Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Creating conforming loans—loans that qualified for GSE backstop—was the basis of the American home loan business. It is a deep irony that the era in which America is commonly thought of as leading the world in a market revolution saw its housing market become dependent on a government-sponsored mortgage machine descended from the New Deal.

American housing policy and mortgage practice since the war had systematically favored home ownership for the white majority.15 In the 1990s promoting home ownership for lower-income and “underserved” minority communities became a congressional priority.

In December 1995 the government issued targets for underserved areas and low-income housing. Many of the new home owners in the 1990s and 2000s were ethnic minority families who had been denied mortgages for decades under the regime of “redlining” institutionalized by New Deal housing policy. Viewed in this way the real estate boom was part of the rise of the diverse African American and Latino middle class on which the Democrats as a political party had a lot riding.16

Deep down most free market advocates are convinced that the interferences of the GSEs were responsible for the disaster that was beginning to unfold in 2006. The GSEs had political mandates set by progressives to funnel money into underserved communities. They had a market-distorting funding advantage due to their attachment to the federal government. When you distort the market, crises are inevitable.17 It was this conservative critique of the GSEs that shaped the Republican reaction when the crisis reached fever pitch in 2008.

For many in Congress the bailout was not just of the banks—they at least were private businesses trying to make a buck. The bailout was also a desperate effort to make the taxpayer pay for the rescue of a Democrat-controlled parastate housing welfare apparatus designed to serve pampered minorities.

God the racism runs deep huh

as an explanation of the crisis that was brewing in 2006, this political critique is wide of the mark. Fannie Mae and Freddie Mac set a high minimum standard for the quality of loans they would buy. The GSEs didn’t support the kind of low-quality, subprime loans that were beginning to fail in droves in 2005–2006. Those toxic loans were the products of a new system of mortgage finance driven by private lenders that came into full force in the early 2000s.

Though the GSEs met their government lending quotas, private lenders driven by the search for profit were far more adventurous in lending to underserved communities.

what they did contribute were two innovations without which the crisis is hard to imagine: the originate-to-distribute mortgage lending system and securitization.

From its origins in the 1930s, the GSE model of subsidy separated the origination of a mortgage from its ultimate funding. The commercial banks that issued the original loans to American families were repaid when they sold the mortgages to Fannie Mae. That enabled them to make more loans.

Mortgage lenders no longer needed to hold the mortgages on their balance sheets; they became brokers operating for a fee.

Starting in the 1970s, as they confronted the instability of interest rates and its damaging implications for America’s mortgage model, the GSEs took a further critical step. Working with the help of investment banks, they pioneered securitization.19 Rather than holding the locally originated mortgages on their own books and financing them by issuing bonds, they would sell the mortgages directly to investors.

Rather than having small savings and loans gamble on what was a viable loan, securitization would let the collective process of market haggling determine funding costs.

It was in the aftermath of the interest rate shock of the early 1980s that securitization came to the fore. The mortgage lender stranded with portfolios of low-interest mortgages turned to the market to recover whatever value they would yield by securitizing them and selling them off.

From the 1980s, the GSEs, working with the investment banks, created not just pass-through mortgage-backed securities (MBS) but so-called collateralized mortgage obligations (CMO) that allowed a pool of MBS to be tranched into separate risk tiers profiles.

Those with the top-tier first claim on the revenue stream had low risk of both default and early repayment. Tranches lower down the pecking order could be sold off ...

By the 1990s, Moody’s Investors Service and Standard & Poor’s divided 80 percent of the global debt-rating business between them.21 Fitch took another 15 percent of the market. They did not attain that control of the global market by freely handing out top AAA ratings. In 2008 there were only six AAA-rated corporations and no more than a dozen countries enjoying that ranking.

the agencies had much to lose if they appeared to be selling good ratings and relatively little to gain if they showed favor to a client that was involved in only occasional bond issues. The mortgage securitization business changed that calculus.

even more important was the nature of MBS as such. What made rating MBS different was that the underlying assets were not bonds issued by a company facing the unpredictable force of global competition. The MBS bundled thousands of what were supposed to be predictable assets—regular domestic mortgages. The ratings agencies did not have to calculate the risks of default on the basis of more or less subjective evaluations of a company’s business prospects.

If you knew default rates and could make assumptions about the degree of correlation between them, once you assembled enough mortgages and tranched them, the likelihood of the top tranches not paying was infinitesimal.

