Inside the Meltdown That Woke Us Up to How Necessary Reform Is.
By: Jordan Young
In part one of our Financial Reform 101 series, we'll be looking at what actually happened on Wall Street and how this crisis was caused. I've made every effort to make this understandable, but realize that many people believe Wall Street insiders intentionally embrace complicated definitions and endless lingo foreign to outsiders precisely so normal Americans can't understand the system. I encourage you to ask questions in the comments section if any of the following confuses you.
I would also point out at the outset that this is not an exhaustive explanation and there were certainly other contributing factors to the crisis. I would argue, however, that the circumstances detailed below were the main causes and provide the general picture of the problem we need to fix.
I also apologize for the length of these posts. I hope they're worth the time I put into writing them.
Abusive Lending Practices
For nearly thirty years leading up to the crisis, Wall Street had been embracing riskier and more speculative practices to make more and more money in shorter and shorter periods of time. This mindset led some of our smartest financial insiders to become more and more entrepreneurial in their schemes, and, as we'll see below, to suspend their intellect in favor of more and more ridiculous get-rich schemes.
The heart of the crisis was really born from a wave of abusive lending practices. At the beginning of the 2000s, lenders began approving more and more loans to lower-income Americans. Seeking out the poor and minorities in huge numbers, they offered them mortgages on homes they couldn't afford. These lenders originally claimed altruism as their motivator, asserting they were simply helping more people achieve the American dream. No matter that these people were living entirely on credit and couldn't possibly afford the mortgage they were being offered after the initial teaser-rate wore off. From the lenders perspective, this simply meant they'd be able to keep people in debt in perpetuity, encouraging a cycle of refinancing: endlessly paying interest, and never fully paying off their mortgages. Even more troubling, if the lenders could make the original loan and then sell it to someone else, they didn't even need to care whether the loan was repaid. They could simply pass the risk off to someone else.
The next step on the road to crisis was to allow Wall Street to get in on the game. Lenders would proceed to sell these mortgages to institutions, which would bundle them together into bonds and sell them to Wall Street firms.
Gramm-Leach-Bliley and the Beginnings of the Speculation Craze
In 1932, Congress approved the Glass-Steagall Act as part of FDR's response to the Great Depression. Glass-Steagall had separated depository banks (which took your money and kept it for you) and investment banks (which used money to invest in different efforts in hopes of making money). The idea had been simple: it was too risky to allow a bank to use the money its depositors had entrusted to it to invest in risky schemes where that money might be lost. And since Congress had created the Federal Deposit Insurance Corporation (FDIC) in the same piece of legislation, which pledged to protect depositors money with funds from the U.S. Treasury, such a concept didn't seem like too much for which to ask.
After more than six decades though, Wall Street saw Glass-Steagall as an unnecessary and annoying stumbling block to making a lot more money. So, they successfully lobbied Congress to repeal much of it in 1999, in a piece of legislation known as the Gramm-Leach-Bliley Act. Wall Street exploded with action, creating new institutions like Citigroup to put their depository and investments arms under the same roof.
In the 80's and 90's, Wall Street had discovered they could basically speculate, or place bets, on just about anything. You simply needed a person or institution with money on both sides. One guy bets Microsoft stocks will increase by at least 30% within two years, and another bets they will not. At the end of the two years, whichever guy was right pays the other. In order to do this, Wall Street had a concept called a security.
A security is a negotiable financial instrument representing some value. For the purposes of this crisis, the type we care most about is equity securitization. Examples of these include common stocks and derivatives contracts, such as futures and options. A futures contract requires the purchaser to buy or sell some item at a fixed price at some future date. An option gives the purchaser the right to do so if they so choose. For example, if I think the value of something is going to increase from $20 (where it is now) to $50 in six months, I might buy a futures contract on this item that requires me to buy fifty more of this item in seven months at the price of $25. This would allow me to buy more of these items, which would then cost $50, at half the price. If I'm wrong, and the price stays at $20, then I'm forced to buy more at a price of $25 each.
These derivatives contracts will be the main focus of the rest of this piece, since they provided the vehicle for the crisis.
Derivatives Trading and Sub-Prime Speculation
The name derivative is taken from the concept that the value of the item is derived from some underlying or "reference" security or commodity. For example, you could have a derivative in the form of a futures contract on the new iPad. The value of my contract to me is dependent on the underlying commodity, in this case the iPad.
