The Subprime Crisis
There were a number of factors that led to the subprime crisis: Fannie Mae, Countrywide Financial, the Federal Reserve, Moodyâ€™s, Merrill Lynch, Bear Stearns, Goldman Sachs, AIG, Michael Burry, who shorted the mortgage backed securities being sold to investors that were full of subprimeâ€”and guys like him (the ones depicted in Michael Lewisâ€™s The Big Short)â€”they all had a role to play in the subprime crisis of 2007-2008 (McLean, Nocera). But, truth be told, the lead-up to the crisis started well before the actual collapse of the market. It started with housing in the 1990s. But one could even go back further to the 1970s when Lewis Ranieri of Salomon Brothers invented the mortgage backed security (MBS)â€”a bond made up of thousands of home mortgages that were bundled together, sliced up and sold to investors who would collect the interest (Lewis). It was a way for the original lenders to offload the risk to other investors and a way for new investors to collect a nice ROI (return on investment), and it was ultimately at the heart of the subprime crisis. So long as the MBSs were legitâ€”and with the ratings agencies doing their part to rate them accurately (they could give these securities a good rating of AAAâ€”meaning the chance of default was slim to none, or a bad rating of junkâ€”meaning default was likely imminent), they could work as a legitimate investment. It was when they were not rated well that the trouble began (or rather got worse). For example, junk bonds would pay a higher returnâ€”but the risk of getting nothing was also much higher. AAA-rated MBSs were supposed to be a sure-thing: little to no risk, and a decent, predictable return at a decent rate. When Moodyâ€™s and the other ratings agencies began getting sloppy in their ratings of MBSs leading up to the collapse in 2007, many investors failed to realize they were buying junk that was mistakenly rated AAA (Lewis). Yet, lenders also played a part because they had been incentivized by the government to give out home loans to people who genuinely could not afford them. That was another big part of the problemâ€”and that led right back to the government and politicians trying to promote the American Dream and make it a reality for people who really had no business realizing it. Yet there were several other problems and issues that led to the crisis. This paper will look at the causes of the subprime crisis, the ethical issues that underlay the crisis, and what can be done to prevent a similar crisis from occurring in the future.
The major root causes of the recent subprime financial crisis were numerous. The dotcom bubble at the end of the 1990s-early 2000s led to a collapse in the Fed Funds rate, which brought interest rates down to between 1 and 2% from 2002 to 2005. The low rates made borrowing more attractive to consumers, which meant there was more demand for things like housesâ€”which made sellers jack up the prices of their homes. Sellers of homes wanted to get rich by collecting a 30% return on their purchase of a few years prior: with housing heating up, and everyone who applied for a loan getting one (thanks to lenders like Countrywide Financial), homes were going like hotcakes and prices were soaring. Mortgage lenders were encouraged to hand out loans to subprime borrowers because restrictions had been eased and during the 1990s the Clinton Administration had wanted to see to it that everyone should have the opportunity to own a home and live the American Dream (McLean, Nocera). Thus the housing bubble was created by way of artificial demand made possible through risky lending practices, with the risk being sold off to investors who were starved for yield. Personal greed was an ethical issue at every level: the owners of Countrywide wanted to get rich off the subprime market. Home owners wanted to get rich by selling into the bubble. Mortgagees wanted to feel rich by becoming â€œhome ownersâ€ of multiple homes that they could not normally have been able to afford under traditional lending standards (which would be restored following the bursting of the bubble). The problem was epic, howeverâ€”and the dotcom bubble that burst at the start of the 21st century also played a part, as it caused big fund managers to have to find a place to obtain yield (ROI) for their vast funds (such as those responsible for paying pensions). The MBS market looked attractive. In other words, a global savings glut had occurred following the bursting of the dotcom bubble, with developing nations reversing course; they stopped running deficits and starting saving more. Subprime borrowing began to rise and the banks and financial industry were happy to let it because there was a demand for fixed yield in the international market at the selling of these mortgages as fixed yield was a way to satisfy that crowd (McLean, Nocera). The shoddy mortgages were thus bundled into securities and sold to third parties who would chop them up and bundle the different tranches together and sell them again. But these financial instruments were problematic on the face of it because they really were not what they were made to seemâ€”because the ratings agencies were getting paid a pretty penny to overlook the junk subprime mortgages piling up in the bundles. Only people like Michael Burry, who actually bothered to look at what was inside the MBSs, knew they were ticking time bombs (Lewis). Yet even his impulse was to bet against themâ€”not to warn the world. Thus, personal greed was everywhere a problem in this fiasco.
