By Price Fishback, Frank and Clara Kramer Professor of Economics
The “greatest financial disaster since the Great Depression” has become the catchphrase for the current situation. In Old Testament fashion, the U.S. appears to be paying for the financial excesses associated with a real estate boom between 2000 and 2006. The reasons for the boom were many. As the stock market dropped at the beginning of the decade, investors sought a new haven for their assets in housing and real estate. The boom was fueled in part by low interest rates stemming from a loose monetary policy and a series of financial innovations that led mortgage lenders to make many more loans.
The Bush administration and many members of Congress pushed for an “ownership society,” in which a larger share of people owned their own homes. One way to achieve this was to find ways to loan to people who had long been considered bad credit risks because they lived in neighborhoods where housing values were at risk or because lenders considered them to have inadequate capacity to repay the loans. Some of the efforts were designed to correct the discrimination in lending to minorities that many once perceived to be commonplace.
Fannie Mae and Freddie Mac, the government-sponsored entities established to create markets for mortgage loans, were given more incentives to purchase subprime and alt-A mortgages. The subprimes are the highest risk loans; the alt-A mortgages carried less risk than the subprimes, but were risky nonetheless because they lent to borrowers who provided minimal or no down-payments and were not required to document their incomes and assets. Fannie and Freddie eventually bought 44 percent of the subprime loans in 2004, 33 percent in 2005, and 22 percent in 2006. The plan was for Fannie and Freddie to use their rigorous standards and procedures to monitor and ensure that these risky loans did not default. The goals of the ownership society were met to some degree as home-ownership rates rose from 67 percent in 2000 to an all-time high of 69 percent in 2004 and 2006.
The heads of Fannie and Freddie were not dragged kicking and screaming into these purchases. In fact, Fannie and Freddie have become infamous for their active lobbying of their regulator and Congress to allow them to make these purchases. Both entities were profit-seeking corporations selling stock on Wall Street and issuing bonds. Originally established to purchase the conventional mortgages guaranteed by the F.H.A. or V.A., Fannie and Freddie had slowly been expanding the range of mortgages they purchased through the 1980’s and 1990’s. Both enterprises profited greatly from the common perception that they were backed by the federal government.
The perceptions of backing held even though President Lyndon Johnson had removed the federal guarantee for Fannie in 1968 and Freddie had been established as Fannie’s competitor without government backing in 1970. This perceived guarantee, which proved true in September 2008, allowed them to issue bonds and borrow at interest rates only slightly higher than the no-risk federal treasury bill rates. They could then purchase mortgages that paid higher rates and either hold them or package them up in mortgage-backed securities and sell them to investors. Despite this advantage, Fannie and Freddie faced increasing competition from other financial institutions who provided the same services. To maintain their strong position in the mortgage markets, they lobbied strongly to expand their base.
The modern boom was fueled by far more than policy by government and government-sponsored agencies. The shift of assets out of stocks and into housing touched off a rise in housing demand that outstripped the existing housing supply in Arizona, California, Florida, and a number of the largest cities around the country. Even as the recession of 2001 led to increased mortgage foreclosures, the losses to lenders were dampened greatly because foreclosure sale prices were near or even above the value of the loans. Private lenders therefore began perceiving less risk from lending even to riskier borrowers. Meanwhile, the economic models used in the mortgage industry were showing that borrowers in high-price areas were able to meet their mortgage payments with much higher monthly payment to income ratios than the 36 percent maximum long recommended in the industry.
Seeing the rising housing prices, a higher share of the population saw home ownership as an opportunity to buy the houses as an investment opportunity. An increasing number of borrowers sought adjustable-rate mortgages with low initial rates with the expectation that they could easily “flip” the home for a higher price when the interest rate reset at a higher level. A number of mortgages, particularly alt-A and subprime loans, carried “teaser” rates that were incredibly low with the proviso of a substantial repayment penalty if the loan were refinanced. A borrower faced with this option still thought it was a good one if they expected to move and resell the house at the much higher price that seemed likely in the go-go atmosphere of the early 2000’s.
