Ratings agencies themselves were intrinsically compromised. They were for-profit companies that got paid for each security they rated, and each competed with the other for business. Whoever rated the most securities made the most money, and a sure way to get repeat business from issuers was to be lenient with ratings. These agencies got and deserved significant blame for abetting this runaway lending period, yet in its aftermath the ratings system has remained largely unchanged. But it should be noted that it doesn’t take a rating agency fiasco or exotic securities to allow for runaway lending and a crisis. There have been plenty of crises without them. Over the last two hundred years, purveyors of credit have used many different ways to minimize or obfuscate concerns about risk. In this book we’ve reviewed many of them over a period of two centuries. And assuredly, there will be new techniques, now unimagined, in the future.
Many other countries were experiencing their own bout of runaway private lending in the 2000s, so the financial crisis was by no means confined to the United States or, by inference, attributable solely to idiosyncrasies in U.S. regulations, laws, or other factors. By 2008, in the United Kingdom, for example, loans had skyrocketed from 160 percent to 194 percent of GDP in just five years.27 The United Kingdom was more profligate than the United States on a percentage basis, yet Spain was even worse. The acceleration in Spain’s private debt, which was also mainly an increase in mortgage debt, began in 1999, with loans almost quadrupling to 216 percent of GDP by 2010,28 a far greater increase than any of the other of the world’s top twenty GDP countries. Real estate prices rose 200 percent during this period as a direct result of the accelerated lending. Spain’s lenders offered every imaginable incentive, including forty- and fifty-year mortgages. Home ownership in Spain reached 80 percent, belying the notion that increased home ownership is always a virtue.29
At the peak, over 700,000 new Spanish homes30 were being built each year, which yielded almost 4 million empty houses in a country with only 24 million total houses. Reports in late 2008 put the housing vacancy rate at 28 percent.31 As is typical in a lending-led expansion, at first the tax revenues from the construction industry mushroomed, and the government debt-to-GDP profile improved.
The financial crisis of 2008 affected many more European countries. Some economists suggest that this simultaneous global outburst is evidence that the culprit was a technical economic factor, namely, a global savings surplus. This theory is also referred to as a “global savings glut,” a phrase coined by Ben Bernanke in his February 20, 2004, speech that anointed the era as the financial “great moderation” (a mordantly ironic speech since at that moment the country was moving irrevocably toward crisis).32
A kindred theory is referred to as imbalances, or “increases in cross-border investment flows,” as one of its proponents, Robert Aliber, describes in the introduction to a highly esteemed textbook that he helped author on financial crises, Manias, Panics, and Crashes. Aliber espouses the view that “the source of banking crises are the surges in cross-border investments.” In elegant terms, he argues that the surge in real estate prices in the 2000s followed from the rapid increase in the United States’ capital account surplus (the inverse of its current account deficit). It was this surge in cross-border investment that caused lenders to overlend and led to the financial crisis, not the “wayward behavior of Countrywide Financial, Lehman Brothers,” and others. Those who look to the lenders, he asserts, mistake “the symptoms of the crisis for the cause.”33
Figure 6.4. Global Current Account Imbalance and Change in Private Debt, 1982–2016
The countries included in this chart are United States, China, Japan, United Kingdom, Germany, France, Iran, Kuwait, Russia, Saudi Arabia, and United Arab Emirates. Current Account Imbalance equals the sum of the absolute value of each country’s current account surplus or deficit.
In other words, lenders had too much money and almost no choice but to lend it. They were victims of this circumstance rather than perpetrators. Others, taking up Bernanke’s and Aliber’s cause, have clarified or refined the argument—that it is not the imbalance of a single country but the overall global imbalance in accounts that creates booms, regardless of which countries experience changes in current account surplus and deficit.34
But lending booms are often domestically funded, as in Japan in the 1980s and 1990s. In fact, as Figure 6.4 shows, while there might have been such a correlation in the 2000s, there was no correlation in cross-border investments and rapid lending increases in the pivotal 1980s and early 1990s, when we had major crises not only in Japan but in the United States and elsewhere.
In fact, as the figure shows, changes in private debt are generally much larger than changes in the current account balance. So even in instances where they are correlated, is the small change in the current account balance causing the large change in private debt, or is the large change in private debt bringing about the smaller change in the current account balance? I believe it is the latter. Further, the so-called savings or current account surplus did not occur in advance of the rapid lending growth; it happened contemporaneously and was more likely the result than the cause. This is because an increase in the current account surplus would take time to translate into new loans: as a lender, I know it takes months or years to cultivate new lending opportunities. However, a new loan would likely instantly translate into a change in the current account balance: the purchase of a new building or the order of retail goods from overseas usually does happen at the same time as the extension of the loan. In fact, my view is that the rising trade imbalances of the 2000s would not have been possible if not “financed” by concurrent runaway growth in the United States’ and other countries’ private debt. The dramatic increase in Chinese exports in 2003 to 2008 (which economists interestingly refer to as its saving exceeding its investment), which we noted in Chapter 3, could not have occurred if there had not been a debt binge in the West, the very debt binge that brought the crisis (Figure 6.5).
