The Path to a Crisis
Was this the case of one group or one company falling asleep at the wheel? Is this the result of too little oversight, too much greed, or simply not enough understanding? As is often the case when financial markets go awry, the answer is likely "all the above"
Remember, the market we are watching today is a byproduct of the market of six years ago. Rewind back to late 2001, when fear of global terror attacks after Sept. 11 roiled an already-struggling economy, one that was just beginning to come out of the recession induced by the tech bubble of the late 1990s.
In response, during 2001, the Federal Reserve began cutting rates dramatically, and the fed funds rate arrived at 1% in 2003, which in central banking parlance is essentially zero. The goal of a low federal funds rate is to expand the money supply and encourage borrowing, which should spur spending and investing. The idea that spending was "patriotic" was widely propagated and everyone - from the White House down to the local parent-teacher association - encouraged us to buy, buy, buy.
It worked, and the economy began to steadily expand in 2002.
Real Estate Begins to Look Attractive
As lower interest rates worked their way into the economy, the real estate market began to work itself into a frenzy as the number of homes sold - and the prices they sold for - increased dramatically beginning in 2002. At the time, the rate on a 30-year fixed-rate mortgage was at the lowest levels seen in nearly 40 years, and people saw a unique opportunity to gain access into just about cheapest source of equity available.
Investment Banks, and the Asset-Backed Security
If the housing market had only been dealt a decent hand - say, one with low interest rates and rising demand - any problems would have been fairly contained. Unfortunately, it was dealt a fantastic hand, thanks to new financial products being spun on Wall Street. These new products ended up being spread far and wide and were included in pension funds, hedge funds and international governments.
And, as we're now learning, many of these products ended up being worth absolutely nothing.
A Simple Idea Leads to Big Problems
The asset-backed security (ABS) has been around for decades, and at its core lies a simple investment principle: Take a bunch of assets that have predictable and similar cash flows (like an individual's home mortgage), bundle them into one managed package that collects all of the individual payments (the mortgage payments), and use the money to pay investors a coupon on the managed package. This creates an asset-backed security in which the underlying real estate acts as collateral.
Another big plus was that credit rating agencies such as Moody's and Standard & Poor's would put their 'AAA' or 'A+' stamp of approval on many of these securities, signaling their relative safety as an investment.
The advantage for the investor is that he or she can acquire a diversified portfolio of fixed-income assets that arrive as one coupon payment.
The Government National Mortgage Association (Ginnie Mae) had been bundling and selling securitized mortgages as ABSs for years; their 'AAA' ratings had always had the guarantee that Ginnie Mae's government backing had afforded . Investors gained a higher yield than on Treasuries, and Ginnie Mae was able to use the funding to offer new mortgages.
Widening the Margins
Thanks to an exploding real estate market, an updated form of the ABS was also being created, only these ABSs were being stuffed with subprime mortgage loans, or loans to buyers with less-than-stellar credit.
Subprime loans, along with their much higher default risks, were placed into different risk classes, or tranches, each of which came with its own repayment schedule. Upper tranches were able to receive 'AAA' ratings - even if they contained subprime loans - because these tranches were promised the first dollars that came into the security. Lower tranches carried higher coupon rates to compensate for the increased default risk. All the way at the bottom, the "equity" tranche was a highly speculative investment, as it could have its cash flows essentially wiped out if the default rate on the entire ABS crept above a low level - in the range of 5 to 7%.
All of a sudden, even the subprime mortgage lenders had an avenue to sell their risky debt, which in turn enabled them to market this debt even more aggressively. Wall Street was there to pick up their subprime loans, package them up with other loans (some quality, some not), and sell them off to investors. In addition, nearly 80% of these bundled securities magically became investment grade ('A' rated or higher), thanks to the rating agencies, which earned lucrative fees for their work in rating the ABSs.
As a result of this activity, it became very profitable to originate mortgages - even risky ones. It wasn't long before even basic requirements like proof of income and a down payment were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being underwritten and given to prospective homeowners. The logic being that with real estate prices rising so fast (median home prices were rising as much as 14% annually by 2005), a 125% LTV mortgage would be above water in less than two years.
The Fuel That Fed The Subprime Meltdown | Investopedia
Not that the real truth matters all that much when your political ideology insists otherwise...
Please register to participate in our discussions with 2 million other members - it's free and quick! Some forums can only be seen by registered members. After you create your account, you'll be able to customize options and access all our 15,000 new posts/day with fewer ads.