The idea, in the wake of the savings-and-loans disaster, was to spread risk outward from those immediately involved in lending to mortgage borrowers and to attract investors by turning mortgages into securities that offered a wide range of yield-risk profiles. And it worked. In 1980, 67 percent of American mortgages had been held directly on the balance sheets of depository banks. By the end of the 1990s, the risks involved in America’s system of long-term, fixed interest, easy repayment mortgages were securitized and spread across a much wider segment of the financial system than had been the case in 1979 when Volcker made his shock announcement.

Whereas a local lender that held a mortgage for its entire thirty-year duration had every reason to monitor its customer very carefully, by the 1990s American mortgages were passing through at least five different institutions—originators, wholesalers of packages of mortgages, underwriters who assessed risk, government-sponsored enterprises and servicers who managed the flow of interest income—before being sold to an investor.

in fact, in the early 2000s, when the subprime boom unfolded, the industry had changed again. Securitization was more dominant than ever. The GSEs were still responsible for buying and securitizing the top-tier conforming mortgages. But as a new range of actors entered the mortgage market with a more dynamic and expansive agenda, their principal business model was not to disaggregate and to spread the risk but to integrate every step of the process, including the holding of large quantities of securities on their own balance sheets.

It is barely too much to say that the new, deregulated world of national and international finance was made for the investment banks.26 Through their business of trading on their clients’ behalf and launching debt and other securities, they enjoyed an “edge” over all other participants in the market.

In 1975 the abolition of fixed fees charged by Wall Street brokers for trading stocks led to fierce competition, wiped out smaller firms and forced the integration of trading, research and investment banking.

For other clients, the investment bankers were hard at work figuring out how to hedge against fluctuations in currencies and interest rates. They developed swaps, for instance, that allowed clients to trade excessive exposures in currencies. They made instruments that allowed one client to take on the risk of fluctuating interest rates while another client opted for fixed rates.

In the 1990s a team at J.P. Morgan devised the credit default swap (CDS), which offered protection against the risk of nonpayment and allowed lenders to fine-tune their lending risk.

They discovered the profits to be made through volume and leverage. The returns were extraordinary. In the early 1980s America’s investment banking elite earned returns of more than 50 percent on equity. But achieving scale raised the question of funding. Investment banks don’t have deposits. They borrow the money they lend on wholesale markets from other banks or institutional funds.

If investment banks didn’t have depositors, that suited savers, who, in the wake of the inflation, no longer wanted to put their money in bank deposits either. They opted instead for money market mutual funds (MMF), that characteristic financial institution of the new age.29 These were highly attractive to affluent households looking for better rates than those on offer from bank deposits.

Corporations began to manage their cash pools more professionally. Ultrarich individuals who became more and more numerous from the 1970s onward had billions of dollars that were managed by funds and family offices. By the end of the 1990s perhaps as much as a trillion dollars had accumulated in these institutional cash pools, looking for highly liquid, interest-yielding investment opportunities that were absolutely, or close to absolutely, safe.

These institutional cash pools and the liquidity they brought to wholesale funding markets were the rocket fuel for the rise of the modern investment bank.

Until the 1980s, investment banks were relatively small operations, partnerships, well known and respected on Wall Street and the City of London but not household names.

Since the 1980s the investment banks had built their businesses on navigating uncertainty. As asset market booms they leveraged up.

Between 1994 in Mexico and 1998 in Russia the globalized American banks faced a series of major crises. In September 1998, but for concerted action by the major Wall Street firms, the implosion of Long-Term Capital Management triggered by the uncertainty spreading from Russia might have brought down the entire hedge fund industry.

By the early 2000s, after two decades of dramatic growth, Wall Street was facing a political and regulatory backlash and urgently needed the “next big thing.” Given the expertise of the investment banks in bond trading and their role in the securitization of mortgages on behalf of the GSEs, it was not hard to foresee where scrappy investment banks like Lehman and Bear Stearns would look next.

To reestablish profitability in the 1990s America’s high street banks underwent spectacular consolidation. The top ten banks increased their share of total assets from 10 to 50 percent between 1990 and 2000.

Rather than thinking of themselves as maintaining lifelong relationships with clients and their communities, they repurposed themselves as service providers for a fee. They had always originated mortgages but had generally sold them to the GSEs. Given the pressure that they were now under, the mortgage market, with its multiple layers of origination, securitization, selling and servicing, seemed like a natural bridge between their familiar high street banking business and their aspirations to high finance.