Most derivatives are traded with almost no regulation and in private transactions which keep them from being seen by others. These derivatives are classified as Over the Counter (OTC), meaning there are no parties involved but the buyer and the seller. This means the person or institution selling the derivative can charge whatever they like without the buyer knowing for how much some other seller might offer it to them.
So a major new market began for derivatives based on sub-prime mortgage bonds, which acted as securities.
Now, Wall Street relies heavily on confidence. A giant firm like Goldman Sachs depends on the fact that other firms and individuals are confident it's a strong and solid firm. Without this, people stop trusting Goldman Sachs with their money, which causes more people to lose confidence, and on and on.
Inherent in every attempt to make money on Wall Street is the concept of risk. There is always some risk that my speculation will not work out the way I want it to. So a firm like Goldman Sachs, theoretically, needs to make sure it isn't exposed to so much risk that it causes people to lose confidence. To determine the risk of a particular deal, Wall Street employs ratings agencies like Moody's and Standard & Poor's. For the sake of avoiding confusion, we'll operate on S&P's rating system. The best possible rating something can receive is AAA. A commodity, security, or firm rated as AAA is considered highly reliable and stable, in fact, holding a security rated AAA is considered so safe, a firm doesn't even have to declare it as risk. There's little to no risk here. The system goes down gradually from AAA to AA, A, and BBB. Anything below BBB is considered "junk." BBB is sort of medium class risk.
The vast majority of major firms hold a AAA rating, meaning you should be able to trust them and they desperately want to keep that rating. Every transaction a firm does is rated based on its quality and risk. If you're trading U.S. Treasury bonds, those are rated at AAA. If Goldman Sachs were to take on $50 billion in BBB-rated bonds, their exposure to risk would shoot up dramatically. They would stand a reasonable chance of losing hundreds of billions of dollars.
The problem in the system is that the ratings agencies aren't omniscient. They're basically just guessing at the risk related to something. So when they were shown these sub-prime mortgage bonds the firms had taken on, they judged them to only be as risky as the recent housing market might suggest they were. Housing prices had been going up for a while and there was no reason to assume they wouldn't continue to go up forever (yes, this sounds ridiculous, but it's what they thought). So these bonds got tacked with fairly random ratings, many at AAA.
Sub-Prime Mortgage Bonds
The problem with using mortgages as securities is that at least some individuals will default on their mortgages, no matter how secure the original loan seemed to be. People lose jobs, they have catastrophic medical problems, they have unforeseeable life circumstances interrupt their plans, and so, they default. And sub-prime mortgages ran an even higher likelihood of that happening, whether or not the firms knew that at the time. In order to make these mortgages more stable, they were packaged together as bonds containing hundreds, sometimes thousands of different mortgages.
These mortgages were then piled up in a bond, which is sort of similar in this case to a tower. Each floor of this tower, known as a tranche, represented an individual loan. The tranches at the top were those that repaid the fastest. These received AAA ratings, but because they were thought to be low risk, they also paid the lowest rate of interest. This was for people looking for small amounts of sure money. The lower the tranche, the less likely the loan would ever be repaid and the higher the risk, all the way down to BBB-rated loans which carried a very high level of interest. These were for those willing to take a chance at making more money.
Individuals or institutions wanting to purchase these securities would get to choose in which tranche they were interested. People would make money every time a person made their mortgage payment. By the second quarter of 2005, the mortgage bond market was huge, larger than the market for U.S. Treasury notes and bonds. Largely because the repeal of Glass-Steagall meant firms which held billions of dollars of average Americans money were also engaging in these speculative practices and because the shadowy nature of the market itself meant that almost no one was even aware which firms were exposed to risk, the sub-prime mortgage market had silently placed footholds in almost every corner of the financial sector. The entire economy was now dependent on its stability, which was in turn dependent on the continued rise of housing prices. If housing prices fell, large numbers of people who were already teetering on the edge of the cliff and living on credit would fall off. They would suddenly be under water on their mortgages, owing more than their home was worth. It was already a recipe for disaster.
Collateralized Debt Obligations
Incredibly, Wall Street wasn't done. At this point it was decided that more money could be made if it weren't for the seemingly more risky BBB-rated tranches of the bonds (eventually it would become clear that almost all sub-prime mortgages carried an extreme level of risk, regardless of the rating awarded them; AAA and BBB would both default in near equal numbers). Thus was born the Collateralized Debt Obligation (CDO).
A CDO basically allowed a firm to take bottom tranches of a bond, the most risky, and repackage them together with the bottom tranches of other bonds as CDOs. Now CDOs were made up entirely of BBB-rated mortgages, but when they were submitted to the ratings agencies with a new sheen they were declared AAA simply because they had been packaged together. The firms then proceeded to sell off these new "risk-less" instruments just as they had done for the bonds themselves.
