By Max Mastrella
What do you think of stocks and how to invest in them? Most people think of trying to buy stocks at a low price and hope that a bull market, one in which market prices are rising, will bring up the price and make you, the investor, a profit from your investment. The problem faced here is that it's tough to figure out how to invest when the economy is in a bear market, one in which market prices are falling, and prices are already high. The solution to this is a simple strategy of short selling stocks.
A seemingly confusing investment strategy, short-selling stocks is really quite simple. First, there must be an investor who wishes to short sell stocks in the market. The objective he or she is trying to accomplish is to bet that the market will continue to go down compared to the normal investing strategy of hoping the market will rise. The investor borrows stocks from a stockbroker with some sort of contract or agreement to return them. Borrowing stocks on credit is called borrowing stocks on margin, which is a loan you are promising to pay back. Once in the hands of the investor, he or she sells the stocks for the high price that they are worth in the stock market. The investor receives the payment for the stocks and then must wait while he hopes the stock price will fall. After a certain amount of time the investor buys back the same number of stocks hopefully at a lower price. The investor has just bought high and sold low in the opposite order than most investors. With the same amount of stocks the investor originally borrowed, he or she can now return them to the stockbroker from whom he or she borrowed them. The act of giving back the borrowed stock is called covering. Once the stock has been returned to the original broker the investor profits on the difference between the high price at which he or she sold the stocks and the low price at which he or she bought them. Short selling stocks can be a very rewarding strategy, but with a high reward comes a high risk. By short selling, an investor is betting on the market and price of the stock to go down. If the market and stock price go up, the investor will lose money.
It is easier understand the strategy of short-selling stocks using an example. Take a risky investor named Jack for example. Jack wishes to short sell stocks in the bear market in order to make some profit so he borrows 10 stocks each from his stockbroker, Jill, on margin. Jack is betting that the price of his stocks will go down. Jack then goes out and sells all 10 stocks for $56 to another investor named Dow. Over the next couple months the market goes down and the price of the stocks Jack sold to Dow go down to $20. Jack then buys them back from Dow at the $20 price and returns them to Jill, his stockbroker. The original sale of the 10 stocks at $56 each earned Jack a profit of $560. Jack then spent $200 of this profit to buy the 10 stocks back at their $20 price. Jack’s final profit is the $360 difference between the price he originally sold the stocks at and the lower price he bought them back at.
As seen, since the price went up, Jack was able to make a profit. However, if the price had gone up Jack would have needed to buy the stocks back from Dow at a higher price and therefore lose money. Also, as seen in the example, Jack had to sell the stocks at a price ($56) higher than the last trade price ($55). In order to prevent short sellers from further pushing prices down in the already downward moving bear market, the SEC established a rule known as the up-tick rule. The up-tick rule required every short selling transaction of a stock to be entered at a price higher than the previous trade. On July 6, 2007 the SEC eliminated the up-tick rule. The suspension of the up tick rule has caused a steady decline in the market for some stocks by making it easier for short sellers to short the market because the stock can now be sold continually lower, without waiting for a sale at a higher price to stop the downward momentum. The episodes of a rapid decline in the stock price of financial companies over the last year have been attributed to the absence of this uptick rule.
Source:
"Uptick Rule." Investopedia. http://www.investopedia.com/terms/u/uptickrule.asp. Internet; accessed 6 October 2008.
Tuesday, October 14, 2008
Friday, October 10, 2008
AIG
By Rodrigo Quan Miranda
American International Group, Inc. (AIG) is an American insurance corporation, and one of the largest insurance corporations in the world, with a market value of $239 billion at its peak.[1] AIG’s current Chief Executive Officer (Also Chairman for the Board of Directors) is Edward M. Liddy.[2] AIG provides several insurance and financial services throughout the world, including auto insurance, life insurance, health insurance, retirement planning, and the most controversial at the time, Credit-Default Swaps (CDS).[3]
During the past few years, several investment banks and other financial institutions have been issuing Mortgage-Backed Securities (MBS) as ways to raise capital. But as MBSs were issued, these financial institutions realized that the risk of default (not paid back) on the MBS was too high for them to bear. They decided to insure their MBS with CDS offered by insurance companies as AIG. Basically, for a certain fee paid by the financial institution to AIG, a CDS promised that if the borrower defaulted on the MBS, AIG would cover for the costs of the defaulted MBS. Everything was going well, until the house market crashed. Because of this, a high percentage of the MBS were defaulted, and the entire burden of insured MBS was now borne by AIG (and other CDS issuers.) AIG realized they did not have the money to cover for all the CDS issued, its stocks crashed, and eventually, the U.S. government interceded.[4]
The government considered that AIG was too big to let it fall. Because of AIG’s extensiveness across the nation, the government thought that the impact it would cause on the U.S. economy would be devastating. On September 16th, the Federal Reserve bailed out AIG by extending an $85 billion credit line to prevent the company from going into bankruptcy. The credit line is to be paid in 24 months, and the idea behind it is that it will give AIG enough time and capital to improve its standing in an organized manner.[5] The government expects AIG to sell some of its healthy business branches in order to pay back the debt.[6] As part of the credit payment, the U.S. government will receive a %79.9 stake in the company, which basically means that the government will gain control over AIG.[7]
[1] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
[2] AIG Corporate Information. “Corporate Governance: Board of Directors.” About AIG. http://ir.aigcorporate.com/phoenix.zhtml?c=76115&p=irol-govboard (accessed October 8, 2008).
[3] AIG, “AIG Home,” AIG web page, http://www.aig.com/Home-Page_20_17084.html (accessed October 8, 2008).
[4] Ted Hartsoe, “Financial Meltdown and the Economy,” Choate Economics Blog, entry posted October 02, 2008, http://choateeconomics.blogspot.com/html (accessed October 8, 2008).
[5] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
[6] Anonymous, “Saving Wall Street: The Last Resort,” The Economist, September 20-26, 2008.
[7] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
American International Group, Inc. (AIG) is an American insurance corporation, and one of the largest insurance corporations in the world, with a market value of $239 billion at its peak.[1] AIG’s current Chief Executive Officer (Also Chairman for the Board of Directors) is Edward M. Liddy.[2] AIG provides several insurance and financial services throughout the world, including auto insurance, life insurance, health insurance, retirement planning, and the most controversial at the time, Credit-Default Swaps (CDS).[3]
During the past few years, several investment banks and other financial institutions have been issuing Mortgage-Backed Securities (MBS) as ways to raise capital. But as MBSs were issued, these financial institutions realized that the risk of default (not paid back) on the MBS was too high for them to bear. They decided to insure their MBS with CDS offered by insurance companies as AIG. Basically, for a certain fee paid by the financial institution to AIG, a CDS promised that if the borrower defaulted on the MBS, AIG would cover for the costs of the defaulted MBS. Everything was going well, until the house market crashed. Because of this, a high percentage of the MBS were defaulted, and the entire burden of insured MBS was now borne by AIG (and other CDS issuers.) AIG realized they did not have the money to cover for all the CDS issued, its stocks crashed, and eventually, the U.S. government interceded.[4]
The government considered that AIG was too big to let it fall. Because of AIG’s extensiveness across the nation, the government thought that the impact it would cause on the U.S. economy would be devastating. On September 16th, the Federal Reserve bailed out AIG by extending an $85 billion credit line to prevent the company from going into bankruptcy. The credit line is to be paid in 24 months, and the idea behind it is that it will give AIG enough time and capital to improve its standing in an organized manner.[5] The government expects AIG to sell some of its healthy business branches in order to pay back the debt.[6] As part of the credit payment, the U.S. government will receive a %79.9 stake in the company, which basically means that the government will gain control over AIG.[7]
[1] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
[2] AIG Corporate Information. “Corporate Governance: Board of Directors.” About AIG. http://ir.aigcorporate.com/phoenix.zhtml?c=76115&p=irol-govboard (accessed October 8, 2008).