There were also opportunities for fraudulent activity on both sides of the transactions, although we have no way to really measure its extent. Some lenders misrepresented the terms of the loan, glossing over repayment penalties or the probability of an interest rate jump on the loan. Meanwhile, a number of borrowers misrepresented their income and assets. Some hid the fact that they had borrowed the down-payment on their homes.
The financial industry built an innovative series of financial instruments on top of these mortgages and other types of loans. A large number of lenders and financial institutions joined Freddie and Fannie in packaging up the mortgages into mortgage-backed securities (MBS’s) that they then sold to investors. The mortgage is just like a bond in that it represents a stream of payments, so the MBS is similar to a bond fund that fluctuates in price with fluctuations in interest rates and the likelihood of default or early repayment of the underlying asset. The MBS’s offered more liquidity to the housing markets because lenders like Countrywide had more options to sell the mortgage to others. They could then turn around and use the cash they received to make more loans. Investors saw the MBS’s as a new investment opportunity in an asset that was far more liquid than the real estate it is based on. Furthermore, a large portfolio of mortgages inside the MBS was a way to spread risk just as risk could be spread by buying stock and bond funds. Even better, the MBS’s offered a new form of investment that an investor could add to a portfolio of domestic stock funds, bond funds, exchange-rate funds, and foreign-investment funds. To the extent that movements in value were uncorrelated with the movements in value of the other funds, the purchase reduced the risk in the overall portfolio.
Unfortunately, the financial industry did not stop with the MBS’s. Many firms began packaging up large numbers of MBS’s and pieces of MBS’s into collateralized debt obligations (CDO’s) that could be sold to large institutional investors. Again, the goal was to offer new opportunities for investment and offer people a broader portfolio. The CDO’s, which took off
in the 2000’s, contained “tranches” of MBS’s with different risk characteristics. Rather than having to buy a large number of MBS’s to diversify a portfolio, an investor could purchase a CDO that contained a range of risks. Over the course of the decade, CDO’s increasingly contained more tranches to fulfill this role.
As a means of reducing risk, financial institutions added another layer to this asset tower in the form of credit default swaps (CDS’s), which were essentially insurance contracts. Holders of CDO’s created contracts with firms like A.I.G. The CDO owner made payments to A.I.G., which in return promised to purchase the CDO at an agreed-upon price if the CDO declined in value. Given the extent of the tower built on the mortgages, one might think that it was hard for anyone to know what was in the CDS’s, the CDO’s, and the MBS’s, but that is not actually true. Credit-rating agencies were evaluating the quality of assets in the structure. The owners, typically large investment operations, were all using the analyses of a large number of smart people to evaluate the securities themselves. Meanwhile, other firms were evaluating the assets as well, as they considered purchasing them or wrote CDS contracts on CDO’s owned by other firms.
Problems arose as the rise in housing prices slowed. By 2007 housing prices were falling. The Case-Schiller housing-price index for 20 cities across the nation rose from 100 to 230 between 2000 and 2006. By October 2008 it had fallen back to around 170. It should be noted that the Case-Schiller index is dominated by the highest-flying housing markets in the country. An alternative index from the Office of Federal Housing Enterprise Oversight (OFHEO) shows that prices for homes with conventional and prime mortgages rose from 100 in 2000 to around 160 in 2007 before falling to 142 in November 2008.
Builders had responded to the rising housing prices with a surge in building, while the Federal Reserve had pushed the target federal funds rate from 1 percent in June 2003 to 5.25 percent in June 2006. Over the period the quality of the typical loan had deteriorated as the share of subprimes and alt-A loans expanded. As the housing-price rise slowed and prices began falling, the best-laid plans of many borrowers were interrupted. People facing the prospect of substantially higher monthly payments when the adjustable rate reset found it difficult to sell their houses at a profit. Subprime and alt-A borrowers began falling behind on their payments, and foreclosure rates began a steady rise from 1.7 percent in 2005 to 2.8 percent in 2007.
