by the competition between Moody’s, Standard and Poor’s and Fitch (and others) to “win” deals.
The Structuring of the asset backed securities and CDOs used a waterfall mechanism in allocating tranches of risk to investors, “where income received gets paid out first to the highest tranches, with the remaining income flowing down to the lower quality tranches i.e. AAA. CDOs were typically structured such that AAA tranches which were to receive first lien (claim) on the BBB rated loans cash flows, and losses would trickle up from the lowest quality tranches first.” (Source: Wikipedia). Using this structure, although the underlying assets of the subprime mortgage bonds were often rated BBB, when pooled into a CDO, 80% of the bond could be re-rated AAA. This financial alchemy is at the heart of the seismic fault line in the whole system.
5. The Regulators and Governments
We have briefly discussed the role of Government and Regulation above. The key point here is that as the complexity and sophistication of the capital markets and its instruments evolved, the regulators and governments failed to keep up. Given a set of rules, the route to higher profits was to work out how best to exploit loopholes in the rules without actually breaking them. One key example of this was Structured Investment Vehicles – SIVs, otherwise referred to as part of the Shadow Banking system. These vehicles were used by Banks to move the asset backed off their balance sheets. These finance companies funded themselves through issuing short-term securities at low interest rates and then lent that money (invested in CDOs) by buying long-term assets at higher rates. This mismatch in funding maturities only worked provided they could continually refinance their loans. Critically the SIVs did not fall under the Basel II regulations and therefore Banks were not obliged to make capital reserves against losses, but as they were rated AAA by the Rating Agencies, the Banks did not anticipate any credit risk problems. At their peak the SIVs had assets in excess of $400 billion but were unregulated. When the crisis started to evolve the risks associated with these assets, which the banks believed represented no risk to them, came back to bite them with a vengeance. We will discuss SIVs in more detail when we look at some of the key market instruments.
6. Investors
It may be argued that Investors should carry some share of the blame for the problems associated with the crisis. In their insatiable search for higher returns (in a low inflation, low interest rate environment) they allowed themselves to buy into a wide range of complex instruments, most of which they did not understand. Relying often on the Rating Agencies assurances with the AAA rating, investors bought into increasingly complex and esoteric instruments, very quickly losing sight and understanding of the underlying assets behind their investments.
The investors are an important element to the crisis as they represented investors and investments funds from across the world. It was another error of judgement that this “risk spread” made the system less risky. In the event when the crisis hit it meant that the crisis rapidly became a global crisis which affected markets all over the world, counter party confidence evaporated and the worlds entire financial system tottered on the edge of disaster.
Summary
The market participants launched themselves into a dance of death, which was only sustainable as long as asset prices continued to rise. Once house prices started to fall, the unstable and unsustainable nature of the complex market structure became apparent and fell apart.
In my next post I will look at some of the financial instruments which played a central role in the crisis and examine why increasing financial innovation and complexity led to disaster.
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