How Did We Get Here? A Summary of the Credit Mess

The tech bubble burst in March 2000, just as many individual investors were deciding to put their money in the stock market amid financial media calls for 6,000 on the NASDAQ. The ensuing recession claimed many jobs, reduced corporate spending, increased unemployment, and destroyed NASDAQ investors' portfolios. The situation was made substantially worse by the terrorist attacks on September 11, 2001. Many people gave up on the stock market and decided to invest in real estate.

As the economy continued to stagnate, the Federal Reserve, chaired by Alan Greenspan (who has now sort of admitted he made a mistake), slashed rates down almost to 1%. The rates were kept at these low levels far too long, experts now say. Low interest rates on mortgages made houses more affordable, and demand for real estate increased. As demand and prices grew, mortgage lenders started changing their business models. Traditionally, a mortgage lender (bank, credit union, etc) would lend money for a home purchase and would hold that loan until it matured (usually for 15 or 30 years). This is called the originate to own model.

Since business was good, banks started shifting their strategy to an originate to sell model. Banks began to sell their mortgages to third parties (these third parties often sold them to fourth parties, and so on), freeing up capital to fund new loans. Mortgages started to become a mass produced product. While lenders made a small profit on every loan they sold, they started to make a lot of money on the volume of their mortgage sales.

With the originate to own model the lender cares deeply about the credit quality of its borrowers. Since the lender holds the loan until maturity, it makes no sense to lend to someone who is likely to default. With the originate to sell model, on the other hand, the lender has no incentive to be careful because any defaults are the purchaser's problem. In fact, since earnings on this model depend on the volume of sales, the lender has every incentive to make its lending practices as lax as possible. With many mortgages being sold less than a week after they're originated, lenders did just that.

The boom in mortgage selling led to and was reinforced by rising housing prices. Two out of every five new jobs created in the middle of the decade were housing related. (You may recall your friends and neighbors becoming mortgage brokers.) As fraudulent practices almost always develop in booming industries, housing was not immune. Lenders started approving pretty much anyone who could sign their name, with little or no attempt to verify employment status, etc. Fraudulent home appraisers started overvaluing homes. Speculators, thieves, the unintelligent, and people who were swindled, started purchasing homes with no money down for ever increasing prices, paying interest only.

The now nationalized Fannie Mae (FNM) and Freddie Mac (FRE) certified (insuring purchasers against some potential losses) some of these loans, making it easier to bundle and then securitize them, to make mortgage backed securities (MBS). Securitized loans were then sold to yield hungry banks, investment banks, and so on. But there was a problem. Fannie Mae and Freddie Mac only certified prime (the most credit worthy borrowers) mortgages, making it difficult to bundle and securitize subprime (borrowers with poor creditworthiness) mortgages.

In 2004, the retards in Congress (led by the Democrats--please note that I dislike both parties equally) came to the rescue. They started clamoring for Frannie Mae and Freddie Mac to certify subprime mortgages on a widescale. More people with low incomes, they argued, should have access to homes they cannot afford. Since Fannie and Freddie were making money on it, it did not prove difficult to have them assure subprime mortgages. When Republicans started to worry about questionable practices at the two government sponsored entities, the Democrats fought back. (See Maxine Waters praising subprime loans at the 5:30 mark.)

Lenders immediately started trying to get more subprime customers. Some firms specialized in subprime lending. People with low incomes (which is correlated with low levels of education) and others with terrible credit were swindled (many, of course, knew exactly what they were getting into but were greedy) into buying homes they could not afford. They were given adjustable rate mortgages, initially at teaser rates of 2 to 3%, that were later to reset to as much as 9% or more.

Now that subprime mortgages had Fannie and Freddie backing, it was easier to bundle and securitize them. It's obvious that subprime mortgages are riskier than prime mortgages. The geniuses on Wall Street took that into account when they thought of collateralized debt obligations (CDOs). CDOs were made by combining lots MBSs. These were then sliced into tranches, and the credit rating industry (Fitch, Standard and Poor's, Moody's) issued credit ratings on them.

The smart people who participated in this were trying to make as much money as they could before everything collapsed. The stupid bankers and risk modelers, on the other hand, thought there wasn't much to fear, as housing prices would continue to go up forever. (Was Franklin Raines a moron or a thief? See video at 7:46.) The ratings agencies, which were paid by the issuers of CDOs had zero incentive to understand what they were rating and every incentive to please their clients. Suddenly garbage subprime debt became AAA (the highest credit quality, with little risk of default).

As the debt was often rated AAA or AA and carried a higher yield than was otherwise available for safe investments in the low interest rate environment, yield hungry (and some risk averse) institutional investors like banks, investment banks, hedge funds, money market funds, and pension funds developed an insatiable appetite for CDOs. Some buyers, like hedge funds and investment banks, used borrowed money to make their purchases. For every dollar of assets some of these institutions had, they were buying over $20 or $30 worth of mortgages.

For a time everything was grand. Thanks to rising housing prices, some lenders like Washington Mutual had negative default rates. That is, when borrowers defaulted WaMu was able to make a profit when the mortgaged properties were foreclosed. Amid this surreal environment banks decided to up the ante by creating structured investment vehicles (SIVs). Banks started selling their mortgages to the SIVs they created.

