Crashed: How a Decade of Financial Crises Changed the World

by Adam Tooze

the securitization of mortgages, their incorporation into expansive and high-risk strategies of banking growth, the mobilization of new fu...

And there was another part of America’s postwar political economy that did not survive the disinflationary shock of the 1980s: the peculiar system of housing finance that had emerged from the New Deal era. Since the 1930s, America’s housing finance had been based on commercial banks and local savings banks, so-called savings and loans, making

long-term fixed interest loans. By the late 1960s thirty-year fixed interest loans had become normal, with as little as 5 percent in down payment.10 The funding was provided by depository institutions, which offered government-insured savings accounts with capped interest rates. This was the basis on which home ownership had expanded to almost 66 percent of households by the 1970s. For home owners on fixed interest, long-term mortgages, the inflation of the post–Bretton Woods era was a windfall. The real value of their loans was eaten up while their interest rates remained fixed. For the banks that lent to them it was a disaster. In an era of inflation and fluctuating interest rates, at the capped interest rates inherited from the 1950s they could not retain their depositors, let alone attract new ones. To borrow from money markets or issue bonds, they now faced the withering interest rates set by the Fed. Meanwhile, their portfolios of fixed interest mortgages were devalued as rates on new loans soared.11 By the early 1980s the vast majority of the almost four thousand savings-and-loan banks still in operation were insolvent. Given the cost of cleaning them up and the prevailing free market ideology of the Reagan era, the path of least resistance was to deregulate and lower capital standards in the hope that they could grow themselves out of trouble. The commercial banks survived this trial by fire; the savings and loans did not. More than a thousand failed. Most of the r...

The basic anchor of America’s mortgage system in the aftermath of the savings-and-loans debacle was the so-called government-sponsored enterprise (GSE).14 The mother ship of the GSEs was Fannie Mae, founded in 1938 to create a secondary market for lenders who were willing to issue the new type of government-insured Federal Housing Authority mortgages promoted by the New Deal. Fannie Mae did not issue mortgages. It bought them mainly from commercial banks across the United States that specialized in issuing FHA-insured mortgages. By acting as a backstop, Fannie Mae lowered the cost of lending and set a national standard for both lenders and “prime” borrowers. It helped to unify America through mortgage debt. Fannie Mae was able to fund its purchases of these standardized mortgages cheaply because its credit rating was that of a government agency that could not fail. So-called agency debt was equivalent to that of the Treasury. By the same token, the obligations of Fannie Mae featured on the federal government’s balance sheet. To get them off at a time of fiscal stress during the Vietnam War, in 1968 Fannie Mae was privatized. The branch still devoted to making loans to public employees and veterans was split off as Ginnie Mae. “New Fannie Mae” was licensed to buy any mortgages, government guaranteed or not, that conformed to certain quality standards—so-called conforming loans. And in 1970 Congress legislated into existence a third agency, the Federal Home Loan Mortgage Cor...

the GSEs were hit hard by the Volcker shock of the early 1980s. Fannie Mae came close to failure. But it survived, and as the housing market recovered in the 1990s, the GSEs flourished. Thanks to their residual tie to the federal government, the GSEs continued to enjoy a substantial discount in funding costs. By the end of the century Fannie Mae and Freddie Mac together were backstopping at least 50 percent of the total national mortgage market. 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. It was also the source of deep and irreducible politicization of the mortgage issue in the United States.

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. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 called for lending goals to be set for the GSEs. 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 On the back of their influence over the Democratic Party, the GSEs built one of the most powerful lobbies in Washington, DC. Their political firepower was legendary. By the same token, the GSE mortgage regime always attracted the ire of the American Right.

Deep down most free market advocates are convinced that the interferences of the GSEs were responsible for the disaster th...

The GSEs had political mandates set by progressives to funnel money into underserved communities. They had a market-distorting funding advantage due to t...

When you distort the market, crises a...

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 t...

the taxpayer pay for the rescue of a Democrat-controlled parastate housing welfare apparatus designed...

This was powerful mobilizing rhetoric for the Republican base. But as an explanation of the crisis that was brewing in 2006, this po...

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.18 In this sense the GSEs did not create the crisis. But what they d...

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. It was the debt issued by the GSEs to finance the mortgages they were holding on their balance sheets that ultimately funded the loan. This was the basic structure of what became known as “originate to distribute.” Mortgage lenders no longer needed to hold the mortgages ...

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. To do so they packaged the mortgages into pools, in which they sold shares—securities. The idiosyncratic risks o...

to build a branch network necessary to make loans across the far-flung economy of the United States. They did so fully aware of the risks and returns generated by the fluctuation of interest rates. Rather than having small savings and loans gamble on what was a viable loan, securitization...

In 1970 Ginnie Mae carried out the first securitization. It was a simple model—a so-called pass-through—under which the flows of revenue from a pool of mortgages...

Not satisfied that this should remain a public monopoly, Lewis Ranieri and his team at hard-driving investment bank Salomon Brothers put together the first private securitization of mortgages for Bank of America in 1977.20 But it took a brave investor to buy a package of fixed interest mortgages at that moment. 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. This was the origin of so-called structured finance. 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 to investors looking for riskier investments. The top-tier senior tranches would pay out except in the highly unlikely even...

Not surprisingly, given the very high ratings they handed out for MBS, the role of the ratings agencies would later become highly controversial. 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. This was despite the fact that since the 1980s it was issuers of debt who paid the ratings agencies to make their classifications, not the subscribers to their information services. Payment by the issuer created a conflict of interest. But 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. The sheer volume of mortgage-backed security issuance, involving tens of thousands of tranches, combined with the fact that the flow was concentrated in the hands of a few issuers, gave ...