[3] AIG, “AIG Home,” AIG web page, http://www.aig.com/Home-Page_20_17084.html (accessed October 8, 2008).
[4] Ted Hartsoe, “Financial Meltdown and the Economy,” Choate Economics Blog, entry posted October 02, 2008, http://choateeconomics.blogspot.com/html (accessed October 8, 2008).
[5] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
[6] Anonymous, “Saving Wall Street: The Last Resort,” The Economist, September 20-26, 2008.
[7] Anonymous, “AIG’s rescue: Size Matters,” The Economist, September 20-26, 2008.
Thursday, October 9, 2008
Credit Default Swaps
By Angus Maguire
Credit default swaps (CDS) are the most commonly used type of credit derivative. (Credit derivatives are privately held contracts that allow users to manage their credit risks; the price of these contracts is driven by the credit risk associated with them.) Credit Default Swaps were first created in 1995 by JP Morgan and quickly accelerated in use; there were $62.2 trillion dollars in these contracts by the end of 2007. To put that in perspective the US Nominal GDP in 2007 was $13.794 trillion. Credit default swaps usually work when a large bank, or investment firm sell a CDS to an individual or firm who would like to insure a risky bond. In exchange for the seller promising to pay back how much the bond is worth if the company who issued the bond defaults on the bond the buyer will pay a percentage of the bonds dividend occasionally over the period of the bonds life. If you don’t understand refer to the diagram below.
Credit default swaps (CDS) are the most commonly used type of credit derivative. (Credit derivatives are privately held contracts that allow users to manage their credit risks; the price of these contracts is driven by the credit risk associated with them.) Credit Default Swaps were first created in 1995 by JP Morgan and quickly accelerated in use; there were $62.2 trillion dollars in these contracts by the end of 2007. To put that in perspective the US Nominal GDP in 2007 was $13.794 trillion. Credit default swaps usually work when a large bank, or investment firm sell a CDS to an individual or firm who would like to insure a risky bond. In exchange for the seller promising to pay back how much the bond is worth if the company who issued the bond defaults on the bond the buyer will pay a percentage of the bonds dividend occasionally over the period of the bonds life. If you don’t understand refer to the diagram below.
The problem with Credit Default Swaps is that there is no guarantee that the seller of the CDS will be able to fulfill their side of the contract if the buyer of the bond needs to be reimbursed if their bond defaults. The other problem is that CDSs are unregulated; when the banks or investment firms sell CDSs they do not need to pay anything to do this. In selling the CDS, the seller merely promises that they will pay if the bond defaults. Many more Credit Default Swaps were sold than can actually be reimbursed meaning that in the recent collapse of many financial institutions many CDSs have had to be paid back by other financial institutions, leading them to lose even more money therefore helping the downward spiral in the financial sector.
The Housing Market
By Kendall Thigpen and Rohit Shankar
Today, the housing market in the United States is simply in shambles. There were many factors that contributed to the collapse of one the most important parts of America’s Economy. The main contributor to the downfall of the United States housing market was increased lending by banks to unqualified borrowers. Borrowers were often unable to pay back these loans because they lacked the resources to pay off their debts.
After the recession in 2001, the housing market surged . Demand for homes was at an all-time high. Also, home prices were on the rise which meant people thought that purchasing homes would be a good investment for the future as they were certain that their house values would continue to go up. In order to purchase these homes, home-seekers looked for loans from banks. However, many of these future borrowers were unqualified to take on the mortgages supplied to them by banks. In an effort to thwart this problem, banks set up Adjustable Rate Mortgages. These ARM’s had low interest rates to begin with, but after a set period of time the interest rates would increase leading to the borrowers being unable to pay back the loans. Borrowers and the banks had assumed that the value of the houses would rise and the borrowers would be able to take out new loans to replace the old loans. In 2007, there was 1 trillion dollars worth of these ARM’s due back to banks. Millions of over-leveraged homeowners had defaulted on their mortgages putting pressure on the banks, which sent the economy into a tailspin.
As the housing market boomed, many contractors sought to satisfy this increased demand. The result was a large amount of homes being built in growing markets such as Las Vegas, later to be left vacant due to a lack of purchasers of property. The increased supply caused a drop in prices across the board in the housing market, and many home-owners were losing significant value in their homes. This meant that the mortgages that homeowners owed were generally more than the house’s worth. By the time the housing “bubble” deflates millions of working-class Americans who took out ARM’s will be left to pay off loans which will create a deeper divide between middle-class and the wealthy.
To sum up the whole housing market crisis in terms of supply and demand, the demand for houses increased due to people’s speculation that house prices would keep rising. With such a big increase in demand for houses, contractors started building houses to the point where they oversaturated the market with homes. Too many houses were built, and there were not enough buyers in the market. This caused the price of houses to drop. This was a problem for the people who had taken out home loans because they ended up paying more for the mortgage than what the actual house was worth. Also, with the ARM’s resetting to higher rates, a lot of people could not afford to pay back the loans and were forced to foreclose on their new homes. If the banks did not lend money out to unqualified borrowers and contractors did not flood the market with excess houses, then this whole housing market crisis could have been prevented. Housing conditions may not improve for several years and the housing market must make a strong comeback to help stabilize the US economy.
Info source: http://www.marketoracle.co.uk/Article383.html
Today, the housing market in the United States is simply in shambles. There were many factors that contributed to the collapse of one the most important parts of America’s Economy. The main contributor to the downfall of the United States housing market was increased lending by banks to unqualified borrowers. Borrowers were often unable to pay back these loans because they lacked the resources to pay off their debts.
After the recession in 2001, the housing market surged . Demand for homes was at an all-time high. Also, home prices were on the rise which meant people thought that purchasing homes would be a good investment for the future as they were certain that their house values would continue to go up. In order to purchase these homes, home-seekers looked for loans from banks. However, many of these future borrowers were unqualified to take on the mortgages supplied to them by banks. In an effort to thwart this problem, banks set up Adjustable Rate Mortgages. These ARM’s had low interest rates to begin with, but after a set period of time the interest rates would increase leading to the borrowers being unable to pay back the loans. Borrowers and the banks had assumed that the value of the houses would rise and the borrowers would be able to take out new loans to replace the old loans. In 2007, there was 1 trillion dollars worth of these ARM’s due back to banks. Millions of over-leveraged homeowners had defaulted on their mortgages putting pressure on the banks, which sent the economy into a tailspin.
As the housing market boomed, many contractors sought to satisfy this increased demand. The result was a large amount of homes being built in growing markets such as Las Vegas, later to be left vacant due to a lack of purchasers of property. The increased supply caused a drop in prices across the board in the housing market, and many home-owners were losing significant value in their homes. This meant that the mortgages that homeowners owed were generally more than the house’s worth. By the time the housing “bubble” deflates millions of working-class Americans who took out ARM’s will be left to pay off loans which will create a deeper divide between middle-class and the wealthy.
To sum up the whole housing market crisis in terms of supply and demand, the demand for houses increased due to people’s speculation that house prices would keep rising. With such a big increase in demand for houses, contractors started building houses to the point where they oversaturated the market with homes. Too many houses were built, and there were not enough buyers in the market. This caused the price of houses to drop. This was a problem for the people who had taken out home loans because they ended up paying more for the mortgage than what the actual house was worth. Also, with the ARM’s resetting to higher rates, a lot of people could not afford to pay back the loans and were forced to foreclose on their new homes. If the banks did not lend money out to unqualified borrowers and contractors did not flood the market with excess houses, then this whole housing market crisis could have been prevented. Housing conditions may not improve for several years and the housing market must make a strong comeback to help stabilize the US economy.