Others cite “contagion” as the reason multiple countries were affected in a similar time frame, as if crises have biological properties.35 But tellingly, countries that had no runaway lending, did not lend much internationally, and were not overly dependent on exports to countries engaged in runaway lending were largely immune to the contagion. Many countries in Asia and Latin America, for example, suffered little damage from the 2008 crisis.
Like a lending surge within a country, the simultaneous emergence of several lending surges globally is most persuasively explained by cross-border lender links and as a function of human nature itself. Lenders see the rapid growth of their cross-border peers and want to keep up. The world of financial institutions is in some respects quite small and transcends national boundaries. Lending itself reaches across borders, and lending success is often a global game of one-upmanship.
Much of Germany’s lending that led to the damage of its own financial institutions was to borrowers outside of the country. In fact, toward the end of the boom, Germany’s lenders were viewed as the hapless latecomers who did the least homework and, suffering from the fear of missing out, came to the lending and derivative party just as U.S. lenders were wising up.36 As the explosion in lending in the United States rampaged forward, some of the most astute analysts in this space noticed that a large number of these securities had terrible credit quality and that a large proportion of loans had been made in 2005 with an artificially low interest that would revert to a fairly high rate in 2007.
Figure 6.5. China: Private Debt, Imports, and Exports as a Percentage of GDP, 1992–2017
These analysts reasoned that when this occurred, a very high percentage of loans would quickly become delinquent and the securities with these loans would quickly lose value. As vividly described in Michael Lewis’s The Big Short, one of these investors, Mike Burry, worked with investment bankers to create a mechanism to use to bet on this calamity, the credit default swap on mortgage-backed securities. CDSs were a type of derivative, which is
a synthetic financial instrument that is usually based on an actual underlying stock, bond, or commodity contract and is a way to bet on the movement—up or down—in the price of those underlying stocks, bonds, or commodities. It therefore has the effect of amplifying the risk of their price movement.
Starting in May 2005, Burry deployed his strategy. He paid an insurance company a relatively small premium for a CDS. If the underlying MBS remained good, then Burry would lose only the premium he’d paid. However, if the MBS went bad, then Burry would get paid in proportion to the loss. The worse the problem, the more Burry made. All Burry needed was an insurance company that was as certain that these securities would perform well as he was certain that they would go bad. Early on for many buyers of these CDSs, that insurance company was AIG, which had been lured into its optimism about MBSs by their high ratings.37
Figure 6.6. Net New Credit Default Swaps for Mortgage-Backed Securities, 1998–2017
Derivatives amplified loss but didn’t cause overcapacity. Buyers in 2005 and 2006 were savvy contrarians. Those institutions that sold swaps in 2008 were in many cases late to the game and lacked insight on recent trends.
Other skeptical analysts began to seek CDSs, and other institutions began selling them. In 2007, over $61 trillion in CDSs were sold.38 Notably, however, enough bad mortgage loans had been made before these CDSs were created that there would have been a financial crisis anyway, albeit smaller. In fact, a substantial portion of these CDSs were written on mortgages made before or during 2005. The creation of the CDS simply made the crisis much larger and longer than it would have been otherwise and lured some institutions such as AIG to participate, and thus get hurt, that wouldn’t have otherwise. Investor John Paulson placed a similarly notable and even larger bet against the mortgage market.39
Derivatives, in this case CDSs, amplified the damage because with them more institutions could get hurt on the same underlying loan volume. As early as 1998, Brooksley Born, head of the Commodity Futures Trading Commission, had advocated regulating derivatives. But President Bill Clinton’s Treasury secretary Robert Rubin (and later Treasury secretary Larry Summers), Securities and Exchange Commission chair Arthur Levitt, Fed chair Alan Greenspan, and various senators derailed Born’s efforts, not wanting to constrain activity in derivatives.40
Figure 6.7. Sales and Prices of New U.S. Single-Family Homes, 1991–2016
Note: Homes sold are in millions. For Case-Schiller Index, January 2000=100.
In the meantime, with their ears to the ground, institutions that provided funding and bought securities from mortgage lenders, especially from mortgage brokers and subprime lenders, began to hear of problems, get wary, and curtail that funding. As a result, new loans declined with the predictable result that house prices began to fall. New home sales, existing home sales, and new home construction began to decelerate. (Overall loans continued to grow somewhat for a short period even as new loans declined owing to the nature of amortization.) Just as things had spiraled up, they now spiraled down.
The moment that the key asset associated with a boom begins to decline in price is pivotal in most crises; in this case, it was the decline in housing prices. Overcapacity was rampant, and a point of no return had been reached. As we’ve seen with all financial crises, lenders fail when their funders (and if a bank, depositors) lose confidence in them and pull their funding. This soon happened to the aggressive subprime lender New Century Financial. On April 2, 2007, the company filed for bankruptcy.41 Funders of mortgage banks and subprime lenders became decidedly more cautious, and thus those institutions had to curtail lending, and home sales and lending growth plummeted further. With funding drying up, things went from bad to worse for most mortgage banks.