Now, this didn't mean that the bonds were pulled from their original home at the bottom of the bond. The firms basically copied the loans and made a new security out of thin air for people to trade. This meant that one person owned the original tranche and carried its risk, while another had an exact duplicate of that risk.
Credit Default Swaps
Now, a small number of individuals by this time had predicted the forthcoming crisis and had sought a means to bet against the market. While most of Wall Street was betting the bonds would continue to increase in value, a few bet the entire thing would collapse. To do this, they used a complicated type of insurance called a Credit Default Swap (CDS). The buyer would essentially short an entire bond, by buying insurance against its failing. And as each tranche of the bond defaulted, they would slowly get paid. At first, few took this bet; in fact, it wasn't until 2007 that major firms started to use CDSs to limit their risk by hedging their own bonds.
Like the market for mortgage-backed securities trading, the CDS market was shockingly secretive and was marked by a total lack of regulation or oversight. This allowed firms like AIG, Lehman Brothers, and Bear Sterns to take on billions and billions of dollars in risk. They were not only exposed to the initial risk that individuals wouldn't be able to pay back their loans, but they would owe an additional amount of insurance to a completely unrelated third party as well. Eventually, the type of derivative known as a CDS became much more dominated by those purchasing insurance on the failure of the firms themselves. A company like Merrill Lynch would take one look at a AAA-rated firm like AIG and offer extremely cheap insurance to just about anyone foolish enough to bet on its failure. Through this practice, the risk was spread even wider. The incredible interconnectedness of these firms would prove to be a major problem.
All Hell Breaks Loose
Eventually, all good things must come to an end, and so it was with the sub-prime mortgage craze. As we know, eventually the housing market stopped going up as waves of individuals defaulted on their loans. As more and more people defaulted, they brought the market down, causing further individuals to default, created a death-spiral that sent the entire market plummeting.
As this happened, firms scrambled to figure out exactly how much risk they had taken on. Remember that many of the derivatives and assets had been rated as AAA, which meant the firms didn't even have to declare them as risk on their balance sheets. As it became clear that these firms were exposed to massive amounts of risk, confidence fell dramatically. Major firms weren't just on the hook for the money they owed, they now found people scrambling to pull their money out and sell their stocks, causing a similar death-spiral in confidence. This run on the firms led to the possibility of company failures throughout the system. And as this happened, firms realized they had exposed themselves to each others risk as well by selling Credit Default Swaps insuring each others stability.
The rest, as they say, is history. Major firms now exposed to massive amounts of risk were on the brink of failure and economist were nearly unanimous in their belief that a domino effect was inevitable. A total system collapse of the entire financial market was inevitable unless someone stepped in to guarantee the firms. The lack of a wall between depository and investment banks meant that such risk also now threatened the money regular Americans had entrusted to the banks. If the banks were allowed to fail, one after another, the financial sector would collapse and the federal government, through the FDIC which insured individuals deposits, would be on the hook to pay out.
So drastic measures were adopted. The Federal Reserve injected nearly a trillion dollars in capital into the system. Congress approved an emergency bailout through a program known as the Troubled Asset Relief Program (TARP) which loaned billions of dollars to stabilize the firms. Treasury adopted the Term Asset-Backed Security Loan Facility (TALF) to purchase the bad assets from the firms and take the risk off their books. All of this was done to prevent a financial armageddon caused by the actions of a few wealthy individuals trying to become more wealthy. Through actions that can only be described as risky, greedy, stupid, and staggeringly ridiculous, these individual brought the entire global economy to its knees. More than a year and a half later, we are still recovering, and although the economy has improved significantly too many Americans are still out of work. At the same time, Wall Street seems to have learned nothing from the crisis.
In the coming weeks, Congress will attempt to put into place a system of basic regulations to prevent such a crisis from happening again. In our next Financial Reform 101 piece we'll explore the actual reforms being discussed and how they address each individual piece of the crisis detailed above, from a consumer financial protection system to look out for consumers and prevent abusive loan practices to new public trading systems and oversight for derivatives trading to a simple and safe plan for breaking up banks that would otherwise pose a risk to the entire system.
There is certainly room for debate about how best to fix the egregious problems detailed above, but it's my hope that this piece gives everyone a clear picture of the problem itself and that that understanding better equips us to have the necessary discussion about a way forward.