Info source: http://www.marketoracle.co.uk/Article383.html
Proposed Rescue Plan
By Ryan Rice
In the past week and a half, talk of the proposed rescue plan to lighten the detrimental effects of the recent financial crisis has flooded the news. Many plans have been suggested but as of September 21, 2008, only one has been proposed to Congress. This proposed rescue plan involves the purchasing of “troubled assets from financial institutions in order to promote market stability, and help protect American families and the U.S. economy”(MarketWatch).
The first plan of action in this rescue plan involves the swift timing in purchasing these troubled financial assets. The plan calls for the Treasury to have the authority of issuing $700 billion of securities to purchase the assets. In order to fund this large amount of securities, the Treasury is requesting the funds from its general fund (MarketWatch). These assets that the Treasury plans to purchase are “residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans” (MarketWatch). Furthermore, if the Treasury deems it necessary, it will also have the right to procure other assets as need be. After the purchase of these troubled assets, the Treasury will then personally manage these assets to its own discretion. According to this plan, the Treasury holds the right to do as it pleases with these troubled assets whether it is selling the assets, holding them until “maturity,” or liquidating them. But, only certain financial assets constitute as eligible for the Treasury to procure and manage. Requirements for eligibility include: [One: the assets] must have been originated or issued on or before September 17, 2008. [And two,] participating financial institutions must have significant operations in the U.S., unless the Secretary makes a determination, in consultation with the Chairman of the Federal Reserve, that broader is necessary to effectively stabilize financial markets.”(MarketWatch)
Because the funding for this operation is fueled by taxpayer’s money, government plans to compensate the people. As compensation for the purchase of these assets, the government will receive stock warrants, which will give taxpayers the possibility to obtain future profits from the saved companies and assets (Yahoo Finance).
Summarized, the proposed rescue plan “decisively address[es] the troubled assets now clogging the financial system, helps lenders resume the flow of credit to consumers and businesses, and allows the American economy to get moving again”(WhiteHouse News). On October 3, 2008, congress voted and passed the proposed rescue plan 263 to 171.
Bibliography
Davis, Julie H. "$700B rescue plan finalized; House to vote Monday." Yahoo Finance. 28 Sept. 2008. 6 Oct. 2008
MarketWatch, ed. "Treasury Fact Sheet on Rescue Plan." Www.marketwatch.com. 21 Sept. 2008. The Wall Street Journal. 2 Oct. 2008
"President Bush Discusses Economic Rescue Plan." Whitehouse News. 30 Sept. 2008. 6 Oct. 2008.
In the past week and a half, talk of the proposed rescue plan to lighten the detrimental effects of the recent financial crisis has flooded the news. Many plans have been suggested but as of September 21, 2008, only one has been proposed to Congress. This proposed rescue plan involves the purchasing of “troubled assets from financial institutions in order to promote market stability, and help protect American families and the U.S. economy”(MarketWatch).
The first plan of action in this rescue plan involves the swift timing in purchasing these troubled financial assets. The plan calls for the Treasury to have the authority of issuing $700 billion of securities to purchase the assets. In order to fund this large amount of securities, the Treasury is requesting the funds from its general fund (MarketWatch). These assets that the Treasury plans to purchase are “residential and commercial mortgage-related assets, which may include mortgage-backed securities and whole loans” (MarketWatch). Furthermore, if the Treasury deems it necessary, it will also have the right to procure other assets as need be. After the purchase of these troubled assets, the Treasury will then personally manage these assets to its own discretion. According to this plan, the Treasury holds the right to do as it pleases with these troubled assets whether it is selling the assets, holding them until “maturity,” or liquidating them. But, only certain financial assets constitute as eligible for the Treasury to procure and manage. Requirements for eligibility include: [One: the assets] must have been originated or issued on or before September 17, 2008. [And two,] participating financial institutions must have significant operations in the U.S., unless the Secretary makes a determination, in consultation with the Chairman of the Federal Reserve, that broader is necessary to effectively stabilize financial markets.”(MarketWatch)
Because the funding for this operation is fueled by taxpayer’s money, government plans to compensate the people. As compensation for the purchase of these assets, the government will receive stock warrants, which will give taxpayers the possibility to obtain future profits from the saved companies and assets (Yahoo Finance).
Summarized, the proposed rescue plan “decisively address[es] the troubled assets now clogging the financial system, helps lenders resume the flow of credit to consumers and businesses, and allows the American economy to get moving again”(WhiteHouse News). On October 3, 2008, congress voted and passed the proposed rescue plan 263 to 171.
Bibliography
Davis, Julie H. "$700B rescue plan finalized; House to vote Monday." Yahoo Finance. 28 Sept. 2008. 6 Oct. 2008
MarketWatch, ed. "Treasury Fact Sheet on Rescue Plan." Www.marketwatch.com. 21 Sept. 2008. The Wall Street Journal. 2 Oct. 2008
"President Bush Discusses Economic Rescue Plan." Whitehouse News. 30 Sept. 2008. 6 Oct. 2008
Mortgage-Backed Securities
by Ellis Reilly
“A mortgage-backed security or MBS is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.”[1] This simply means that a MBS is a type of security (like a bond) that is backed by the payments that people or businesses make to pay off their mortgages. For example John goes to a bank to take out a $200,000 mortgage to buy his house. The bank gives him the $200,000 and John pays the bank monthly installments with interest until he has paid off the $200,000. From here Fannie Mae and Freddie Mac would buy John’s mortgage (and many others) from the bank so that banks could lend out more mortgages allowing more Americans to buy homes. Fannie and Freddie would then sell these mortgages to investment banks as mortgage-backed securities so that they (Frannie and Freddie) could get more money to buy more mortgages from more commercial banks. So now when John makes his monthly payment for his mortgage the money goes to the investment bank which is holding John’s mortgage. Normally when MBSs are created and sold they are made up of many different mortgages (for example: 20% of John’s mortgage, 10% of Sally’s mortgage, etc.) which makes the MBSs less of a risk for investment banks (that way if one person does not pay their mortgage the investment bank still gets money from the other mortgages that make up their MBS).
There are many risks to holding MBSs however. MBSs are not backed by the Federal government (which is a reliable government), but by common people. The MBS’s value is not certain either. The only way the owner of the MBS receives their money is if the people who took out the mortgages pay them. When people are unable to pay their mortgage the investors get no money and are stuck with a worthless security. MBSs get more risky when it is made up of mortgages of people who have trouble paying them or are not qualified to take out large mortgages. Other problems are: people can refinance their mortgage at a lower rate which makes the MBS worth less; if a person begins to pay off their mortgage early the mortgage is gaining less interest which also can potentially lower the value of the MBS.
Mortgage-backed security sub-types include:[2]
-Pass-through mortgage-backed security is essentially a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
-Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property
-Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property
-Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
-Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
-Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
-Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
[1] En.wikipedia.org/wiki/mortgage_backed_securities
[2] En.wikipedia.org/wiki/mortgage_backed_securities
“A mortgage-backed security or MBS is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.”[1] This simply means that a MBS is a type of security (like a bond) that is backed by the payments that people or businesses make to pay off their mortgages. For example John goes to a bank to take out a $200,000 mortgage to buy his house. The bank gives him the $200,000 and John pays the bank monthly installments with interest until he has paid off the $200,000. From here Fannie Mae and Freddie Mac would buy John’s mortgage (and many others) from the bank so that banks could lend out more mortgages allowing more Americans to buy homes. Fannie and Freddie would then sell these mortgages to investment banks as mortgage-backed securities so that they (Frannie and Freddie) could get more money to buy more mortgages from more commercial banks. So now when John makes his monthly payment for his mortgage the money goes to the investment bank which is holding John’s mortgage. Normally when MBSs are created and sold they are made up of many different mortgages (for example: 20% of John’s mortgage, 10% of Sally’s mortgage, etc.) which makes the MBSs less of a risk for investment banks (that way if one person does not pay their mortgage the investment bank still gets money from the other mortgages that make up their MBS).