The broader market might have taken notice but didn’t. Wall Street was still viewing this as a potential problem that would be confined largely to the mortgage industry. Analysts did not recognize its sheer size and magnitude. Real estate and mortgages had become by far the biggest component of the country’s private debt and one of the biggest components of the economy. Trillions of dollars were at stake.
Banks, those institutions whose presumed competency was credit risk, were oblivious. Though they would shortly begin writing off hundreds of billions of dollars in losses, their reserve ratio was near a twenty-year low. Banks had adequate levels of capital during the years leading to the crisis, and in fact this ratio improved. But that was in part due to the preferential capital treatment some assets received, including mortgages and mortgage backed securities. If banks had used the more old-fashioned leverage ratio, which required banks to have a set amount of capital no matter the type of assets, the assessment of capital adequacy would not been as sanguine. Banks, investment banks, and other lenders took full advantage of the capital rules to maximize lending during this period.
Both consumer and business confidence were comfortably positive, dispelling the general view that a collapse in confidence causes rather than follows the crisis. While confidence—false optimism—may have everything to do with runaway lending, no amount of confidence could have prevented the bad loans from unraveling and the lenders from tumbling. A lack of confidence does not cause a crisis but follows with grim logic from the horrid realization of how much damage has occurred.
By mid- to late 2007, as ARM introductory rates expired and a large number of loans moved to higher interest rates, they became unaffordable for many borrowers. A flood of delinquency followed. Bernanke assured markets that subprime losses would not exceed $100 billion,42 but they would dwarf that estimate in the end. It slowly dawned on the broader financial world that the problem might reverberate far beyond the mortgage industry. Defying these emerging trends, the Dow reached an all-time high of 14,164 on October 9, 200743—but soon took the first big tumble of the Great Recession, dropping almost 50 percent over the next fifteen months.
The CRE lending boom had lagged behind the mortgage boom, in some part because banks sought to increase other sources of earnings as mortgage problems emerged. Thus, the unraveling of CRE followed that of residential mortgages. Looser credit terms and increased loan volume had led to higher building valuations, but with insufficient actual tenant demand, CRE delinquency went from 1.02 percent in 2005 to 8.67 percent in 2009.44 As lenders pulled back, the prices for buildings declined as well. In Manhattan, average per-square-foot prices for buildings went from $347 in 2002 to $947 in 2008, only to fall back to $404 by 2009.45 In one notable case, a high-profile New York investor bought 6.5 million square feet of property for $7.5 billion, or $1,100 per square foot, financed almost entirely with debt. But he was unable to service the debt, and the lender moved to foreclose and sell many of these properties for $818 per foot, a 26 percent loss, only eighteen months later.46 The CRE debt rout was on.
There was a similar pattern for home equity loans. Though far smaller in volume than mortgages, the peak loan totals were in the years 2008 to 2010, well after the decline in housing prices—and so reflected the compromised credit judgment of the industry. Some portion of this volume came from borrowers trying to cope with the crisis. On January 10, 2008, Ben Bernanke bravely dismissed concerns of a recession.47 However, not long after, the Fed reported that a recession—defined as two consecutive quarters of GDP decline—had officially begun. The next day, Bank of America announced its purchase of troubled Countrywide on terms it mistakenly viewed as favorable.48 Before long, the purchase would cost Bank of America more than $40 billion and push it to the brink of failure. Regulators would take over and sell or dispose of other major subprime lenders, including Washington Mutual and Indy Mac, later that same year.
In mid-February, President George W. Bush, who presided over the mortgage lending frenzy, signed the Economic Stimulus Act of 2008, which was an attempt to battle the burgeoning crisis by giving individual tax rebates and encouraging businesses to invest. It was far too little, far too late, and the government now had to step up the rescue of banks. Rampant mortgage lending hadn�
��t just implicated mortgage brokers, such as New Century and Countrywide, or even banks, such as JPMorgan Chase and Citibank. Investment banks, including Goldman Sachs, Merrill Lynch, Bear Stearns, and Lehman Brothers, had been buying and selling MBSs and CDOs, and in many cases had billions of dollars of those securities on their own balance sheets. Like any lender, these institutions were dependent on funding, and their funders were anxious.
The first of these investment banks to lose its funding and thus succumb was Bear Stearns, which collapsed in March and was bought out by JPMorgan Chase with substantial government assistance. At this point, the government was dealing with the crisis on an ad hoc basis, believing that if it could successfully deal with a few big problems, then the overall market would right itself.
Bear Stearns had participated aggressively in the mortgage securities market and was holding over $30 billion in rapidly deteriorating mortgage-backed securities.49 Rumors of this were flying, and the company’s short-term creditors were both refusing to lend more and demanding repayment of existing loans—the modern equivalent of a run on the bank. On March 14, 2008, Bear received a much-needed twenty-eight-day loan from JPMorgan50 but was denied its hoped-for funding from the Federal Reserve, and, by Sunday, the circumstance was sufficiently dire that it had agreed to be acquired by JPMorgan Chase for $2 a share,51 revised to $10 two weeks later.52 The stock had been trading at more than $40 just days before. Integral to the deal was the Fed’s agreement to fund and backstop losses on nearly $30 billion of Bear’s mortgage-backed securities.
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