Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

Emerging market investors bought first Treasurys and then GSE-issued agency debt. This left other institutional investors looking for alternatives. What filled the gap was financial engineering.

The shuffling of global demand for dollar-denominated safe assets helps to explain why the mortgage pipeline did not result in an oversupply of AAA securities. But to the extent that private label asset-backed securities were actually sold off to investors, little more was heard of them.

The subprime mortgage boom of the early 2000s led to a financial crisis because, contrary to the professed logic of securitization, hundreds of billions of private label MBS were not spread outside the banking system, but were stockpiled on the balance sheets of the mortgage originators and securitizers themselves.

Why did the securitizers end up holding their own product? In part it was a matter of the production system itself. Securitization produced some attractive tranches and some less so. The less attractive tranches needed to be held off the market.

the banks operating the pipeline believed their own business proposition. Holding MBS was very profitable at prevailing funding costs. The banks in the mortgage supply chain were at the source of the profit. So why not get rich too?

Building a big balance sheet of MBS didn’t just involve risk on the asset side. It also involved expanding the liabilities of the bank on the funding side.

If the mortgage production line was holding hundreds of billions of private label MBS and ABS on its own balance sheet, how were those holdings funded? Here too it was the new model of investment banking that provided the answer. If an upstart mortgage lender like Countrywide didn’t have depositors, neither did Lehman. Lehman got its funding wholesale by tapping the cash pools and so too would the new mortgage lenders, including Lehman.

Funds from money market cash pools were channeled into financing the holding of lar...

The three biggest American issuers of ABCP were Bank of America, Citigroup and J.P. Morgan. The vehicles for managing this operation were so-called structured investment vehicles (SIV), legal entities provided with a minimum layer of capital by their “sponsors,” but otherwise separate from the balance sheets of their parent banks. Onto these SIVs the parent bank would offload a large portfolio of mortgage bonds, securitized car loans, credit card debt or student debt.

Remarkably, under the bank regulations prevailing until the early 2000s, assets parked off balance sheet in the SIV could be backed by a fraction of the capital that would be required if they were on balance sheet.

Typically, an ABCP vehicle would hold a portfolio of securities with maturities of three to five years and would fund those securities by selling commercial paper repayable between three months and as little as a few days. For the managers of cash pools, the commercial paper was more attractive than the underlying securities, because it was very short term and backed by a top-rated commercial bank.

The entire business model of investment banks was based on wholesale funding. The most elastic vehicles for this were so-called repurchase agreements, or repo. In a repo transaction a bank would buy a security and pay for the purchase by immediately reselling it for a period of as little as one night or as long as three months, with a promise to repurchase at a certain price.

In the meantime, the haircut determined how much of its own money the investment bank would have to put into holding the securities, and thus the leverage in the deal.47 A 2 percent haircut meant that to fund the purchase of $100 million of securities and to receive the interest paid on those bonds, a bank would need $2 million of its own money.

Using this mechanism, a small amount of capital could support a far bigger balance sheet, provided, of course, that the repo could be repeatedly “rolled” and that the haircut did not suddenly increase.

By the 2000s the collateral posted in repo markets in New York ran to several trillions of dollars a day. It was split into two ...

The best available data suggest that the bilateral repo market was three times larger than the triparty segment.49 Because the players in the bilateral market tended to be investment banks and hedge funds, the types of assets acceptable as collateral were more wide ranging. It is here, along with ABCP and various types of interbank and unsecured borrowing, that the investment banks financed their holding of private label MBS and CDO portfolios.

As in commercial paper, repo was exposed to serious funding risk. You might not be rolled over. Specifically, the risk was that if an investment bank like Lehman or Bear was thought to have suffered major losses on some big part of its portfolio—whether that was funded by commercial paper, bilateral repo or other types of interbank borrowing—it would suffer a general loss of confidence.

The scale of the potential risk was huge. At Lehman at the end of fiscal year 2007, of its balance sheet of $691 billion, 50 percent was funded through repo.

If any one of these investment banks was to lose access to the repo markets, at a stroke its business model would collapse, taking its entire balance sheet—not just its MBS business, but its derivatives book, currency and interest swaps—down with it.

Between 1999 and 2003, 70 percent of the new mortgages issued in the United States were still conventional GSE-conforming. With the end of the refinancing boom, that balance shifted. By 2006, 70 percent of new mortgages were subprime or other unconventional loans destined for securitization not by the GSE, but as private label MBS.

In both 2005 and 2006, $1 trillion in unconventional mortgages were issued, compared with $100 billion in 2001. Fannie Mae and Freddie Mac were scrambling to keep up, purchasing $300 billion in nonagency securitized mortgages to hold in their own portfolios.

In 2005 two thirds of the mortgages contained in Lehman’s issuance of $133 billion in MBS/CDO were sourced from its own subprime loan originators. A top Wall Street name was scraping the very bottom of the credit barrel.

The message that this communicated down the food chain was simple: We want more mortgage debt to process, and the worse the quality, the better. By the magic of independent probabilities, the worse the quality of the debt that entered into the tranching and pooling process, the more dramatic the effect.

From 2004, fully half the subprime mortgages being fed into the system had incomplete or zero documentation, and 30 percent were interest-only loans to people who had no prospect of making basic repayment.

Fitch, which applied a risk assessment model that generated fewer of the coveted AAA-rated securities, found itself largely cut out of the subprime securitization business.53 As later congressional inquiries revealed, the ratings agency staff at Moody’s and S&P were clearly aware of the monster they were creating.

The profits of the 1980s and late 1990s had been good in investment banking. Now everyone was making money. In the early 2000s 35 percent of all profits in the US economy were earned by the financial sector.