There are many risks to holding MBSs however. MBSs are not backed by the Federal government (which is a reliable government), but by common people. The MBS’s value is not certain either. The only way the owner of the MBS receives their money is if the people who took out the mortgages pay them. When people are unable to pay their mortgage the investors get no money and are stuck with a worthless security. MBSs get more risky when it is made up of mortgages of people who have trouble paying them or are not qualified to take out large mortgages. Other problems are: people can refinance their mortgage at a lower rate which makes the MBS worth less; if a person begins to pay off their mortgage early the mortgage is gaining less interest which also can potentially lower the value of the MBS.
Mortgage-backed security sub-types include:[2]
-Pass-through mortgage-backed security is essentially a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
-Residential mortgage-backed security (RMBS) - a pass-through MBS backed by mortgages on residential property
-Commercial mortgage-backed security (CMBS) - a pass-through MBS backed by mortgages on commercial property
-Collateralized mortgage obligation (CMO) - a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
-Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan's principal and partly used to pay the interest on it. These two components can be separated to create SMBS's, of which there are two subtypes:
-Interest-only stripped mortgage-backed securities (IO) - a bond with cash flows backed by the interest component of property owner's mortgage payments.
-Principal-only stripped mortgage-backed securities (PO) - a bond with cash flows backed by the principal repayment component of property owner's mortgage payments.
[1] En.wikipedia.org/wiki/mortgage_backed_securities
[2] En.wikipedia.org/wiki/mortgage_backed_securities
The Demise of U.S. Investment Banking
By Adi Rajagopalan and Jenny Jang
At the year’s onset, five investment banks presided over Wall Street, each bank seemingly a model of attaining staggering profits for employees and investors alike. By October, there were none. The aftershocks of the rapid demise of the five investment banks were felt from small businesses in Toledo to financial markets in Tokyo, as confidence in the world’s banking system vaporized.
The Banks
In the wake of the Panic of 1929, Congress passed the Glass-Steagall Act of 1933, prohibiting commercial banks from engaging in investment banking. Investment banks are responsible for raising funds for companies by selling those companies’ shares to the public; investment banks often engage in asset management, which includes investing in real and financial assets. The separation of the spheres of investment banks and commercial banks enabled investment banks to escape the federal oversight to which commercial banks were subject, but, because of the inherently risky nature of the investment banking, also left investment banks vulnerable to large crashes. Although Congress repealed the Glass-Steagall Act in 1999, allowing commercial and investment banks to merge, five investment banks remained independent: Bear Stearns (the fifth-largest), Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs (the largest).[i] In recent years, the Fed’s loose monetary policy has enabled investment banks to easily obtain funds for investment. Low-cost funds for investment enabled the investment banks to leverage in the high-risk-high-yield Mortgage-Backed Securities (MBS – see post on MBS for more information) market. Leveraging involved taking advantage of high yields on MBS and relatively lower interest rates, investment banks had large incentive to borrow large sums of money and invest in MBS to make profits. Although leveraging allowed investment banks to enjoy great profits between 2003 and 2006, leveraging with MBS was highly risky, as the repayment of the MBS hinged on the mortgage payments of American homeowners.[ii]
The Causes of the Failures
Leveraging only offered great profits as long as the housing market boom of the early 2000s lasted. When the housing bubble burst in 2007, more homeowners defaulted on their loans, substantially diminishing the returns on many MBS. This caused many investors to pull out of their positions in investment banks. Since investment banks often have about half the capital base of commercial banks, high-leverage MBS-holding firms were forced to sell many of their MBS assets, in a process known as deleveraging.[iii] Deleveraging caused asset prices to drop, causing investment banks to write down more and more losses on their balance sheets.[iv] Further exacerbating the problem were CDS losses facing investment banks, particularly Lehman Brothers. Just as investors pulled away from investment banks, further reducing the investment bank capital base, shareholders began to question the profitability and stability of investment banks, leading to a sell-off of investment bank stock. As ratings agencies began to downgrade investment banks for their inability to raise sufficient capital for investment, confidence in investment banks continued to diminish, leading to a uncontrollable downward spiral for investment banks, particularly Bear Stearns and Lehman Brothers (Merrill Lynch appeared to be in the early stages of a similar fall—fears of future losses triggered its sale). Within months, years of profits were turning into devastating losses.
The Consequences
The unexpected subprime mortgage crisis precipitated the downfall of investment banks. After significant losses in 2007, Bear Stearns, Merrill Lynch, and Lehman Brothers collapsed the following year. In March 2008, Bear Stearns was bought out by JP Morgan, forming a universal bank with both commercial and investment banking divisions. On September 14th, 2008, Merrill Lynch was sold to Bank of America. Mired in vast CDS-related debt, Lehman Brothers filed for liquidation bankruptcy in September 2008. A Japanese investment bank, Nomura agreed to buy the European and Asian divisions of the firm. The final two investment banks, Goldman Sachs and Morgan Stanley, converted into bank-holding companies. With the permission of the Fed, they can create commercial banks that will take deposit and bolster the resources of both firms. With this conversion, the age of the standalone investment bank on Wall Street is over.[v]
[i] The Economist, “The financial crisis: Wall Street’s bad dream,” The Economist, 26 Sept. 2008, 85-86.
[ii] Investopedia, ULC, “Leverage,” Investopedia, (accessed 6 Oct. 2008).
[iii] James Saft, “Credit crisis likely to redefine investment banking and cut its profitability,” The International Herald Tribune, 3 Apr. 2008. (Accessed online:, 6 Oct. 2008).
[iv] The Economist, “Deleveraging: A fate worse than debt,” The Economist, 3 Oct. 2008, 90.
[v] Martin Crutsinger, “Last major investment banks change status,” The Huffington Post, 21 Sept. 2008. (Accessed online:, 6 Oct. 2008).
At the year’s onset, five investment banks presided over Wall Street, each bank seemingly a model of attaining staggering profits for employees and investors alike. By October, there were none. The aftershocks of the rapid demise of the five investment banks were felt from small businesses in Toledo to financial markets in Tokyo, as confidence in the world’s banking system vaporized.
