The final episode of this series opens in summer of 2006 at the peak of the US housing markets. Consumers have been leaning on their home equity to finance their spending and drive economic growth. In addition, the advent of the credit default swaps have made risk a transferable and tradeable product. The perception that risk can be stripped out of an investment vehicle and transferred to another counter party has driven credit spreads (the difference between the cost of risky, corporate debt and the risk free US government debt) to historically low levels. Tight credit spreads have made it very cheap to borrow money and create leverage to amplify returns. But all that is about to change as the era of easy money and excessive leverage comes to a screeching halt.
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The trigger that started the downward spiral known as the"credit crisis" was the deflating of the housing bubble. For over a decade, the average home price in the US had been rising at a breakneck pace. As previously discussed, this rise was driven primarily from a sharp increase in demand as speculators drove real estate prices to the moon. Eventually houses became too expensive and no type of exotic loan could put the average American family into the average American home. The housing market peaked and prices slowly started to come down as demand began to dry up. When the markets began to soften, the accessibility of exotic loans, which were built on the premise that home equity could be created through home value appreciation rather than principal payments, dried up. Around this same time, the teaser rate on the first major wave of ARMs (adjustable rate mortgages) expired and over extended home owners found it hard to make the floating rate payments or refinance with a classic fixed rate loan at a much higher rate. With little to no equity invested in their house, these same people stopped making payments and defaulted on their loans. This was the first domino to topple in a chain reaction that later grew into the current credit crisis.
The perpetual rise of the housing market was a cornerstone assumption behind many of the AAA rated securitized loans. It behooved rating agencies to assign AAA ratings to securitized loans in order to open them up to a wider audience of potential buyers (mainly pension funds and insurance companies which can't hold anything rated below AAA). In order to assign a securitized loan an AAA rating, certain assumptions have to be made about the underlying whole loans and the probability of each of those loans going into default. As long as housing prices continued to rise, equity would be created for the homeowner, which lowers the probability of default. In the rare instance where default does occur, the bank can then take over the property and recoup their investment by selling the appreciated asset. But everything isn't quite as rosy if the housing market where to suddenly stop rising and actually start falling. Under this scenario, equity is being destroyed and the probability of default is much, much higher. When the bank has to take over the house and sell it, they may not be able to recoup their investment as the value of the home is eroding.
The inability to collect payments and recoup principal greatly reduced the value of many securitized loans. Rating agencies, slashed their ratings on the loans forcing some buyers who could only hold the highest grade investments to sell their positions. Everyone started rushing for the door at the same time causing the securitized loan markets to freeze up. The affect was felt beyond just mortgage backed securities (MBS) as the markets for securitized student, auto, and credit card loans froze up as well. There were no buyers for the glut of securitized loans that had been created over the past two decades.
Obviously, the first sector to feel the pain of the withering securitization market was the financial industry, which created, traded, and held the vast majority of these products. The basic business model in banking (borrow at a low rate, lend at a higher one) lends itself to a large amount of financial leverage. One way to think about financial leverage is the ratio of debt to equity a company utilizes. For example, let's say a company has $100 million in assets and $90 million in debt. The equity is simply the assets minus the debt or $10 million dollars in this example, so the ratio of debt to equity is 9 (90/10), which is very high by any industry standard. Now imagine that the assets had to be repriced and it was determined that they were really only worth $90 million. This would wipe out the equity and also upset the debt holders as the assets of the company would most likely have been used as collateral to secure the debt. This is exactly what happened to banks and other institutions that held securitized loans and were forced to take write-downs on their value.
As asset values dropped, creditors (banks who lend other banks money) started demanding more collateral for the funds they lent out where securitized loans had been used as collateral. This created a huge problem for institutions that didn't have cash on hand as they were forced to sell the securitized loans in order to raise cash, which pushed the value of the loans down even further, creating another collateral call, and starting the snowball esk cycle all over again. It wasn't long until the equity capital was totally destroyed along with investor's confidence. All the write-downs and general lack of confidence led to several modern day "bank runs" as investors bolted for the door sending stock prices plummeting (which further perpetuated the general lack of confidence) and customers yanked away their funding/business.