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. The...

Compared with the model of the savings and loan, securitization thus did its job in spreading risk. But did it by the same token reduce the incentive to carefully monitor the underlying loans? By splitting origination from funding, had the new system eliminated the incentive to monitor loans carefully? 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. Along that chain, what confidence could an investor have that the job was being done correctly? At each step of the way the main concerns were volume and fees. Who had an interest in maintaining quality? Perhaps it was not the government subsidy but these perverse incentives that led to the huge boom in bad lending and the crisis of 2007–2008.24

It is a theory that would have a superficial plausibility if the 1990s model of GSE-centered mortgage finance had still been dominant in the early 2000s.

But, 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 securiti...

The path that led to the supercharged private mortgage industry of the early 2000s was twisted, but it too goes back to the breakdown of Bretton Woods in the 1970s and the unfettering of currencies, prices, interest rates and capital movements that followed. It was not just the savings and loans but the entire financial sector that was forced to rethink its business model, and this went for the investment banks of Wall Street as much as for the commercial banks.

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.27 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. In the 1980s, with interest rates coming down and bonds beginning their long bull run, trading in so-called fixed-income securities—as opposed to equities—became ever more important.

Drexel Burnham Lambert pioneered the market in high-yield corporate bonds, also known as junk bonds. Meanwhile, Salomon Brothers helped the GSEs devise the securitization model and launch each new batch of mortgage-backed securities. 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.28 At the same time, the investment banks progressively increased their own...

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. In the aftermath of the inflation and interest rate shocks of the late 1970s and early 1980s, this put them in a sweet spot. 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. The money market mutual funds offered instantly accessible accounts without official government guarantee, but pledged by their private sector operators to return at least a dollar on the dollar ...

Nor were the MMFs the only ones. 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.30 Lending against security, or buying the commercial paper of well-known investment banks, was precisely the kind of safe short-term asset that the managers of the cash pools wanted. And acting as the banker to the funds, so-called prime brokerage, was ideal business for the investment banks. These insti...

the wholesale market or on deposit, the bigger the turnover, the larger the profits. 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. The belief in the ability to manage risk inspired by the new derivative instruments, combined with access to th...

Firms like Goldman Sachs, Morgan Stanley and Merrill Lynch went from obscurity to star status. Originally built as partnerships, the huge scaling up of trading activity and the derivatives business meant that they needed to issue shares and go public. Merrill Lynch had done so already in 1971. Bear Stearns followed in 1985...

With Robert Rubin a classic exponent of this new Wall Street, the investment banks even had their man in government. Goldman Sachs began to e...

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. In addition they looked for a new business model.36 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. But to engage in that full range of activities they needed regulatory relief. The New Deal–era regulations that separated retail from investment banking had to fall. The Clinton Treasury, first under Rubin and then under Larry Summers, gave them what they needed. 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.37 As feeders to the GSEs they were restricted to mortgage origination. But why limit their ambitions? Why not integrate the entire chain? By the late 1990s and early 2000s all three groups of banks—investment banks, commercial banks and mortgage lenders—were following this logic. 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. By the early 2000s the corporate strategies centered on private mortgage securitization were fully in place. But Fannie Mae and Freddie Mac still enjoyed a dominant position in the market thanks to their funding advantage. What gave the private mortgage sec...

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. The industry churned as it had never churned before. 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 this huge boom the GSEs were still the major players. They continued to monopolize the prime mortgage segment. Their share of the market reached its maximum point in 2003 at 57 percent. But at that point it stalled. 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. To make sure it was the latter, caps were imposed on their total balance-sheet size.39 The door to the private issuers was opened.

During Greenspan’s refinancing boom of 2000–2003, it wasn’t just the GSEs that were busy. The huge surge in issuance meant that there was plenty of unconventional, “nonconforming” business to go around too. But 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...

What the private issuers discovered was that if scrutinizing conventional mortgages was profitable, subprime was even more so.40 The financial engineering was more elaborate and one could charge more money for the services. The techniques of the...

A surprisingly large share even of nonconforming private label MBS could still attract an AAA rating once combined in structured products. 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. CDOs were derivatives based on repackaged middle-ranking “mezzanine” tiers of other securitized mortgage deals. 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 ...

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.

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. Such assets constitute as close as the unstable capitalist economy can offer to a neutral safe position. They are desired and in some cases legally required by all investors with a particular aversion to risk and little cap...

As one of the key economists in the field has rem...

lmost all human history can be written as the search for and the production of different forms of safe assets.”43 This may be true, but it begs the question of what was happening in the late 1990s and early 2000s to drive a huge surge in the demand for safe assets. 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 Treasur...

first Bush administration could provide. 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. 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. If pension funds, life insurers and the managers of the gigantic cash pools ac...

When the market turned bad, they would sit on balance sheets as an illiquid entry. They were no longer counted as safe assets. There would be lawsuits against investment banks that had knowingly repackaged unsafe mortgages.

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. Furthermore, 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? It was a choice. Not every bank did it. Those that took the biggest risks were large mortgage originators and the most aggressively expansive commercial banks—Citigroup, Bank of America and Washington Mutual—and the two smallest and scrappiest investment banks—Lehman and Bear Stearns. By contrast, J.P. Morgan began throttling back its mortgage pipeline already in 2006 and bought as much protection as it could in the CDS market. Goldman Sachs went beyond hedging to place a large bet on an imminent housing market collapse.

Their caution was easy to justify given the kind of business that subprime lending involved. But it also reflected a more basic banking consideration.