The Banks
In the wake of the Panic of 1929, Congress passed the Glass-Steagall Act of 1933, prohibiting commercial banks from engaging in investment banking. Investment banks are responsible for raising funds for companies by selling those companies’ shares to the public; investment banks often engage in asset management, which includes investing in real and financial assets. The separation of the spheres of investment banks and commercial banks enabled investment banks to escape the federal oversight to which commercial banks were subject, but, because of the inherently risky nature of the investment banking, also left investment banks vulnerable to large crashes. Although Congress repealed the Glass-Steagall Act in 1999, allowing commercial and investment banks to merge, five investment banks remained independent: Bear Stearns (the fifth-largest), Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs (the largest).[i] In recent years, the Fed’s loose monetary policy has enabled investment banks to easily obtain funds for investment. Low-cost funds for investment enabled the investment banks to leverage in the high-risk-high-yield Mortgage-Backed Securities (MBS – see post on MBS for more information) market. Leveraging involved taking advantage of high yields on MBS and relatively lower interest rates, investment banks had large incentive to borrow large sums of money and invest in MBS to make profits. Although leveraging allowed investment banks to enjoy great profits between 2003 and 2006, leveraging with MBS was highly risky, as the repayment of the MBS hinged on the mortgage payments of American homeowners.[ii]
The Causes of the Failures
Leveraging only offered great profits as long as the housing market boom of the early 2000s lasted. When the housing bubble burst in 2007, more homeowners defaulted on their loans, substantially diminishing the returns on many MBS. This caused many investors to pull out of their positions in investment banks. Since investment banks often have about half the capital base of commercial banks, high-leverage MBS-holding firms were forced to sell many of their MBS assets, in a process known as deleveraging.[iii] Deleveraging caused asset prices to drop, causing investment banks to write down more and more losses on their balance sheets.[iv] Further exacerbating the problem were CDS losses facing investment banks, particularly Lehman Brothers. Just as investors pulled away from investment banks, further reducing the investment bank capital base, shareholders began to question the profitability and stability of investment banks, leading to a sell-off of investment bank stock. As ratings agencies began to downgrade investment banks for their inability to raise sufficient capital for investment, confidence in investment banks continued to diminish, leading to a uncontrollable downward spiral for investment banks, particularly Bear Stearns and Lehman Brothers (Merrill Lynch appeared to be in the early stages of a similar fall—fears of future losses triggered its sale). Within months, years of profits were turning into devastating losses.
The Consequences
The unexpected subprime mortgage crisis precipitated the downfall of investment banks. After significant losses in 2007, Bear Stearns, Merrill Lynch, and Lehman Brothers collapsed the following year. In March 2008, Bear Stearns was bought out by JP Morgan, forming a universal bank with both commercial and investment banking divisions. On September 14th, 2008, Merrill Lynch was sold to Bank of America. Mired in vast CDS-related debt, Lehman Brothers filed for liquidation bankruptcy in September 2008. A Japanese investment bank, Nomura agreed to buy the European and Asian divisions of the firm. The final two investment banks, Goldman Sachs and Morgan Stanley, converted into bank-holding companies. With the permission of the Fed, they can create commercial banks that will take deposit and bolster the resources of both firms. With this conversion, the age of the standalone investment bank on Wall Street is over.[v]
[i] The Economist, “The financial crisis: Wall Street’s bad dream,” The Economist, 26 Sept. 2008, 85-86.
[ii] Investopedia, ULC, “Leverage,” Investopedia,
[iii] James Saft, “Credit crisis likely to redefine investment banking and cut its profitability,” The International Herald Tribune, 3 Apr. 2008. (Accessed online:
[iv] The Economist, “Deleveraging: A fate worse than debt,” The Economist, 3 Oct. 2008, 90.
[v] Martin Crutsinger, “Last major investment banks change status,” The Huffington Post, 21 Sept. 2008. (Accessed online:
Fannie Mae and Freddie Mac
By Daniel Hartsoe and Tom Guo
Fannie Mae, created during the Great Depression, and Freddie Mac, created in 1970, are government sponsored enterprises (GSE). Both help to facilitate mortgage lending as they buy mortgages from banks. These two corporations, owned by stockholders, are regulated by Congress and have access to loans at lower rates than competing financial institutions. In addition, the ties the two corporations have to the federal government give them the implicit backing of the Treasury in the event of bankruptcy or financial trouble.
In the 1990’s, Congress pressed Fannie and Freddie to issue more mortgages to low-income families to increase the proportion of families that owned their own home. To do this, the companies, with Congress’s approval, dropped their capitalization ratio (the equivalent of their reserve ratio) to 2.5%, one-quarter of the standard rate for financial companies. This advantage allowed Fannie and Freddie to insure or hold half of all U.S. mortgages. More importantly to the companies, though, this exposed them to the collapse of the housing market. Through the first half of the decade, as housing prices rose to record heights, more families took out more risky mortgages. Convinced that housing prices, and thus the value of their house, would rise forever, as they had for years, and given the low interest rate of 1.25% of 2003 that rose very slowly through 2006, homeowners decided to buy more expensive houses with more risky mortgages. Since some mortgage rates are adjustable (and usually closely mimic the fed funds interest rate that the Fed influences), the interest rates on these mortgages rose higher and higher, and, as home prices started to fall, more homeowners defaulted on their mortgages and had their homes foreclosed. As the housing bubble burst, Fannie and Freddie experienced increased difficulty in paying off their debt to bondholders, and faced the prospect of bankruptcy. It was at this point in time that the Federal Government nationalized both corporations, absorbing their assets and liabilities into the federal budget.
Congress’s directive to Fannie and Freddie had far-reaching impacts on the U.S. housing market. The easy access to mortgages both Fannie and Freddie provided to low-income families (ordered by Congress) artificially lowered the price of houses for families, since these mortgages were backed with very little in down payments. The easy access to mortgages for these low-income buyers that normally would not have been able to afford a home boosted the percentage of families owning the home in which they lived from 64% to 69% between 1994 and 2004. This represents the quantity of housing demanded in the market. But instead of this increase in quantity demanded being a result of increased supply of housing, it was a consequence of increased demand for housing—an increase fueled chiefly by the availability of mortgages to families that otherwise could never dream of affording the house they now were able to buy. The surge in demand for houses led directly to the surge in house prices, the surge now known as the housing bubble. When the bubble burst just over a year ago, the families that couldn’t afford their mortgages any more, that had no steady source of income—the families Congress meant to help by ordering Fannie and Freddie to issue more mortgages at lower prices—were the first to lose their homes. Congress’s policies in the housing sector, specifically in the case of Fannie Mae and Freddie Mac, directly fueled the housing bubble and led to the financial crisis that plagues the economy today.
Sources:
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=a8vyq70TQcMM
http://online.wsj.com/article/SB122298982558700341.html
Fannie Mae, created during the Great Depression, and Freddie Mac, created in 1970, are government sponsored enterprises (GSE). Both help to facilitate mortgage lending as they buy mortgages from banks. These two corporations, owned by stockholders, are regulated by Congress and have access to loans at lower rates than competing financial institutions. In addition, the ties the two corporations have to the federal government give them the implicit backing of the Treasury in the event of bankruptcy or financial trouble.
In the 1990’s, Congress pressed Fannie and Freddie to issue more mortgages to low-income families to increase the proportion of families that owned their own home. To do this, the companies, with Congress’s approval, dropped their capitalization ratio (the equivalent of their reserve ratio) to 2.5%, one-quarter of the standard rate for financial companies. This advantage allowed Fannie and Freddie to insure or hold half of all U.S. mortgages. More importantly to the companies, though, this exposed them to the collapse of the housing market. Through the first half of the decade, as housing prices rose to record heights, more families took out more risky mortgages. Convinced that housing prices, and thus the value of their house, would rise forever, as they had for years, and given the low interest rate of 1.25% of 2003 that rose very slowly through 2006, homeowners decided to buy more expensive houses with more risky mortgages. Since some mortgage rates are adjustable (and usually closely mimic the fed funds interest rate that the Fed influences), the interest rates on these mortgages rose higher and higher, and, as home prices started to fall, more homeowners defaulted on their mortgages and had their homes foreclosed. As the housing bubble burst, Fannie and Freddie experienced increased difficulty in paying off their debt to bondholders, and faced the prospect of bankruptcy. It was at this point in time that the Federal Government nationalized both corporations, absorbing their assets and liabilities into the federal budget.