One of the biggest contributors to the problem, however, was the ratings agencies, which were supposed to put a rating on these securities based on the underlying likelihood of default. The ratings agencies like Moodyâ€™s failed to rate them appropriately, and so investors thought they were buying AAA-rated securities when in reality they were buying what were basically junk bondsâ€”mortgage-backed securities, asset-backed commercial paper (ABCP) and collateralized debt obligations (CDOs). The idea was to put high-risk mortgages into bundles of low-risk so that the high-risk mortgage was neutralized. The problem was that a fifth of all mortgages were high-risk, so when they all began defaulting when the Fed started raising rates again in 2006 (as the rates on their loans were not fixed), the catalyst was set in motion for the housing bubble to burst: there were no more buyers and sellers couldnâ€™t sell fast enough. The MBSs that seemed like a sure thing for yield chasers suddenly blew up and those who had purchased insuranceâ€”credit default swapsâ€”on the MBSs suddenly stood to make out like bandits (such as Michael Burry did). The banks that had sold all the credit default swaps now had to make good on them and, unless the federal government stepped in with a loan/bailout, they would have to liquidate. That led to the major policy responses to the financial crisis by the Federal Reserve, the Treasury and regulatory agencies. The response was, basically, for the guys in the government to lend a helping hand to their cronies (after all, the Treasury was run by an ex-Goldman Sachs guy).
American International Group (AIG) had been a big player in the financial crisis of 2007-2009, too. The company had been selling credit default swaps and making a commission on the sales (McLean, Nocera). AIG had not expected the market to turn south in subprime lending as quickly and as devastatingly as it did. The result was disastrous for the global economy as many around the world were left holding toxic debt and had to race to buy the kind of insurance that only Michael Burry and a few others had (the others being the banks that eventually caught on to the fraudâ€”i.e., Goldman Sachsâ€”and also positioned themselves to profit from the collapse rather than warn investors of what was happening) (McLean, Nocera; Lewis).
The credit default swaps were like insurance on the bundles of home loans sold to investors. Investors would buy the mortgages for the fixed return and then ultra-savvy investors would buy insurance on the investments to hedge against risk (i.e., the CDSs) in case the mortgages were not repaid. The bundles of loans were supposedly mortgages of home owners who were unlikely to default, according to their AAA-rating (that was where Moodyâ€™s was supposed to come in to play the ref and make sure everything was on the up-and-upâ€”but Moodyâ€™s was not even watching the game). Thus, many of the bundles of loans ended up being full of tranches that were nothing but sub-prime loans with a high default risk. Investors who saw this immediately starting buying up CDSs anticipating a huge default blow-up (Burry did so along with the other â€œheroesâ€ of The Big Short).
AIG was mostly oblivious to this and did not mind collecting the commission sales on the CDSs. As far as it was concerned, it was selling insurance on something that would never be needed. Then the bottom fell out and suddenly a flood of defaults came in, starting right with the sub-prime mortgages that filled up all the bundles of loans that were being sold. Those with insurance now wanted to sell back the CDSs but just at a higher price. This in essence was their â€œbig shortâ€ play, which Lewis describes in detail in his book by the same name.
The biggest buyer of AIGâ€™s CDSs was none other than Goldman Sachsâ€”and Goldman wanted to make sure it got paid, so that is why AIG got a bail-out from the government: Goldman always has friends in high placesâ€”like Henry Paulson who was former CEO of Goldman and served as U.S. Treasury Secretary at the time of the economic crisis. He made sure to see to it that AIG could make good on its CDSs sold to Goldman. Thus, AIG got a bailout from the governmentâ€”so Goldman could come out a winner.
AIGâ€™s sales agents didnâ€™t mind one way or another in the time leading up to the explosion in 2007-2008. They got to collect their commissions on the sales of the CDSs that ultimately blew up in everyone elseâ€™s facesâ€”and then their company got a bail-out from taxpayers so they were never really held accountable. AIG is still around todayâ€”unlike companies like Lehman Brothers and Bear Stearns. In the eyes of the victors (those left standin), allâ€™s well that ends well. AIG lived to see another day, and they still made a lot of money. The only thing that suffered was their ethics. But ethics have taken a back seat to the business of making money and making sure someone else was left holding the bag when the time came around for the music to end.
At any rate, the top two groups affected by AIG were Goldman Sachs and the taxpayers who had to foot the bill for TARPâ€”the Troubled Asset Relief Programâ€”a $700 billion stimulus package handed to the all the major players on a silver platter once the crisis ripped through the global economy. Banks all over the world were affected by the subprime mortgage debacle, but in the U.S. the two most affected were Goldman and the people on Main Street. TARP would eventually be repaidâ€”but the banks were never really penalized for their practices, and the cost to taxpayers was still severe, as the money printed by the Fed to keep everything going just added to the inflation of prices that Main Street America would go on feeling. The worst part of it was not even the bailout but the Fedâ€™s role in all of it. The Federal Reserve began buying the mortgage-backed securities that no one wanted and the treasury bills the U.S. needed to sell in order to pay for TARP, etc. The Fedâ€™s money helped inflate asset bubbles all over the place, pushing the stock market to all-time highs and then some (which is where we are at todayâ€”and with the Fed now raising rates and the specter of recession looming around the corner, the markets are on the cliff edge looking down into the abyss wondering if there will be anything to catch them this time or if the jig really is up). As Milton Friedman has pointed out, the Fed simply helped to create an inflationary bubble through its use of quantitative easing (unconventional monetary policy), and that bubble is now about to pop, 10 years after the 2007-2008 housing bubble popped. In America, it is a merry-go-round of endless bubbles being blown and then bursting over the heads of the bag holders. This is why the common worker saw the value of his dollar drop substantially over the past decade as hedges like gold soared. And while Goldman and all the other banks of the world were affected, like Deutsch and Swiss Bank and other central banks, the Fed was the one that really got the ball rolling on saving the world from the bankersâ€™ and lendersâ€™ and credit rating agenciesâ€™ blunders.