As each new cohort of adjustable-rate mortgages reset, the problems increased and housing prices in the markets where prices boomed the most began falling. As housing prices have fallen, the number of loans where the house value fell below the value of the loan has increased. Given that mortgages in most parts of the country are nonrecourse loans, some people have walked away from their loans, leaving the mortgage owner with the house. One of the remaining fears is that a large number of these borrowers who are “under water” will decide to follow suit.
The combination of rising foreclosures and falling house prices jeopardized a larger share of mortgages and the asset towers built upon them began to crumble. The forecasts of the downsides of foreclosure by ratings agencies and the owners of the CDS’s, CDO’s, and MBS’s turned out to be overly optimistic, and values of the assets began to slide. The stock price of Lehman Brothers and Bear Stearns, which was heavily invested in these financial instruments, started experiencing problems in the summer of 2007.
Meanwhile, A.I.G., which had sold CDS’s on CDO’s through 2005, began facing a substantial problem that it had not anticipated. The main risk it had anticipated was the default risk on the underlying mortgage loans, and its models seem to have done a good job of measuring that risk. What it had not anticipated was the possibility that it might have to post collateral to show that it could pay off the CDS’s if either the assets insured by the swaps declined or A.I.G.’s own corporate debt rating declined.
As the markets weakened between fall 2007 and fall 2008, A.I.G.’s CDS trading partners began demanding that A.I.G. post collateral. By August 2008, A.I.G. had posted $16.5 billion in collateral with more demands coming. Meanwhile, the Dow Jones Industrial Stock Index hit an all-time peak of 13,930 in October 2007 and then began a series of declines with temporary interruptions in April and the summer of 2008.
The Federal Reserve responded to these problems by purchasing bonds in open-market operations. To signal its efforts, it reduced the target for the federal funds rate from its peak of 5.25 percent in June 2006 to 4.25 percent in December 2007 to 2.25 percent in March 2008. Bear Stearns’s problems escalated to the point where in March 2008 Treasury Secretary Henry Paulson forced the sale of Bear Stearns to Chase for $2 per share (later adjusted to $10 per share) with an unusual guarantee of $29 billion to Chase against potential future losses on Bear Stearns assets in the sale. The Dow Jones responded with a temporary up-tick in April and then continued to slide, despite the Fed’s purchase cut in the federal funds rate target to 2 percent on April 30th.
The whole financial system seemed to be unraveling in September 2008. On September 9, Fannie and Freddie were put under conservatorship under federal regulators with up to $200 billion in liquidity backstops. Lehman Brothers was still failing and seeking buyers, but the buyers were seeking loan guarantees for the sale from the Treasury and the Federal Reserve. Secretary Paulson argued that the problems in Lehman’s balance sheet were too large and let Lehman Brothers go bankrupt instead on September 15. The next day he reversed field and the federal government took an 80 percent ownership stake in A.I.G. and offered $123 billion in credit to the struggling company.
In late September, Paulson, Federal Reserve Chair Benjamin Bernanke, the Congress, and the president negotiated a $700 billion bailout bill. The bill passed on October 3 and established the Temporary Asset Recovery Program (TARP). The same day, the Federal Deposit Insurance Corporation raised the limit on accounts eligible for deposit insurance from $100,000 to $250,000 through the end of 2009. On October 7, the Fed announced the unusual step that it would purchase commercial paper directly, and the next day the Fed led a global interest rate cut by lowering the target federal funds rate to 1.5 percent. Although the TARP’s announced goal was to purchase the “toxic” assets on the balance sheets of financial institutions, Paulson switched gears and used a large part of the first $350 billion to take ownership stakes in major banks. Another significant portion of the TARP funds went to shoring up A.I.G. with loans of up to $150 billion to meet collateral calls and to bail out Citigroup in November 2008. Meanwhile, the Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008.