Congress’s directive to Fannie and Freddie had far-reaching impacts on the U.S. housing market. The easy access to mortgages both Fannie and Freddie provided to low-income families (ordered by Congress) artificially lowered the price of houses for families, since these mortgages were backed with very little in down payments. The easy access to mortgages for these low-income buyers that normally would not have been able to afford a home boosted the percentage of families owning the home in which they lived from 64% to 69% between 1994 and 2004. This represents the quantity of housing demanded in the market. But instead of this increase in quantity demanded being a result of increased supply of housing, it was a consequence of increased demand for housing—an increase fueled chiefly by the availability of mortgages to families that otherwise could never dream of affording the house they now were able to buy. The surge in demand for houses led directly to the surge in house prices, the surge now known as the housing bubble. When the bubble burst just over a year ago, the families that couldn’t afford their mortgages any more, that had no steady source of income—the families Congress meant to help by ordering Fannie and Freddie to issue more mortgages at lower prices—were the first to lose their homes. Congress’s policies in the housing sector, specifically in the case of Fannie Mae and Freddie Mac, directly fueled the housing bubble and led to the financial crisis that plagues the economy today.
Sources:
http://www.bloomberg.com/apps/news?pid=20601109&refer=home&sid=a8vyq70TQcMM
http://online.wsj.com/article/SB122298982558700341.html
Thursday, October 2, 2008
Financial Meltdown and the Economy
Financial markets have been in turmoil for the last month, with stock prices falling dramatically then partially recovering. Triple digit swings in the Dow Jones Industrial Average have become the norm. The Treasury Department and the Federal Reserve have helped to engineer the takeover of some of the biggest banks and financial institutions in our economy over the last six months. Congress is debating a huge bailout plan to try to solve the crisis, but the original proposal negotiated by Treasury Secretary Paulson and Congressional leaders was defeated in the House of Representatives. What is going on? What led to these problems? What are we facing in the future?
What happened?
The seeds of this crisis were planted in the housing boom of the past decade. In some states, principally California, Las Vegas and Florida, prices of homes increased over 10% per year. These price increases were fueled by increases in demand, as the builders happily increased their supplies in a building boom in response to the increases in prices. The demand for home purchases was increased by the easy availability of mortgages for buyers who could not previously afford to buy. In part this was due to the low level of interest rates throughout the economy as the Fed cut rates from 2001-2003 to try to stimulate the economy out of the last recession, and only slowly raised rates back to a more normal level. But even more important were the new types of mortgages that many nonbank mortgage lenders (and some banks) created. A large portion were adjustable rate mortgages (ARMs), in which the interest rate on the loan is adjusted after a period of time, after an initial low interest rate to lower the initial monthly payments to enable the borrower to qualify for the loan. There was also a big increase in subprime mortgages, which are loans to borrowers with more risk of default (nonpayment). Because there is a greater risk of default (nonpayment) with these loans, the borrower is forced to pay a higher interest rate. In some cases, loans were extended to people without checking their credit history or their income, so-called “no-doc” loans. These lenders and borrowers believed that house prices would continue to rise, and the subprime borrowers and borrowers with ARMs would be able to refinance their mortgage, using their increased equity in the house to obtain a better deal. In addition, in the last stages of this increase in housing prices, many people bought houses as speculative investments rather than as residences, which further increased the demand for housing and pushed prices up faster.
How were banks and these nonbank lenders able to offer so many mortgage loans? In the old days, local banks took in deposits from savers and lent these funds out to local businesses in commercial loans and to local residents for mortgages. The banks then held these mortgages and collected the loan payments. As loans were repaid, and as new savings were deposited in the banks, the banks could extend new loans. But this didn't allow for much growth, for many new homeowners. The federal government wanted to encourage more people to own their homes, rather than to rent, to realize the "American dream" of living in their own home. So the federal government created Fannie Mae and Freddie Mac (I'm not sure why they created two separate institutions). As government-sponsored enterprises (GSEs), these institutions were able to borrow (by selling new bonds) at low interest rates. Fannie and Freddie then used these funds to buy mortgages from the local banks. Fannie and Freddie used the mortgage loan payments from the homeowners to pay off their bonds. And the local banks then had new funds to use to extend new mortgage loans. This process helped to lower mortgage interest rates and enabled many more people to buy a home. The American Dream realized! This process worked fine for years.
But Fannie and Freddie were only allowed to buy "regular" mortgages, for borrowers who were good credit risks with a limit on the amount of each mortgage (most recently $417,000). And I don't think that Fannie and Freddie were allowed to purchase mortgages from nonbank financial institutions. These mortgage companies needed a way to recycle their mortgages so they could extend new mortgages and continue to earn fees for initiating new mortgages. Investment banks (whose function is to help businesses raise financial capital to enable them to extend, by issuing new stocks or selling new bonds) came up with the idea to create mortgage-backed securities (MBSs). These MBSs are similar to the bonds sold by Fannie and Freddie in that they were to be paid off by the mortgage payments. But there were two important differences: First, they were not issued by a GSE with the implicit backing of the federal government, so they were inherently riskier. Second, they were structured differently. Whereas Fannie and Freddie incorporated entire mortgages into their bonds, the MBSs included only pieces of mortgages. The investment bank would divide each mortgage into pieces, representing specific payments. The first set of payments that were paid by the homeowners on a whole group of mortgages would go into one "tranche", the second set of payments would go into a second tranche, and so forth, with the last set of payments going into a final tranche. Since they would be paid first, the first tranche was the least riskiest, so the MBS created from this first tranche would pay the lowest interest rate. The second tranche would not be very risky, but a little riskier than the first, so it would pay a slightly higher interest rate. And so on, down to the last tranche, which was the riskiest and paid the highest interest rate. Because it was so risky, generally no one would want to buy the last tranche, so the investment bank would hold it. When the economy was strong and the housing market still booming, nearly everyone was paying off their mortgages, so all the tranches would be paid. The investment banks made lots of profit from the interest they earned on their last-tranche MBSs.
But then housing prices stopped rising. The demand for new houses eventually slowed because people couldn't afford the higher prices. People who had borrowed subprime mortgages found they could not refinance their mortgage because their house was not worth more than they had paid. Homeowners who had taken out ARMs were faced with substantially higher monthly mortgage payments as their interest rate reset to the new higher levels. These mortgage difficulties led to a substantial increase in mortgage payment delinquencies and foreclosures. With people experiencing these difficulties paying their existing mortgages, the demand for new houses decreased dramatically, which led home prices to fall. The drop in home prices made it even harder for those with high interest-rate mortgages to refinance. Some homeowners even got to the point where the new value of the home was less than what they owed on their mortgage (the mortgage was "under water"), and some of these walked away from their house, basically turning it over to the mortgage holder instead of paying off the mortgage. With banks and other mortgage holders in possession of a lot more houses due to foreclosures and walk-aways, the supply of houses in the market increased as the demand was falling, contributing to the continuing decline in house prices, even as homebuilders drastically reduced their construction of new homes.
What was the effect of the drop in home prices on the financial system? First, mortgage lending companies saw a huge decrease in demand for new mortgages, which drastically reduced their income from issuing new mortgages and selling them to the investment banks. Second, many of these companies were stuck holding the new subprime mortgages they had just written because they hadn't been able to sell them yet, and these mortgages were declining in value by the day because no one wanted to buy them anymore. So many of these mortgage companies went bankrupt or were taken over by others. The largest mortgage lender in the country, CountryWide Financial in California, was purchased by Bank of America. (Local note: That humongous office building under construction at exit 13 off I-91 in Wallingford? It was started by a local mortgage company which wanted a new headquarters for its rapidly growing workforce of 3000 employees; six months later the company went bankrupt.) So the mortgage companies were the first to get hit.
