Understanding the 2008 Financial Crisis 1. Introduction Nicoli Nattrass Centre for Social Science Research University of Cape Town January 2015
An inverted pyramid of debt was built on a narrow base of booming US house prices. 1997-2006: US house prices rose 124% (from 3 to 5 times the average wage). The quality of loans declined: by the mid 2000s, most new home loans were NINJA loans, typically with ‘teaser’ By 2007 16% of sub-prime adjustable interest rates. mortgages were in default. As most had been ‘securitized’ and sold as complex When interest rates rose derivatives, this affected the entire from 1% in 2004 to 5% in financial sector…. 2006, the trouble began.
Assets previously believed safe were no longer trusted and banks stopped lending to each other. The UK nationalized Northern Rock in Feb 2008. In Sept 2008 the US took Fannie Mae and Freddie Mac (mortgage underwriters) into public ownership. A week later regulators let Lehman Brothers go bankrupt, owing $600 billion. Stock markets crashed…..
Huge tax-payer financed rescue packages (amounting to 80% of GDP in the US and UK) and the purchase of ‘toxic assets’ (of $1 trillion) by the Fed prevented the total collapse of the financial system. But debt ‘de - leveraging’ by firms and households depressed demand, causing a recession. Global trade fell by more than 20% and growth declined everywhere. Fiscal deficits expanded, sparking a sovereign debt crisis in 2009 (notably Greece and Ireland) and then a crisis for the EU and a corresponding shift to austerity policies. The economic legacy lingers today in low interest rates and mostly anemic growth.
Meanwhile, bank bonuses bounced back to pre-crisis levels (and were 29% higher in 2014 than in 2013). http://www.newstatesman.com/politics/2013/06/unsqueezed-top-how-bankers-pay-has- already-returned-its-peak see also http://www.theguardian.com/business/2014/mar/11/banking-bonuses-rise-city-of-london
The Big Short : An evocative, sometimes laugh-out loud funny and very smart book on the financial crisis and some of the few investors that made money betting against sub-prime mortgage derivatives How Markets Fail : A good introduction to economic theories and to the 2008 The Inside Job : Award winning financial crisis. For documentary with a cynical those particularly and somewhat conspiratorial interested in bent: ‘It was a Wall Street economics. Government’
The mortgage is a bank asset because it has a Mortgage: stream of expected payments. A loan from When banks evaluate clients, they offer lower a interest rates to less risky clients. commercial Banks rarely loan the full value of the house bank to a because it is safer if the home-owner has a home- owner, for a substantial economic stake in the house. fixed Securitization period. The Least risky: Client Most risky: changed all home is has strong no earnings, this as collateral earnings, no equity mortgage significant equity (NINJA Interest Loan originators in the house loans) payments could sell these assets on to investment banks
Interest financed payments Senior tranches (AAA rated) to owners of different tranches of the mortgage Junior tranches (AA rated) backed security. Senior Mezzanine tranches (BBB tranches get lower interest rated) payments but are the last Wall street investment banks to take losses; the mezzanine tranche gets Mortgage Backed Security higher interest payments (or mortgage bond) made but is the first to take losses up of pools of home loans See The Mortgage Originators Big Short pages 126-8 on financial language
Collateralised debt obligation (CDO) rated AAA BBB rated tranches Mortgage bonds Mortgage bonds made up of pools made up of pools of home loans of home loans
Collateralised debt obligation (CDO) rated AAA This CDO was BBB rated tranches also AAA rated!!! Mortgage bonds Mortgage bonds by made up of pools made up of pools rating of home loans of home loans agencies whose models had been ‘gamed’ by Wall Street
Incentives facing Wall Street traders Starting with Salomon Brothers in 1981, the Wall Street partnerships became corporations. Shareholders expect high return on equity (ROE ): “from that moment the Wall Street firm became a black box. The share-holders who financed the risk-taking had no real understanding of what the risk-takers were doing, and as the risk-taking grew ever more complex, their understanding diminished’ (Lewis, The Big Short , p.258).
Return on Equity (ROE) = Net Income Total Shareholder Equity = Net Income x Sales x Total Assets Sales Total Assets Total Shareholder Equity Asset turnover Net profit margin Leverage ratio Return on Assets (ROA) Net profit margin x Asset turnover x Leverage ratio = ROA = x Leverage ratio Royal Bank of Scotland (RBS) and Citi were the largest banks in the UK and the US respectively in 2007. Their leverage was around 50 when the crisis hit: They could absorb only $2 in losses on each $100 of assets.
Deregulation and risk • 1990s: growth of derivatives Side-bar: What is a derivative? • One of three main financial instruments (the other two being debt and equity) • A derivative is a contract that derives its performance from an underlying entity (‘the underlying’). It is used to insure, hedge and speculate. Common derivatives are futures, options (‘call’ and ‘put’) and swaps • Most are traded ‘over -the- counter’ (off exchange). The ISDA (International Swaps and Derivatives Association) provides a standardized contract and rules to manage how and when payments are made
E.g. a LEAP (a ‘long -term equity anticipation security) • It is an option to buy a stock at a fixed price for a certain amount of time. • Jamie Mai and Charlie Ledley used LEAPS when they thought that stocks were under-valued because of some uncertainty and that their value would increase significantly later once that uncertainty had been resolved ( Big Short , pages 113-4). • This derivative allowed you to make a bet without having to buy the stocks upfront.
Deregulation and risk • 1990s onwards, growth of derivatives and related financial innovation. • 1999 Gramm-Leach-Bliley Act (Financial Services Modernization Act ) which ‘allowed commercial banks and investment banks to combine and form vast financial supermarkets’ ( How Markets Fail , page 7). • 2000 Commodity Futures Modernization Act (to prevent the Commodity Futures Trading Commission from regulating ‘over -the- counter’ derivatives • The US Securities and Exchange Commission (SEC) relaxed leverage ratios for the big investment banks and effectively stopped regulating the investment banking industry. • All this was justified by an ideology of market efficiency that was blind to the incentives on Wall Street to drive up leverage and increase returns on assets through riskier lending…
Credit Default Swap (CDS) • A CDS is a derivative which allowed investors to pay a premium in return for insurance against default on a particular asset (e.g. a mortgage bond or a CDO). They were good for shorting the market (you effectively paid a small premium each month (and you knew exactly what this ‘downside’ was) and your upside was very big. • For example: It cost Michael Burry 200 basis points (2%) to buy CDSs on BBB rated tranches that would be worth zero if the underlying mortgage pool experienced losses of just 7 percent. This meant that on a CDS of $100 million he would pay $2 million a year with the chance of gaining $100 million when the loans went bad. ( The Big Short , page 50-51).
Credit Default Swap (CDS) • CDS’s transferred all the risk to the insurers (sellers of CDSs) – notably AIG. CDOs had typically comprised a mix of loans, credit card debt etc. but by mid 2004 they were 95% sub- prime mortgages. (‘Bait and Switch’, The Big Short page 71 • CDSs could be paired with CDOs, the package declared ‘risk - free’ and held off the bank’s balance sheet ( The Big Short page 77) • Some CDS’s were repackaged into (synthetic) CDOs and hence continued to ‘fuel the doomsday machine’ • 2006 Goldman Sachs started buying CDS’s against the CDOs they were selling to their customers
The Inside Job (Charles Ferguson) • The Inside Job clip: 21.53-40.50 • Deregulation, powerful financial institutions, adverse incentives…. • A justificatory economic ideology that was opposed to regulation and which assumed that the ‘sophisticated’ financial companies and products were good for capitalism and for spreading risk. • Warnings ignored and ridiculed.
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