This moved the mortgages off their books and freed up capital to issue more loans or buy more mortgages from other issuers. SIVs allowed banks to pretend their capital reserves were much higher than they actually were. That is, banks used SIVs to get around pesky laws preventing them from leveraging too much.

You may wonder where the SIVs got the money to buy subprime mortgages from their sponsoring banks. That's right, they borrowed! They issued asset backed commercial paper and sold it to investors like money market funds. The subprime debt SIVs owned paid a higher interest rate than the SIVs paid the money market funds. Thus, SIVs made money on the difference between the interest they received and the interest they paid out, enabling them to buy more subprime mortgages and sell more debt to money market funds and other investors. As housing prices rose and default rates were low or negative, everyone seemed to be a winner.

But there was a nagging feeling in the backs of mortgage purchasers' minds. There was some risk here, wasn't there? Ever the prudent bunch, they decided to buy insurance on their MBSs by purchasing Credit Default Swaps (CDS). Companies like AIG (AIG) made a good business of leveraging their assets many times over to sell CDSs. For example, a mortgage purchaser would pay AIG $200,000 to insure $2,000,000 worth of mortgages. AIG promised to pay the mortgage holder if borrowers defaulted on the mortgages. Soon, sellers of CDSs were insuring debt worth dozens more times than their assets.

Eventually everyone was buying and selling CDSs, and now no one really knows who owes whom how much when there's a default. Hopefully most of the outstanding CDSs offset each other, but the market for them is as big as the world's economy: $45 trillion. If you were upset that AIG wasn't allowed to fail, you should consider whether you really want to find out what would happen if this house of cards were allowed to fall.

Because of the rising housing prices, low rates, MBSs, CDOs, SIVs, etc, everyone from homeowners to hedge funds had the incentive to overproduce and overleverage. As demand went ever higher, homebuilders built houses as fast as they could. People who already owned homes bought extra houses, or refinanced their current mortgages and started using their homes like ATMs (credit cards is probably a better analogy).

For example, someone who had $200,000 left on their mortgage discovered that his house was worth $400,000. He'd go to the bank, get a $400,000 loan, pay off the $200,000 he owed on the first loan, and use the remaining $200,000 to buy crap he didn't need, like an extra gas guzzling car, another house, stocks, cell phones, computers, etc. All the while, he'd pay only the minimums on his credit cards and mortgage. (Around two years ago I was amazed to see that suddenly half the people on my block had BMWs in their driveways. I thought about buying an ultra short ETF, but as the market was galloping up, I got caught up in the optimism and didn't do it.) As houses became more and more expensive, fewer and fewer people had enough for a downpayment, so more and more mortgages covered 100% of the home purchase. Most of these mortgages, like subprime mortgages, came with low teaser rates that were later adjusted upwards.

All this borrowing and spending created lots of jobs here and abroad, and fueled the world's developing economies. We buy a lot of their oil and junk products. Asian countries, like China, India, and Korea, started running greater and greater trade surpluses. They were flooded with dollars. They took this money and started to buy US mortgages, increasing demand for MBSs and creating incentives for lax lenders to lend even more. We borrowed and bought their crap. They used the proceeds to buy our debt. It was a kind of perpetual cycle. All asset classes were inflating, from real estate to stocks to commodities.

Then reality asserted itself. Interest rates on adjustable rate mortgages started reseting. Suddenly people, who were living from paycheck to paycheck and paying only the minimums, were faced with mortgage bills two or three times as high. Instead of having to pay $2,000 a month, all of the sudden they had to pay $4,000 or even $6,000 a month. These people started defaulting.

As defaults grew, foreclosures increased. As foreclosures increased, the supply of houses on the market grew. Lenders also started to become a little more wary. Fewer people started getting mortgages. This decreased the demand for houses. As supply grew and demand decreased, housing prices started falling. Now people who owed $600,000 on a house worth $580,000 and declining decided it wasn't worth it, and walked away. Defaults increased. The supply of houses grew greater and demand decreased. As refinancing became more difficult, consumers facing mountains of debt started spending less. Employers, especially in housing related industries, started making job cuts. The situation started reinforcing itself.

The MBS market began drying up as defaults rose. Some investors started demanding higher yields. Other investors, like pension funds, discovered that the subprime debt they bought wasn't AAA after all. They are not allowed to purchase or hold debt that is below a certain quality (usually AAA or AA). With the MBS market going down, lenders started lending even less. The situation reinforced itself further.

Pretty soon, no one wanted to buy MBS or CDOs at all. Banks were left holding billions in potentially worthless mortgages. It became harder for even prime borrowers to get financing. As fear spread, companies and municipalities started having a hard time borrowing to fund their operations, leading to layoffs and reductions in spending. Banks, now worried about their capital reserves and fearing their rivals might go under, pretty much stopped lending, even to each other. That's sort of where we are now.

As everyone delevers, we're in for a painful recession. Our economy, and the world's to the extent the world depended on American consumers buying imported junk, for the last five years or so (we can probably say the last 10 years) has been fake. It was based almost exclusively on credit. Almost half of the jobs created this decade were housing related. This new employment fueled growth in other industries. But everywhere, pretty much everything Americans bought was bought with borrowed money. We had a negative savings rate. Now that it will be harder to borrow, what will fuel future economic growth?

One thing about the future is rather clear. If we manage to get out of this crisis and go back to business as usual, our next boom will peak lower and our next bust will bottom deeper. We have to find a way to live within our means, with more saving than borrowing.


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