Next it was the investment banks which had participated most heavily in the MBS market. As more and more mortgages were not being repaid, those that held the lowest tranches of the MBSs lost out. The holders received fewer payments. And because no one knew how low house prices would fall or how many people would declare bankruptcy or otherwise fail to pay their mortgage, no one was willing to buy these MBSs, so their market value dropped precipitously. The holders were forced to "write down" the value of these securities on their balance sheets and take these decreases in value as losses on their profit statement. The damage got so bad for Bear Stearns, the fifth largest investment bank in the U.S., that it faced bankruptcy in March. To avoid that fate, the Fed (Federal Reserve, our central bank in the U.S.) encouraged JP Morgan to buy Bear Stearns with the help of a $29 billion loan from the Fed. The Fed's rationale for assisting with this buyout was that if Bear Stearns had gone bankrupt, the other investment banks and other financial institutions would have lost lots of money also because Bear would be forced to sell all its assets, all the securities in its own portfolio, in order to pay off its debts to its creditors. The forced sale of these assets would force prices down in all these asset markets, which would damage the financial position of all the other holders of these types of assets, as they would be forced to write down their losses even further, and these losses might push some into bankruptcy.
What is happening?
After the Fed’s actions in March, the stock market seemed to calm down for a while. But home prices continued to fall as more and more mortgages went into default. These difficulties led to further write-downs on MBSs for the investment banks and all the other financial institutions who held them.
Some of the institutions who had originally purchased these mortgage-backed securities had realized that they contained risk. As a form of insurance against the default on these securities, they had purchased a credit-default swap (CDS). A CDS is a contract in which the issuer agrees to pay off a security that is defaulted by its original issuer of the original security. For example, suppose investment bank A create a mortgage-backed security from a bunch of mortgage tranches and sells this MBS to financial institution B. Recognizing that there is some risk that A will not be able to pay off the MBS, financial institution B purchases a credit-default swap from investment bank C. C collects the fee from B for this swap. If the mortgages all come in then A can pay off the MBS to B and C does not have to do anything and pockets the swap fee as profit. But if A can’t pay off the MBS to B, then B turns to C for a payoff on the CDS. With normal insurance policies, the more policies the insurance company writes, the less risk it is exposed to because it assumes that in most circumstances the pay-off events are completely independent; if I get into a car accident and the auto insurance company has to pay to fix my car, it does not affect the probability that you will get into an accident and the company will have to pay again. But with credit-default swaps, the pay-off events are not likely to be independent, as these investment banks have discovered to their misfortune. They wrote trillions of dollars in credit-default swaps on all sorts of securities. With the problems in the housing market and with many more mortgages going into default than in normal times. Many of these MBS went into default at the same time. So the financial institutions that were on the hook for the credit-default swaps faced enormous losses. Lehman Brothers, the fourth largest investment bank, was exposed to these losses, and its losses grew so dramatically that it discovered that it could not cover them all. After failing to find someone to invest more capital in the company or to take them over and cover their losses, the firm was forced to file for bankruptcy because the Treasury Department and the Fed refused to bail them out. Almost immediately, though, the world’s largest insurance company, AIG, realized that it owed more on these credit-default swaps than it could pay. Because it held these swaps for such a wide range of firms and because it also had a huge insurance business with millions of policies across the country, the Treasury decided to bail out AIG.
As more and more financial firms have reported huge losses and the need for capital infusions to stay in business, other financial firms and investors have begun to wonder which firms will be able to survive. As investors fear for their investments, they have sold their stock in all financial firms. These sales forced the price down for these stocks. At the same time, no one (including financial firms) has wanted to lend money to any financial firm because they are not confident that the borrower will be able to stay in business and that they will be repaid. So banks are forced to hoard any cash they can get their hands on, and won’t lend it out to anyone. A credit crunch has resulted.
What could happen?
As the credit crunch has worsened, banks are unwilling to lend. Businesses have started reporting that they cannot obtain loans that they need to operate their business, to pay for new inventory of goods or to invest in new capital to expand their business. Consumers won’t be able to borrow to purchase new cars or houses (worsening the housing market), or to pay for college. As the investment banks have fallen by the wayside, businesses will not be able to raise funds through initial public offerings of new stocks or new bonds. This is what is meant by the claims that there is a lack of liquidity in the economy, in the financial markets. No one can borrow, because those who do actually have cash don’t trust anyone to be able to pay back a loan. As demand falls throughout the economy because people can’t spend as much, firms will start producing less, which means they won’t need as many workers, so unemployment will rise. And the economy will experience a recession. The stock market will continue to fall as firms earn less profits.
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have tried to come up with a plan to halt the deterioration in the financial system. Their proposal, under consideration in Congress now, is to purchase the remaining mortgage-backed securities that financial institutions have not been able to sell because no one knows how to determine an appropriate price. (The obvious question is how will the federal government determine a price.) This action will stop the losses that the financial firms have experienced, and it will provide them with liquidity, with cash, so that they can start lending again.
What happened?
The seeds of this crisis were planted in the housing boom of the past decade. In some states, principally California, Las Vegas and Florida, prices of homes increased over 10% per year. These price increases were fueled by increases in demand, as the builders happily increased their supplies in a building boom in response to the increases in prices. The demand for home purchases was increased by the easy availability of mortgages for buyers who could not previously afford to buy. In part this was due to the low level of interest rates throughout the economy as the Fed cut rates from 2001-2003 to try to stimulate the economy out of the last recession, and only slowly raised rates back to a more normal level. But even more important were the new types of mortgages that many nonbank mortgage lenders (and some banks) created. A large portion were adjustable rate mortgages (ARMs), in which the interest rate on the loan is adjusted after a period of time, after an initial low interest rate to lower the initial monthly payments to enable the borrower to qualify for the loan. There was also a big increase in subprime mortgages, which are loans to borrowers with more risk of default (nonpayment). Because there is a greater risk of default (nonpayment) with these loans, the borrower is forced to pay a higher interest rate. In some cases, loans were extended to people without checking their credit history or their income, so-called “no-doc” loans. These lenders and borrowers believed that house prices would continue to rise, and the subprime borrowers and borrowers with ARMs would be able to refinance their mortgage, using their increased equity in the house to obtain a better deal. In addition, in the last stages of this increase in housing prices, many people bought houses as speculative investments rather than as residences, which further increased the demand for housing and pushed prices up faster.
How were banks and these nonbank lenders able to offer so many mortgage loans? In the old days, local banks took in deposits from savers and lent these funds out to local businesses in commercial loans and to local residents for mortgages. The banks then held these mortgages and collected the loan payments. As loans were repaid, and as new savings were deposited in the banks, the banks could extend new loans. But this didn't allow for much growth, for many new homeowners. The federal government wanted to encourage more people to own their homes, rather than to rent, to realize the "American dream" of living in their own home. So the federal government created Fannie Mae and Freddie Mac (I'm not sure why they created two separate institutions). As government-sponsored enterprises (GSEs), these institutions were able to borrow (by selling new bonds) at low interest rates. Fannie and Freddie then used these funds to buy mortgages from the local banks. Fannie and Freddie used the mortgage loan payments from the homeowners to pay off their bonds. And the local banks then had new funds to use to extend new mortgage loans. This process helped to lower mortgage interest rates and enabled many more people to buy a home. The American Dream realized! This process worked fine for years.