In 1999 the last remnants of 1930s banking regulations were swept aside. Citigroup and Bank of America rushed through the opening to a new era of American universal banking. Stretching from the high street to Wall Street, it was a model more familiar from Continental Europe now applied to America.

The third group of actors in the mortgage boom of the early 2000s was already in the business in the 1990s. They were banks like Washington Mutual, a survivor of the savings-and-loan disaster, and specialized mortgage lenders like Countrywide.

Rather than organizing their mortgage business around the GSEs, they set out to build integrated mortgage securitization businesses. Countrywide expanded from origination to securitization. A giant bank like Citi could envision itself as a provider at every stage, originating, securitizing, selling, holding and dealing in MBS. Even more remarkable was the evolution of investment banks like Lehman and Bear Stearns that had previously defined themselves through their remoteness from ordinary retail customers. Already in the 1990s Bear added the mortgage originator and servicer EMC to its portfolio and Lehman added four small mortgage lenders to its investment bank.

When the dot-com bubble was followed by the shock of 9/11, the Fed dropped interest rates to 1 percent. As Alan Greenspan clearly intended, this unleashed a scramble among borrowers to refinance as many long-term mortgages as possible at lower rates. This was painful from the point of view of the original lenders. But it triggered an immediate wave of consumer spending, and for the mortgage industry it generated a huge surge in fees.

As compared with $1 trillion in new mortgages issued in 2001, in 2003 mortgage origination soared to $3.8 trillion, of which $2.53 trillion were for refinancing.

In the huge surge of business in the early 2000s not everything at the GSEs was aboveboard. Accounting and regulatory irregularities piled up. Fearful of another Enron, regulators subjected first Freddie Mac and then Fannie Mae to capital surcharges. They either had to raise new capital or contract their balance sheets.

the decisive thing was what happened in early 2004 when interest rates had reached rock bottom, the refinancing boom had run its course and the GSEs were stopped in their tracks. With the pipeline ready and waiting, it was at this point that the private mortgage industry took over. Leaving behind the GSE-centered model of the 1990s, they deprioritized conforming mortgages in favor of private label “unconventional” lending—subprime, slightly better Alt-A and oversized jumbo loans.

To manage the risks, the production of credit default swaps (CDS), once the preserve of bespoke investment banks, was industrialized. Mainline insurers like AIG offered CDS insurance on exotic securitized products. Given the quality of the underlying mortgages, not all the tranches were good. But that stimulated the investment banks to expand the collateralized debt obligation (CDO) business.

By combining them together and tranching, you could make a large pool of BBB assets yield further tranches of AAA securities. Once you had done that you could then go one step further. You could take the low-rated mezzanine slices of the CDO and pool and tranche them once more to create CDO-squared. And once again by the logic of independent risks and the good graces of the ratings agencies, a portion even of those securities would warrant an AAA rating.

Someone had to be interested in buying the hundreds of billions of dollars in securities that were being produced. If there had been no demand to meet the supply, the price of MBS would have fallen, yields would have surged leading borrowing rates to rise, choking off the mortgage boom. Not only did this not happen, but long-term interest rates remained flat and the spread—the premium that nonconforming borrowers had to pay—declined.

This points to the third historic transformation that made possible the 2000s boom, a change not on the supply but on the demand side: the surging demand for safe assets and the mobilization of institutional cash pools for mortgage finance.

To understand this connection, the best place to start is to go back to the most scandalous thing about MBS, their credit rating. The AAA label was important because it placed them in a class of assets like Treasurys that attracted investors looking for safe assets.42 AAA was a badge of quality, and, like any certificate of this type, it signaled that if what you were looking for was safety, you had to look no further.

The first part of the answer is the development of the emerging market economies from the 1990s. As a result of their trade surpluses and their desire to self-insure against the risk of a repeat of the 1994–1998 crises, they wanted reserve assets that they could liquidate in an emergency. And the assets that best fit that description were US Treasurys, long- and short-dated.

Macroeconomists worried about the current account imbalance that resulted and the possibility of a catastrophic sudden stop unwinding. What they did not pay attention to, because they did not dirty their hands with technicalities like MBS, was the effect the influx of emerging market funds might have in financial markets.