Investment banks were the first to feel the heat as they utilized the highest degree of leverage (over 20x in some cases) and didn't have a deposit base (people like you and me who keep checking and savings accounts at their local bank) as a cash backstop. The first investment bank to go belly up was Bear Stearns in March of 2008 when the Fed saved it from bankruptcy by forcing an unholy union with JP Morgan. The buyout of Bear Sterns bought the market some time, but eventually others followed suit. Just six months later, Lehman Brothers filed for bankruptcy when they were unable to find a suitor to buy them out. The bankruptcy of a prominent, 150 year old investment bank like Lehman Brothers sent shock waves throughout the investment industry as companies quickly realized that they could be the next to fail. Just a couple days after Lehman's bankruptcy, Merrill Lynch, another prominent investment bank, announced it was being acquired by Bank of America.
The pain of the market deleveraging was not isolated to the investment banking community. Retail banks that were heavily invested in mortgage backed securities were the next "shoe to drop." Several retail banks failed and either had to be taken over by the FDIC or sold off to other banks including the largest bank failure in US history, Washington Mutual. In addition to retail banks, the primary originators of securitized loans, Fannie Mae and Freddie Mac, had to finally be taken over by the US government after several failed attempts by the Fed to keep them solvent. If you remember back to the first article in this series, Freddie and Fannie were the primary originators of securitized loans and guaranteed hundreds of billions of dollars in mortgage backed securities. When these securitized loans dropped below investment grade, Fannie and Freddie were on the hook to make their investors whole. Unable to meet these demands, the only option was to declare bankruptcy sending a massive wave of write downs throughout the market, which in turn would lead to more bankruptcies or be taken over the US government in a tax payer funded bailout. With these two options, the Fed chose the later of the two evils and brought both of the mortgage giants in house.
The "fun" didn't stop there. Remember back to the second article in this series when we studied the birth and rise of the credit default swap (CDS). These contracts could be used to hedge exposure to certain events (e.g. reducing the risk of an investment defaulting or counter parties going bankrupt) or just to bet on the underlying event occurring. As securitized loans dropped below investment grade (the common event that triggers the collection on the corresponding CDS) and banks went bankrupt, investors holding CDSs on these events looked to collect on their contracts. The largest writer (seller) of CDSs was AIG who quickly realized that their "mouth was writing checks that their butt couldn't cash." To quote Nassim Taleb, the author of Fooled by Randomness and The Black Swan, the CDS contracts were like "buying insurance on the Titanic from someone on the Titanic." Faced with the same options as Fannie & Freddie (massive market meltdown or bailout), the Fed again decided to put taxpayers on the hook by extending AIG a loan and taking a significant ownership stake in the company. Since the initial bailout, both the amount of the loan and percentage ownership have increased as AIG has continued to bleed red ink.
With banks and other financial firms going bankrupt or being taken over by the US government on a regular basis, the surviving banks "hunkered down" and tighten up their lending practices. At one point in early October, the global credit market was said to be frozen as banks were hording cash in fear that they might be the next to fail. The freezing of the credit markets was the final punch that brought Wall Street's pain to Main Street. Think of credit as the oil that lubricates the engine that is the global economy. Without a line of credit, companies have a very difficult time balancing their cash inflows and outflows on a daily basis (e.g. purchasing inventory, making payroll, etc...). As the cost of credit/debt increases, the profitability of a company that utilized that credit decreases. The combination of increasing costs and decreasing demand forced companies to cut costs by downsizing their workforce.
All of these factors have culminated in rising unemployment, the US stock market dropping close to 50% from it's 2007 high, and a global wide recession for the first time in modern day history (who knew that the US homeowner had so much power). So that is the long and short behind "the mess in the US" (which should more aptly be named "The Mess Around the World" but it just doesn't roll of the tongue quite as nicely) in a rather large and bloated nutshell. The ending of this sad saga has yet to be written, but it is safe to say that the combination of complex financial innovation (securitized loans and credit default swaps) and greed (excessive leverage and market bubbles) led to the largest market meltdown in US history since the Great Depression. To be fair, innovation and creativity are what make America great and set it apart from the rest of the world and "greed for life, for money, for love, [and] knowledge has marked the upward surge of mankind." Put another way by a fellow Franco follower, complaining about the greed on Wall Street is "like complaining about too much testosterone in a football locker room or too much makeup at a beauty pageant." And with that final thought we put this series to rest.
Ciao,
Frugal Franco
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