Though in the course of the 1990s they had converted to public companies selling shares to investors, the Wall Street firms continued to operate effectively as partnerships. The rule was that half of net revenue after interest costs was reserved for staff payments, the other half being paid to shareholders.

Richard Fuld, who drove Lehman’s dramatic growth as CEO from 1994, earned $484.8 million in salary and bonus between 2000 and 2008. That was staggering enough, but to understand the psychology of those operating the system, one has to appreciate that even the top investment bankers knew that they were not the real kings of the money game.

At the hedge funds and private equity groups, individuals could earn hundreds of millions, or even billions, of dollars per annum. In 2007 the six top hedge fund managers earned at least a billion dollars each in compensation.

No doubt many mortgage borrowers were victimized by a process that systematically misled them and had every interest to do so. But once a real estate market shifts from a state of equilibrium to one of boom, everyone becomes a speculator willy-nilly. As capital appreciation came to be expected, the meaning of home ownership changed. Home owners, whether they liked it or not, were taking a speculative position.

In 2006 fully a third of new mortgages issued in the United States were for second, third or even fourth properties. In what became known as the “bubble states”—Florida, Arizona, California—the percentage was as high as 45 percent.

All told, if we focus on that section of the market that was truly a product of the bubble, by the summer of 2007, $5.213 trillion in private-label asset-backed securities had been issued—that is, MBS generated from unconventional mortgages and credit card, student loan and auto debt. Of this total, the most dangerous mortgage component, subprime mortgage MBS, amounted to $1.3 trillion.

Though this was “only” 12 percent of the total American mortgage market, the $1.3 trillion had been produced in a single surge since 2003.

Of the total sum of $5.23 trillion, more than $3 trillion had been placed with long-term investors and $700 billion were placed directly with investment funds or investment banks. But $1.173 trillion were held by banks that funded them off balance sheet by issuing ABCP. As a result, ABCP had become the largest short-term m...

If there was a channel through which the crisis in real estate could ramify outward to unleash the global financial crisis, this was it—ABCP, the place where private label MBS met wholesale funding.

Rajan was slapped down by Larry Summers. Wielding his full authority as former Treasury secretary, Summers introduced himself as “someone who has learned a great deal about this subject from Alan Greenspan . . . and . . . who finds the basic, slightly Luddite premise of this paper to be largely misguided.”

This response from Summers—his warning that even to discuss risks within the system was to incite dangerous political reactions and tantamount to resisting technological progress—was emblematic of the attitudes that had driven a forty-year deregulatory push.

Dumbfuck

Summers’s reaction to Rajan is all the more telling because the signs of stress in the world economy were so obvious. At the level of macroeconomic policy, Summers himself was willing to sound the alarm with his talk of a balance of financial terror. The commonplace recommendation to tighten fiscal policy might have helped. But this pointed the finger away from where the stress really was, in the financial system.

In the final analysis, it was convenient to make the case at the level of macroeconomic aggregates. It was particularly easy to demand that a Republican president change his course. It was far less comfortable to question the house price boom and the giant Wall Street edifice erected on top of it.

David Lereah, the chief economist for the National Association of Realtors, chipped in with a book titled Why the Real Estate Boom Will Not Bust.

Lol

Conservative pundits such as Larry Kudlow, economics editor of the National Review, railed against “all the bubbleheads who expect housing-price crashes in Las Vegas or Naples, Florida, to bring down the consumer, the rest of the economy, and the entire stock market.”

And of course Chump hired him

in July 2004, as subprime was really hitting its stride, the regulators agreed to provide a permanent exemption that effectively allowed assets held in SIVs to be backed by only 10 percent of the capital that would have been required if the assets were held on the balance sheets of the banks themselves.

Good fucking God

It was following that regulatory shift that the ABCP market exploded from $650 billion to in excess of $1 trillion.63 By the summer of 2007 Citigroup alone was guaranteeing $92.7 billion in ABCP, enough to wipe out its entire Tier 1 capital.

More than the grand gestures of deregulation, like the 1999 act, it was this kind of apparently small-scale regulatory change that unfettered the growth of shadow banking. The same was true for repo.

Traditionally, repo had been limited by the fact that the categories of assets that were exempt from the automatic stay in case of bankruptcy included only US government and agency securities, bank certificates of deposits and bankers’ acceptances. If those classes of security were offered as collateral in repo, ...

In 2005 the Bankruptcy Abuse Prevention and Consumer Protection Act gave creditors much stronger protection against defaulting borrowers, which ironically increased their willingness to lend. But it also expanded the repo collateral provided with special p...

what the Fed did not appreciate was the structural change in the mortgage machine the refinancing boom would trigger. Certainly by 2004 it was clear that it was time to raise rates. In seventeen tiny steps the Fed inched rates from 1 percent in June 2004 to 5.25 percent in June 2006. It was fine-tuning, not shock and awe.

In due course, the inversion of the yield curve might by itself have produced a recession. But it wasn’t Greenspan or Bernanke who killed the mortgage boom. It killed itself. By 2005 at the latest it was clear that low-quality mortgage debt was a ticking bomb.

In 2007 the typical adjustable-rate mortgage in the United States favored by low-income borrowers was resetting from an annual rate of 7–8 percent to 10–10.5 percent.

As traders such as Greg Lippmann at Deutsche Bank realized, between August 2006 and August 2009, $738 billion in mortgages would experience “payment shock.”66 As the escalated interest payments hit, a wave of defaults was more or less inevitable. Once that began it was only a matter of time before house prices stopped increasing and the market turned. At that point, millions of speculative real estate investments would go bad. Families would lose their homes. Thousands of MBS would suffer default and whoever held insurance would get rich. Nowhere in Lippmann’s extensive document arguing for Deutsche Bank to short MBS was there any mention of Fed tightening.