Explained: how home loans sold to gullible Americans led to the greatest financial crisis yet of the twenty-first century.
In 2008, the United States (US) Treasury Secretary Hank Paulson phoned Alan Greenspan, former chairman of the Federal Reserve, to pick his mind on the housing crisis that was shackling the economy. Greenspan, the most powerful banker on Earth for over two decades had a simple suggestion.
He reckoned that there was an excess in housing supply, that is the supply exceeded the demand for the houses, and hence, the US Government should buy up thousands and thousands of houses, and burn them down. He was not joking.
The terrorist attacks of September 11, 2001, had political consequences that changed the face of the Middle East. The events of 9/11 also facilitated a change in the economic structure within the US. Greenspan, who was then the chairman of the Federal Reserve, cut the interest rate from 6.5 per cent to mere 1 per cent in 2003. The lowest in 50 years. Money was being artificially pumped into the economy like never before.
The George Bush administration, after 9/11, to support the war efforts in Afghanistan and Iraq went on a spending spree. Taxes were reduced, especially for the rich, cheap loans were made to boost consumer spending, and national deficit was allowed to increase.
Greenspan’s interest rates had a direct impact on house loans. Due to the reduction in interest rate, monthly mortgage payments for the houses decreased. The same monthly payment that supported a $180,000 loan in 2000 was now able to serve a $245,000 loan in 2003. The American dream of owning a house was made ridiculously cheap.
What began in the early 2000s converged in September 2008 to become the causality of the Great Recession. It was a drama that had multiple acts, characters from both the private and the government sector, characters that included everyone, from the US Treasury Secretary to a bartender turned mortgage broker thousands of miles away from the Wall Street hustle. There were no heroes in this story.
Act-1: Owning The American Dream and the access to easy home loans
When it comes to lending, the population can be segmented into three parts. One, those who have a good credit history and are believed to be in a position to pay back the loans without defaulting. These are the ones who qualify for loans without any trouble.
Two, those who have an average credit history and are believed to be somewhat in a position to pay back their loan. These are the ones who qualify for a loan after an elaborate background check (employment history, credit default history, etc.) by the lender.
Three, ones with no proof of income, no credit history, regular defaulters on their credit card and auto loans. These are the ones who do not qualify for a loan.
By 2005, the lenders in America saw no difference in these three segments. Contrary to popular belief, easy home loans were not increasing home-ownership. Instead, loans were being made to refinance a second home. Less than 10 per cent of the home loans made in the 2000s led to house ownership.
To put things in perspective, assume one owns Rs. 50,000 to the bank in credit card bills. What Americans were doing in the 2000s was not paying the bill and settle the debt, but go for a new credit card that came with a spending limit of Rs. 60,000 or more (usually more) and paid off Rs. 50,000 they owed and spent the rest remaining amount. The bill was settled. The debt wasn’t.
It did not stop at two, three, or five loans. But, why were so many loans being made in the first place?
Act-2: Bond, Mortgage Bond
The citizens were getting their loans. The lending banks were making money from the interest they received on each loan. The mortgage brokers were having a ball with the fee they made on each loan. However, the investment banks were missing out on the action.
For years, the safest place for the investment banks had been the Treasury Bonds issued by the Federal Reserve under the US Government. The investment was safe with a fixed assured return. With the decline in the interest rates to 1 per cent, there was not a lot to gain from there for investment bankers.
Mortgage Bonds (or Mortgage Backed Securities (MBS) were not a creation the Wall Street during Greenspan’s years. The first mention of MBS goes back to 1857. They were even common during the 1920s. However, for long, the Wall Street remained reluctant to invest in MBS.
A bond essentially ensures a fixed return on a sum of money invested. For instance, one buys a $1000 bond at a 10 per cent annual interest rate for ten years. Thus, each year, $100 will be credited to the buyer of the bond as interest, and the principal will be returned at the end of 10 years.
The Wall Street saw this as a profitable avenue in the 2000s. Buying off mortgages (which were essentially houses in this cases) from the lenders across the US, the Wall Street collected millions of mortgages.
While the homeowners were paying their monthly instalments to the lenders they had borrowed from, the payments were essentially going to the investment banks on the Wall Street.
Soon, investment banks started pooling many mortgages together to create a mortgage bond which was then sold to investors. Based on the assured return, the bonds were rated on a scale from AAA (exceptionally great, safest bet) to B (riskiest).
To put things in perspective, think of thousands of mortgage bonds made of million of mortgages as a building facing the ocean. Each floor of the building contains a pool of mortgage bonds. The term wall street gave to these floors was tranches, which in French means ‘a portion of something’.
The highest floors of the building are occupied by AAA, the highest rated mortgage bonds. Below AAA is AA, followed by A all the way down to B (the lowest rating for a bond) on the ground floor.
