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.