In order to see the all-important relationship between the housing bubble and the ensuing financial collapse, one needs to look at the changes made in both areas in the many years prior to the 2007-2008 period.
In the wake of the Great Depression, and a wave of bank failures nationwide, Congress passed a law (the Glass Steagall Act of 1933), which separated commercial banking from investment banking. Commercial banks dealt mostly with taking in deposits, and making loans. So for most of the 20th century, the vast majority of home buyers got their mortgage from a local bank. The bank made sure the buyer was credit worthy enough to most likely pay off the loan, because the bank would hold on to the loan over the life of the mortgage.
Investment banking served as a middle man for corporate finance, e.g. helping firms issue stocks and bonds to investors. Ever since Glass Steagall was passed, investment banks had always been privately owned and run as partnerships until near the end of the 20th century. That meant that they were conservatively run, taking prudent risks with the partners’ money.
By the mid-1990’s lobbyists of the big investment firms (and its people working inside the federal government) ensured that a quiet, though hardly small, corner of finance remained free of any governmental oversight/regulation. That corner included many types of complex “derivatives”, such as MBS (mortgage-backed securities), CDS (credit default swaps), and CDO’s (collateralized debt obligations). In 1999, the Glass Steagall Act was repealed, and by then the investment banks had all become publicly owned, thus taking on bigger risks since much of the risk would now be borne by the shareholders. This was happening just as trillions of dollars of fixed-income investors were brought together with mortgage products.
The main purpose for these derivatives was to provide to investors a way to either diversify or lower risk in their investments. An MBS that included thousands of mortgages would be minimally harmed by 20 mortgages that ended up defaulting. CDO’s took things to another level, packaging the safest mortgages into one “tranche”, the riskiest into another, so that if an investor wanted the mortgages that paid the highest interest, he could buy that tranche which had the highest risk. CDS simply breaks down into “Credit” meaning a bond or loan, and “Default Swap”, swap being a generic term for some instrument, in this instance an insurance policy in case of defaults. If an MBS suffered enough defaults to seriously lower the value of it, buying a CDS would have given the buyer insurance to provide full value of the MBS.
Occasionally some derivatives were used in questionable ways. In 1994, Procter and Gamble was sold over-the-counter derivatives (meaning not traded on any exchange) by Bankers Trust involving interest rates and foreign exchange rates. After P&G lost over $140 million on the transactions, it sued BT, saying it wasn’t made aware of all that could happen if, as in this case, interest rates rose substantially. BT agreed to cover much of the loss to avoid trial. The same year Gibson Greetings and Orange County CA both suffered substantial losses from OTC derivatives sold by BT and Merrill Lynch, respectively, who either paid a fine or settled with the buyers.
Not long after, the U.S. General Accounting Office issued a report on financial derivatives that found dangers in the concentration of OTC derivatives activity among 15 major dealers, concluding that “the sudden failure or abrupt withdrawal from trading of any one of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole.”
While Congress then held hearings on the OTC derivatives market, the adoption of regulatory legislation failed amid intense lobbying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan, who said: “Aside from safety and soundness regulation of derivatives dealers under the banking and securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” What he meant was that the financial markets were “self-regulating”. For example, if a firm bent the rules of its accounting to make its profits look better, eventually the market would figure it out and its stock would plummet as a result. “The market” would be self-policing.
By the time home prices started taking off around 1997, investment banks were pushing hard, selling mortgage related instruments. The market was boosted even more as the Federal Reserve was lowering interest rates following the bursting of the technology bubble. This created a huge demand for mortgages, so non-bank lenders, mortgage brokers, even appraisers found that they could make more money if they created more loans, if the loans were bigger, and the rate on the loan was higher. The rush was on, with introductory rates low enough to get buyers into the biggest loans at affordable monthly payments, at least before the loan would reset.
