What caused the great financial crisis and how the lessons learned apply to our own financial lives.
In this episode you’ll learn:
- What caused the great financial crisis.
- What are mortgage backed securities and collateralized debt obligations.
- What is overcollateralization.
- How leverage and accounting rules contributed to the crisis.
- How we can apply the lessons learned from the great financial crisis to our own financial lives.
What Caused the Great Financial Crisis
Home mortgages were the raw material that fueled the great financial crisis of 2007 to 2009.
In 2007 and 2008, when homeowners began to default on their mortgage liabilities in droves, investment securities (i.e. assets) tied to those mortgages plummeted, spreading fear and panic throughout the financial system. The financial turmoil led to the collapse of major financial institutions and the deepest global recession since the Great Depression.
How could the relatively simple act of buying a house lead to such economic devastation?
First, it is important to keep mind that while a mortgage is the home owner’s liability, it is also someone’s asset.
Initially a mortgage is the asset of the bank making the loan, but for decades U.S. banks have sold their mortgages to entities that package them with hundreds of other mortgages into bonds called mortgage-backed securities that are owned by mutual funds, exchange traded funds, insurance companies, pension plans and other investors.
Collateralized Debt Obligations
A mortgage bond is a straightforward investment, but leading up to the great financial crisis, financial institutions began to repackage those bonds into more risky and esoteric investment vehicles.
Mortgage-backed securities were included in special purpose entities called collateralized debt obligations (“CDOs”) that contained hundreds of different mortgage bonds and other types of debt such as non-investment grade corporate bonds and bonds backed by auto loans and credit card receivables.
These CDOs were highly complex and obscure, causing investors to rely on the credit ratings issued by national rating agencies to determine CDOs’ safety.
Many CDOs were given investment grade credit ratings, implying they were safe, even though the CDOs’ performance was tied to high risk subprime mortgages. Subprime mortgages were mortgages taken out by highly leveraged borrowers with poor credit, many of whom had provided little if any income verification.
These CDOs “merited” their elevated credit ratings through a process called overcollateralization. Overcollateralization is when the principal value of the underlying securities comprising a CDO is greater than the CDO’s starting principal value.
For example, when a CDO was issued it might have mortgage bonds with a principal value $120 million but the CDO would be issued at a face value of $100 million. The extra $20 million served as a cushion to absorb losses due to mortgage defaults.
Some CDOs had lower credit ratings because the mortgage bonds assigned to these junior, lower rated CDOs were also assigned to more senior, higher rated CDOs.
In other words, even though junior CDO’s were also over collateralized, senior CDOs had first dibs on mortgage bond interest and principal payments while more junior CDOs were the first to be assigned any losses due to mortgage defaults.
Leading up to the great financial crisis there was a large global appetite from investors for these CDO structures because of their attractive yields and perceived safety.
Rising Home Prices
Global demand for investment securities tied to mortgages meant there was an increasing demand for both houses and borrowers. Many borrowers bought second and third homes with little money down with the intent of flipping them for a profit. Prices for both new and existing U.S. homes began increasing at double-digit annual rates by 2005.
By 2007, U.S. home prices exceeded 4.5 times median household income, an all-time high and well above historical averages.
As home prices got more and more frothy, the credit worthiness of the average borrower declined while underwriting standards became more and more lax.
By the summer of 2007, home prices in many regions of the U.S. were falling and mortgage defaults increasing.
As the losses flowed into collateralized debt obligations tied to mortgages, it became apparent despite the overcollateralization that these securities were way more risky than their credit ratings implied.
These CDO structures that were in such high demand during the boom years were quickly deemed toxic and no one wanted to own them. Investors fretted about the exposure various financial companies had to these securities.
Collapsing Financial Institutions
Financial entities such Bear Stearns, Lehman Brothers and Morgan Stanley found their stock prices plummeting as fearful investors dumped shares.
These highly leveraged investment banks/broker-dealers had $32 dollars of debt for every dollar of equity on their balance sheets, with much of the debt funded with overnight borrowings.
With the investment banks’ stock prices falling and their asset values deteriorating due to the mounting losses and declining prices for CDOs and other securities, the investment banks’ lenders demanded more collateral in order to continue to provide debt financing.
The declining asset prices were exacerbated by new accounting rules passed by the Financial Accounting Standards Board that became effective in November 2007 requiring corporate entities, including investment banks, to value the assets on their financial statements at the current market price even if those prices were at distressed levels due to fear and panic.
Investment banks faced a nightmare scenario. As they rushed to sell assets to raise cash to put up more collateral so they could continue to fund their operations through debt, it pushed down the value of those assets as they sold in the open market at fire sale prices, which in turn further weakened the investment banks’ balance sheets as they needed to mark down the value of their remaining assets to the most recent distressed market price.
Meanwhile, the investment banks’ stock prices kept falling requiring them to sell even more assets into an illiquid market to lower their leverage. In addition, many of their clients stopped trading with the firms out of fear they wouldn’t survive
Bear Stearns was the first major investment bank to fail in March 2008 as the Federal Reserve orchestrated a sale to JP Morgan. Five months later in September 2008 Lehman Brothers filed for bankruptcy, and other large financial institutions either failed or needed to be bailed out by the federal government.
Stemming the Fear and Panic
The fear and panic cascading through the financial system might have continued unabated, leading to greater economic turmoil and collapse if it had not been for two actions.
First, the U.S. government agreed to buy distressed securities including CDOs from financial entities as part of its Troubled Asset Relief Program, allowing these companies to clean up their balance sheets.
Second, the Financial Accounting Standards Board modified their rules to allow companies more flexibility in valuing their assets. Corporations could now value assets on their accounting books as if they were sold in an orderly sale rather than dumped at distressed sale prices. This stemmed the downward spiral of forced asset sales by companies whose balance sheets were deteriorating due to forced asset sales.
Only then did the financial panic subside, allowing the economy and financial system to begin to mend.