Assuming the sea levels were to rise each week, the ground floor containing the lowest rated B bonds would be the first to sink, followed by BB and BBB, all the way up to AAA. Similarly, the B tranche of bonds contained the riskiest mortgages, that is mortgages of people who were most likely to default on their loans. The AAA tranche included the safest bets and hence was assumed to be immune to the flooding from rising sea levels.
Once these tranches of mortgage bonds were repackaged as financial products for investors, the Wall Street banks offered a higher rate of interests on the lowest rated bonds. The AAA bonds, though safest, attracted the lowest interest rates. Going from the ground floor to the highest floor, the interest rate on a mortgage bond declined. People were being paid for the risk they were willing to take.
Mortgages, from across the US, were being bought by the banks on the Wall Street to fit into tranches as mortgage bonds and then repackaged and sold as financial investments.
From the broker of the mortgage to the trader selling investment options in mortgage bonds, everyone was making thousands of dollars in fee each year.
However, there was a small problem.
Act-3: Lenders go NINJA with No Income No Job Applicants
Financial products packaged around mortgage bonds were proving to be immensely profitable for the Wall Street. However, soon they began running out of mortgages, given not everyone in the US could be given a loan. Greenspan’s one per cent interest rate facilitated the availability of cheap credit within the financial system, and that gave rise to subprime mortgage loans.
Subprime loans constitute loans that are made to people with poor credit history, the third segment of the population. Another term for them was ‘Ninja Loans’ for they were made to applicants with ‘no jobs and no income’.
At the peak of the housing bubble, lenders were willing to loan out to anyone who could sign a document. The lending standards had not declined but thrown out of the window with utmost prejudice. Down Payments were no longer mandatory, and people were helped with 100 per cent of the house cost. Immigrants, with no credit history, were being given loans. Credit score no longer mattered. Free money was available to anyone who wished to reach out for the grand old American dream.
To save themselves from defaulters, the lenders were playing it smart. A loan made by any lender on a Friday afternoon would make it to the trader on Wall Street by Monday evening. The lenders were making innumerable loans without worrying to have them on their books for long. The liability shifted from the lender to the Wall Street.
Washington Mutual, one of the subprime lenders that was acquired by JP Morgan Chase in 2008, had 50 per cent loans in the high-risk categories in 2005. By 2008, they were aiming to take this percentage to 82. New Century, another subprime lender, went from making $3.1 billion worth of loans in 2000 to $51.6 billion in 2006. From 2000 to 2004, their total loans grew by 100 per cent each year. In 2007, it filed for bankruptcy.
Countrywide Financial Corporation was featured in the Fortune magazine in 2003 given its stock value had appreciated by 23,000 per cent in 20 years. Their CEO aimed to occupy 30 per cent of the mortgage market in the US. They had acquired 20 per cent of the mortgage market share by 2006. Running into heavy losses by 2007, the firm was acquired by Bank of America. However, the losses of Countrywide from subprime lending were so severe that it threatened the viability of Bank of America itself in 2012.
In 2000, $130 billion of loans had been made in subprime mortgage lending, and $55 billion worth of mortgage bonds had been sold from those loans. By 2005, $625 billion had been churned out in subprime mortgage lending with $520 billion worth of mortgage bonds being created and sold from those loans. Wall Street had officially gone berserk.
However, what good were mortgage bonds created from subprime loans?
Act-4: Weapons of Mass Destruction: Collateralised Debt Obligations (CDOs)
The original stated purpose of the mortgage bonds was to have the bond investor pay for the loan. This would allow the lender to charge the homeowner with a low rate of interest. It was all about helping the aspiring homeowner with a lower rate of interest. Now, the same logic was being applied to hide the risks that came with subprime loans as they attracted a higher rate of interest in the bond market.
We return to the building of mortgage bonds facing the ocean. With millions of mortgages, thousands of buildings were now constructed. Wary of the rising sea levels, pools of mortgage bonds rated Bs, BBs, and BBBs on the lower floors were not finding investors.
Talk to an Indian homemaker, and they’ll tell you how to best use the leftover dal and dough from last night. Simply mixing the dough and dal along with some water would give you fresh dough, ideal for preparing dal parathas, putting the otherwise wasted dal to good use.
Wall Street did something similar with its pools of mortgage bonds without investors.
The resources from the lowest floors of buildings were used to create another building. Thus, the pools of Bs, BBs, and BBBs mortgage bonds were used to create a new building altogether. Often, new pools were mixed with old ones, or old pools were mixed with a dozen new ones to form a building.
This building was termed as the Collateralised Debt Obligation (CDO), a financial instrument so complex that even today CEOs and rating agencies are baffled by the wizardry that occurred around them.
The next challenge for Wall Street bankers was to get these CDOs with Bs, BBs, and BBBs bonds a AAA rating. This is where credit rating agencies like Moody’s and S&P came into play. In their pursuit to rate more and more CDOs for the fee they earned, credit rating agencies were reckless.