The ethical problem here was that lenders were handing out loans hand over fist just to collect commissions on loans originated. But part of this has to go to the people applying for loans, too. They should have known better than to think they could get something for nothingâ€”that it all was truly just a â€œdreamâ€ that would soon enough turn into a nightmare. Their own lust for wealth and possessions led them down a dark path of financial exploitation. Still, the lenders baited them (Lewis). They did not care that they were handing out bad loans that would have repercussions all around the world. The requirements for handing out loans had been loosened considerably by the government because the government wanted more people to have the opportunity to buy a house, so the lenders could originate loans with little to no paperwork. Thus, the government also acted immorally and recklessly by trying to get everyone into houses that were simply unaffordable for them.
Second, the loans were then carved up and bundled into tranches which were sold to investors as being A-grade investments when they were actually full of sub-primeâ€”and anyone who bothered to look would have seen thisâ€”but Moodyâ€™s did not want to look, as it was being paid well to look the other way (Lewis; McLean, Nocera). Then there were the insurers: AIG did not bother to look and instead sold insurance on the mortgage backed securities. It should have been doing its homework and bothering to find out what it was actually selling insurance on and why this insurance was likely to come back to bit them big time. Then the government got back involved again. This time it acted unethically by bailing out its buddies. Instead of insisting that the firms liquidate their assets to cover the insurance they sold, the government allowed them to get back to business as usual by taking out a huge loan and lending it to the banks so that they could pay their customers like Goldman Sachs. It was one giant incestuous, unethical business scheme in which there was no accountability for anyone because the bankers were in control at all levelsâ€”right on up to the Fed, which has been in control of monetary policy since 1913. That is one reason for the populist blowback seen around the world today.
The Treasury helped to bail out the banks by whipping up TARP, which handed over hundreds of billions in taxpayer money in the form of a loan to the banks so that they could cover their obligations without being forced to divest in a painful way. Lehman was allowed to collapse, like Bear Stearns, and have its bones picked clean for pennies on the dollar by the other big banks like Wells-Fargo, JP Morgan Chase and Bank of America (Lewis). Goldman, which had seen the writing on the wall prior to the collapse and had begun buying credit default swaps, had a friend in Treasury Secretary Henry Paulson (former CEO of Goldman, of course), and Paulson made sure that Goldman got paid by bailing out the insurance agency AIGâ€”which owed Goldman for the swaps. This should have been seen as a conflict of interest, but the government was not interested in ethics at the timeâ€”just in friendshipâ€”so it put the burden on taxpayers (as always).
The regulatory agencies have not done much to address the situation. Leveraging is still the name of the game and moral hazard continues to be an issue. The same cycle is about to start again with the Fed Funds rate rising once moreâ€”this time under Chair Powell. Already the markets are responding and the rate is only at 2%. If the Fed takes it higher, as it intends on doing, it is quite likely that a flight from equities will lead to more volatility the world over. Will another bailout help to wash clean the hands of the major players once more?
Preventing another Crisis like This in the Future
The way to prevent another crisis like this one from happening in the future is to recognize that the system itself is highly flawed. There are too many ways in which it can be gamed. The banks should not be allowed to have their own people (former workers or top level executives) working in government. Paulson and today Mnuchin are just two examples of former Goldmanites directing the U.S. Treasury (in case something bad happens, they have one of their own in there to make sure they are protected).
AIG should have been forced to liquidateâ€”like Lehmanâ€”to cover its costs. Instead, it was allowed to keep going because of the special relationship Goldman had with the Treasury. Lehman collapsed along with Bear Stearns. But AIG was too big to fail? Ethics matter and the government has to be mindful of that. If the system is going to permit unethical practices, the system has to be dismantled. The reality is that when Lehman collapsed and Wells-Fargo bought it up, Wells-Fargo was pulling strings to make a play that it thought it could benefit from, while when AIG was set to fail, Goldman made a play that it thought it would benefit from. Both were running different plays but both were essentially using the same playbook.
In the future, the guilty parties have to be made to suffer the consequences of their actions and that means forcing them to shut down, selling off their assets to cover their expenses, and letting them fail if necessary. Actions have to have consequences. The idea that any one organization or institution is too big to let fail is absurd. AIG should have been let to fail and the government should have gone after the credit ratings agencies that were giving the bundles of loans high credit ratings, too. They were in on the take as well. All of them were acting recklessly and criminally. Even the little people, who were profiting off the bubble by selling into it, and the people seeking home mortgages at a time when banks were handing them out like candyâ€”they should have known to be more responsible. But who was there to tell them the reality of the situation? If anything, this crisis at least may have helped some become wiser.
Lewis, Michael. The Big Short. NY: W. W. Norton, 2010.
McLean, Bethany and Joe Nocera. All the Devils are Here: the Hidden History of the
Financial Crisis. Penguin, 2011.
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