But Fannie and Freddie were only allowed to buy "regular" mortgages, for borrowers who were good credit risks with a limit on the amount of each mortgage (most recently $417,000). And I don't think that Fannie and Freddie were allowed to purchase mortgages from nonbank financial institutions. These mortgage companies needed a way to recycle their mortgages so they could extend new mortgages and continue to earn fees for initiating new mortgages. Investment banks (whose function is to help businesses raise financial capital to enable them to extend, by issuing new stocks or selling new bonds) came up with the idea to create mortgage-backed securities (MBSs). These MBSs are similar to the bonds sold by Fannie and Freddie in that they were to be paid off by the mortgage payments. But there were two important differences: First, they were not issued by a GSE with the implicit backing of the federal government, so they were inherently riskier. Second, they were structured differently. Whereas Fannie and Freddie incorporated entire mortgages into their bonds, the MBSs included only pieces of mortgages. The investment bank would divide each mortgage into pieces, representing specific payments. The first set of payments that were paid by the homeowners on a whole group of mortgages would go into one "tranche", the second set of payments would go into a second tranche, and so forth, with the last set of payments going into a final tranche. Since they would be paid first, the first tranche was the least riskiest, so the MBS created from this first tranche would pay the lowest interest rate. The second tranche would not be very risky, but a little riskier than the first, so it would pay a slightly higher interest rate. And so on, down to the last tranche, which was the riskiest and paid the highest interest rate. Because it was so risky, generally no one would want to buy the last tranche, so the investment bank would hold it. When the economy was strong and the housing market still booming, nearly everyone was paying off their mortgages, so all the tranches would be paid. The investment banks made lots of profit from the interest they earned on their last-tranche MBSs.
But then housing prices stopped rising. The demand for new houses eventually slowed because people couldn't afford the higher prices. People who had borrowed subprime mortgages found they could not refinance their mortgage because their house was not worth more than they had paid. Homeowners who had taken out ARMs were faced with substantially higher monthly mortgage payments as their interest rate reset to the new higher levels. These mortgage difficulties led to a substantial increase in mortgage payment delinquencies and foreclosures. With people experiencing these difficulties paying their existing mortgages, the demand for new houses decreased dramatically, which led home prices to fall. The drop in home prices made it even harder for those with high interest-rate mortgages to refinance. Some homeowners even got to the point where the new value of the home was less than what they owed on their mortgage (the mortgage was "under water"), and some of these walked away from their house, basically turning it over to the mortgage holder instead of paying off the mortgage. With banks and other mortgage holders in possession of a lot more houses due to foreclosures and walk-aways, the supply of houses in the market increased as the demand was falling, contributing to the continuing decline in house prices, even as homebuilders drastically reduced their construction of new homes.
What was the effect of the drop in home prices on the financial system? First, mortgage lending companies saw a huge decrease in demand for new mortgages, which drastically reduced their income from issuing new mortgages and selling them to the investment banks. Second, many of these companies were stuck holding the new subprime mortgages they had just written because they hadn't been able to sell them yet, and these mortgages were declining in value by the day because no one wanted to buy them anymore. So many of these mortgage companies went bankrupt or were taken over by others. The largest mortgage lender in the country, CountryWide Financial in California, was purchased by Bank of America. (Local note: That humongous office building under construction at exit 13 off I-91 in Wallingford? It was started by a local mortgage company which wanted a new headquarters for its rapidly growing workforce of 3000 employees; six months later the company went bankrupt.) So the mortgage companies were the first to get hit.
Next it was the investment banks which had participated most heavily in the MBS market. As more and more mortgages were not being repaid, those that held the lowest tranches of the MBSs lost out. The holders received fewer payments. And because no one knew how low house prices would fall or how many people would declare bankruptcy or otherwise fail to pay their mortgage, no one was willing to buy these MBSs, so their market value dropped precipitously. The holders were forced to "write down" the value of these securities on their balance sheets and take these decreases in value as losses on their profit statement. The damage got so bad for Bear Stearns, the fifth largest investment bank in the U.S., that it faced bankruptcy in March. To avoid that fate, the Fed (Federal Reserve, our central bank in the U.S.) encouraged JP Morgan to buy Bear Stearns with the help of a $29 billion loan from the Fed. The Fed's rationale for assisting with this buyout was that if Bear Stearns had gone bankrupt, the other investment banks and other financial institutions would have lost lots of money also because Bear would be forced to sell all its assets, all the securities in its own portfolio, in order to pay off its debts to its creditors. The forced sale of these assets would force prices down in all these asset markets, which would damage the financial position of all the other holders of these types of assets, as they would be forced to write down their losses even further, and these losses might push some into bankruptcy.
What is happening?
After the Fed’s actions in March, the stock market seemed to calm down for a while. But home prices continued to fall as more and more mortgages went into default. These difficulties led to further write-downs on MBSs for the investment banks and all the other financial institutions who held them.
Some of the institutions who had originally purchased these mortgage-backed securities had realized that they contained risk. As a form of insurance against the default on these securities, they had purchased a credit-default swap (CDS). A CDS is a contract in which the issuer agrees to pay off a security that is defaulted by its original issuer of the original security. For example, suppose investment bank A create a mortgage-backed security from a bunch of mortgage tranches and sells this MBS to financial institution B. Recognizing that there is some risk that A will not be able to pay off the MBS, financial institution B purchases a credit-default swap from investment bank C. C collects the fee from B for this swap. If the mortgages all come in then A can pay off the MBS to B and C does not have to do anything and pockets the swap fee as profit. But if A can’t pay off the MBS to B, then B turns to C for a payoff on the CDS. With normal insurance policies, the more policies the insurance company writes, the less risk it is exposed to because it assumes that in most circumstances the pay-off events are completely independent; if I get into a car accident and the auto insurance company has to pay to fix my car, it does not affect the probability that you will get into an accident and the company will have to pay again. But with credit-default swaps, the pay-off events are not likely to be independent, as these investment banks have discovered to their misfortune. They wrote trillions of dollars in credit-default swaps on all sorts of securities. With the problems in the housing market and with many more mortgages going into default than in normal times. Many of these MBS went into default at the same time. So the financial institutions that were on the hook for the credit-default swaps faced enormous losses. Lehman Brothers, the fourth largest investment bank, was exposed to these losses, and its losses grew so dramatically that it discovered that it could not cover them all. After failing to find someone to invest more capital in the company or to take them over and cover their losses, the firm was forced to file for bankruptcy because the Treasury Department and the Fed refused to bail them out. Almost immediately, though, the world’s largest insurance company, AIG, realized that it owed more on these credit-default swaps than it could pay. Because it held these swaps for such a wide range of firms and because it also had a huge insurance business with millions of policies across the country, the Treasury decided to bail out AIG.
As more and more financial firms have reported huge losses and the need for capital infusions to stay in business, other financial firms and investors have begun to wonder which firms will be able to survive. As investors fear for their investments, they have sold their stock in all financial firms. These sales forced the price down for these stocks. At the same time, no one (including financial firms) has wanted to lend money to any financial firm because they are not confident that the borrower will be able to stay in business and that they will be repaid. So banks are forced to hoard any cash they can get their hands on, and won’t lend it out to anyone. A credit crunch has resulted.
What could happen?
As the credit crunch has worsened, banks are unwilling to lend. Businesses have started reporting that they cannot obtain loans that they need to operate their business, to pay for new inventory of goods or to invest in new capital to expand their business. Consumers won’t be able to borrow to purchase new cars or houses (worsening the housing market), or to pay for college. As the investment banks have fallen by the wayside, businesses will not be able to raise funds through initial public offerings of new stocks or new bonds. This is what is meant by the claims that there is a lack of liquidity in the economy, in the financial markets. No one can borrow, because those who do actually have cash don’t trust anyone to be able to pay back a loan. As demand falls throughout the economy because people can’t spend as much, firms will start producing less, which means they won’t need as many workers, so unemployment will rise. And the economy will experience a recession. The stock market will continue to fall as firms earn less profits.
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have tried to come up with a plan to halt the deterioration in the financial system. Their proposal, under consideration in Congress now, is to purchase the remaining mortgage-backed securities that financial institutions have not been able to sell because no one knows how to determine an appropriate price. (The obvious question is how will the federal government determine a price.) This action will stop the losses that the financial firms have experienced, and it will provide them with liquidity, with cash, so that they can start lending again.
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