After 2000, investors literally around the world were awash in “safe” AAA rated mortgage investments. But not just in bundles of mortgages. CDO’s broke down those bundles into separate tranches, and even the lowest quality of subprimes were bought because the amount of loans in each bundle of a CDO implied a “safety in numbers” way of diversifying the risk of the assets. Then there were “synthetic CDO’s” and “CDO squared”, some of which allowed folks to bet against assets through insurance (CDS) without even owning the assets. Things had gotten very complicated. From 2000 until 2007, when the markets peaked, outstanding OTC derivatives increased more than sevenfold. Issuance just of synthetic CDO’s increased from $5 billion in 2005 to $16 billion in 2006.
AIG, then the world’s biggest insurance firm, so firmly believed in the “home prices always go up” meme that it had sold over $400 billion in CDS on what were AAA rated securities. Some might say that AIG served as a “bookie” by selling its CDS, taking bets with many investment banks and hedge funds around the world on whether enough loans would default to impair the value of an MBS. Since those CDS were not considered normal insurance products (which are well-regulated) but unregulated derivatives, AIG was not required to backstop those deals with virtually any amount of reserves. When the crisis hit, AIG’s losses exploded, and bankruptcy ensued.
The mortgage industry’s two biggest players by far were Fannie Mae and Freddie Mac, a.k.a. government-sponsored enterprises (GSE’s). They never issued any loans, they bought them from lenders, guaranteeing the loans would be paid in full. That’s why for many years they only dealt with high-quality prime loans. Though both firms had been private corporations, they had implicit (not explicit, but assumed) government backing of the bonds they issued to finance their loan purchases. They were the first to “securitize” loans, packaging them into MBS. In 2003 (Freddie) and 2004 (Fannie) both were caught in SEC accounting scandals meant to boost executive pay and bonuses. Both ended up having top executives paying civil fines, but all were cleared of criminal charges.
Prior to the scandals both had relatively small market shares of the booming sub-prime (lower quality) mortgage market, and had actually been criticized by the political right for not being more involved in loans to low income and minority borrowers. Only afterward, in the final few years of the housing bubble, did they rush headlong into this area. In the aftermath of the bubble bursting, both were among the biggest casualties of the bust.
Because of the huge demand for mortgages in the financial markets, millions of home buyers fell for the resulting sales pitches. They kept hearing that home prices always go up. (In fact, since the end of WWII, prices HAD slowly and steadily gone up, but had never spiked higher as they were now doing.) So if their loan were to reset at a higher rate after two years, they could refinance before it did reset, using the rising home equity to spend on a new car, or remodel the home. Or they could sell and move into a bigger home. More and more buyers chose to ignore what their total cost over the life of the loan would be, focusing only on the initial monthly payment to determine how big a home they could afford. Combined with the incentive of lenders/brokers to get buyers into larger loans with higher rates (over the full length of the loan) what could possibly go wrong?
Well, by late 2006 the housing market did finally stop going up, and soon prices began going down. But folks were either still getting themselves into homes they couldn’t ultimately afford, with loan terms that they had no business getting into, or they learned they couldn’t sell without taking a big loss. The number of defaults began to explode higher.
Once the demand for mortgage products dried up, the financial world discovered “counter-party risk”. It turns out that all of the big financial players each had major dealings with most of the other firms through private derivative deals on a one-to-one basis. The firms were counter-parties to each other. If “Firm A” faced the possibility of going under because it was stuck with bad mortgages it could no longer sell to investors, a panic among all the big firms would result because no one knew which other firms were facing losses from being exposed to derivatives deals with Firm A. This caused business to literally ground to a halt since no one was dealing with anyone else. The commercial paper market is a great example. CP is a short term loan any big firm uses to borrow, in sizes of greater than $100,000, in the normal course of business. The loan is for up to 6 months, and is used to e.g. make a payroll or fund new inventories. Even firms like McDonald’s had trouble getting that funding during the depths of the crisis. This situation was so dire that it forced the Treasury and Federal Reserve to implement such extraordinary bailout measures, but that’s for another time.