Thus, two same bonds were rated differently and often, two very different bonds (significant difference in credit history of the borrower etc.) were evaluated on the same level. CDOs comprising of Bs, BBs, and BBBs soon became worthy investments rated AAA, AA, or A. The face of the bonds changed, and the underlying loans didn’t.
Wall Street didn’t stop there. If mortgage bonds were a 20 kiloton atomic bomb, the CDOs were a 400 kiloton nuclear bomb. The worst were synthetic (artificial) CDOs that transformed a 20 kiloton problem into a 40,000 kiloton WMD bomb that crashed the Wall Street.
To protect their investments, investors created insurance against these mortgage bonds called Credit Default Swaps (CDS). The working of a CDS was like that of protection. This insurance could be bought on bonds by anyone.
Anyone could purchase an insurance on, for instance, $500 million worth of bonds for 20-years by paying $1 million as premium each year. Thus, at the end of 20-years, the maximum they could lose was $20 million. If the bonds they had insured failed, they could make $500 million with the bank having sold the CDS taking the $500 million loss.
The periodic payments as cash flows coming from the CDS added to the Synthetic CDOs. Betting against one CDO created the first synthetic CDO. Betting against the first synthetic CDO created the second synthetic CDO and so on. At the peak of the housing bubble, the ratio of money involved in CDS and CDOs to that in a mortgage bond was over 20:1 since there was no need of actualt mortgages for the creation of synthetic CDOs.
Hence, a $50 million mortgage bond transformed into a billion-dollar financial investment. By 2005, there were mortgage bonds worth $500 billion on the Wall Street, all based on the subprime mortgage loans made.
Millions of investors retained their faith in mortgage bonds, CDSs, CDOs, and synthetic CDOs for one simple reason; people do not default on their mortgage payments.
Act-5: The Music Slows Down, and the Defaults Go Up
It wasn’t Wall Street that was indulging in scams alone. To make home loans look appealing to gullible Americans, lenders offered multiple products as home loans.
Conventionally, a home loan came with a fixed rate of interest. Thus assuming, a $500,000 house could be bought with a down payment of $100,000 with the rest $400,000 coming from the bank. With a fixed rate of interest, the homeowner would be required to pay $4000 each month for ten years.
Subprime loans could not be made in the same way for people would have defaulted way early and there would be lesser loans for the mortgage bond market. The lenders, therefore, introduced adjustable rate mortgages where the rate of interest would be low for the first two or three years before the actual rate of interest kicked in.
For most subprime loans, there was a teaser rate. Therefore, a $4000 monthly payment would actually be a mere $1000 in the first two years. This was the teaser rate. After two years, the fixed rate came in, increasing the mortgage by 200-400 per cent.
In 1996, 65 per cent of the housing loans made were at a fixed rate of interest. By 2005, 75 per cent of the loans were adjustable rate mortgages.
The homeowners were also given an option to refinance their loan by another loan. For the $400,000 they owned to the bank, owners took another loan of $500,000, pocketing $100,000 for personal spending. Doing this, people ended up with multiple houses for they seemed a lucrative investment with the house prices going up.
In some regions, people took loans for five to ten houses to sell at a higher price. This practice worked well for some during the bubble. In 2005, for most subprime mortgage loans made, the fixed rates kicked in, and the defaults started rising.
By 2006, defaults were rising. Consequentially, the house prices started to fall. At one point, people were paying mortgages for a house valued at $100,000 which they had bought for $300,000. People began voluntarily defaulting on their mortgages for they saw little sense in paying for a house valued at one-third the price they bought for. Defaults flooded the Wall Street.
Suddenly, the BBBs, BBs, and Bs were coming to roost. At the end of it, banks on the Wall Street were left with thousands and thousands of unoccupied houses with their value falling with each passing day.
Thus, it all boiled down to a single home loan. An average American was lured into buying a home with a loan they couldn’t afford. Thousands of such loans made a mortgage bond. The leftovers from thousands of such bonds made a CDO. The bets on and against the CDOs constituted the synthetic CDOs and CDSs. This was the charade that caused the global economy to crash.
With most lenders either out of business or sold to investment banks, the losses fell upon the ‘Too Big to Fail’ Wall Street Firms.
Trading CDOs for a lucrative fee, the traders on the floors of these investment banks had made thousands and thousands of dollars across the 2000s. The CEOs were pocketing millions of dollars in bonuses each year. Everyone was making too much money to be bothered about the underlying fault lines threatening the entire financial system.
In 2008, Hank Paulson facilitated the bailout of one of the largest invesment banks on the Wall Street, Bear Stearns, by helping JP Morgan buy it for $2 a share. For many months in 2008, the markets were falling, but the music did not stop.
On September 15, 2008, the music finally stopped and ghostly silence engulfed the global financial system. In operations since 1850, Lehman Brothers filed for bankruptcy.
This article is second of a multi-part series on the Great US recession, which marks 10 years this September.