In the previous post, I have described the sequence of events when the Global Financial Crisis happened and how it affects us all. Now I shall explain how the sub-prime mortgage crisis led to the banking crisis and the role of securitization in laying out the foundations causing the GFC. There are important lessons to be learnt from the causes of the GFC.
Mortgage-Backed Securities
The roots of the GFC track back to 2002 and 2003, when Alan Greenspan, the Chairman of US Federal Reserve lowered cash rates 11 times to around 1 percent. Normally, investors buy treasury bills, which are viewed as the safest investment, but 1 percent is a very low return. Hence investors started looking for other investments to increase return on their capital.
On the other hand, at the low cash rate, financial institutions can obtain cheap credit from the Federal Reserve. This makes housing more affordable as interest payments on mortgage loans were lower. Thus, increasing number of borrowers approached mortgage lenders to obtain loans. Investment banks would purchase the mortgage loans off the mortgage lenders’ balance sheets, funding this through cheap credit. The mortgage lenders benefit from this as they receive more cash flow to provide more mortgage loans to borrowers.
What the investment banks did with the mortgage loans is that they bundle the mortgage loans and sell them to investors. This process of grouping loans and selling them is called securitization. The investors that purchased the mortgage-backed securities (MBS) would receive cash flows when the borrowers make repayments on their mortgages. These investors include hedge funds, insurance companies and also pension funds. The investment banks made a lot of money by selling MBS, receiving a much higher return than holding treasury bills at 1 percent.
When most creditworthy borrowers already own homes, the financial institutions started providing loans to less creditworthy people. Financial institutions were less concerned with the ability of borrowers to repay their loans as it was believed that housing prices can only go up. If the homeowner defaults, the financial institution can then sell the house for compensation. Furthermore, in the process of securitization, the financial institutions eliminated their exposure to credit risk by selling MBS to investors, shifting the risk to the investors who bought the MBS. The financial institutions had no incentive to properly assess the credibility of the borrowers, requiring no down payment, nor proof of income. This is called moral hazard. Furthermore, the problem here is that investors have no way of knowing the creditworthiness of the sub-prime mortgage holders. In fact, the MBS was packaged in such a way that sub-prime mortgages were bundled together with other mortgages so the ratings did not reflect their risk. This gap in information is called asymmetric information.
Sub-Prime Mortgage Crisis
The sub-prime mortgage crisis arose when interest rates hiked 17 times in years 2004 to 2006. The sub-prime mortgages were on variable rates so the borrowers had to pay more interest on their loans, which they could not afford. Hence, homeowners defaulted on their mortgages. This is not too bad if the mortgage lenders are able to sell the house and provide cash flow to the investors.
However, as more and more homeowners defaulted, the increase in the supply of houses puts downward pressure on house prices. Other homeowners who could afford to repay their loans also stopped making payments as they refuse to pay for a home that is worth less than they are paying for. Home foreclosures were up by 93 percent in 2007 compared to a year ago. The escalation in defaults dried up the cash flow to the investors, meaning the investors were not receiving returns on their security holdings. Investors started abandoning their holdings, selling them at lower prices. New purchases of the securities also stopped and the value of MBS on the financial institutions’ balance sheets plummet. The financial institutions were in trouble as they had borrowed to purchase mortgages. Without investors purchasing the MBS they could not pay back what they had borrowed.
In the first half of 2007, two hedge funds held by Bear Stearns fell by 28 per cent in 6 months. In August 2007, investors holding MBS with BNP Paribas were barred from redeeming cash in US$ 2.2billion worth of managed funds. In September 2008, Fannie Mae and Freddie Mac, two of the largest mortgage providers that relied on issuance of MBS to raise money, revealed large losses and were nationalized. On 15th September, Lehman Brothers filed for bankruptcy,
This video provides a more detailed explanation of the sub-prime mortgage crisis and the securitization process.
The Problem of Asymmetric Information and Moral Hazard
The lack of regulation on the securitization process in the financial system had led to two major problems: asymmetric information and moral hazard. Asymmetric information is a situation when one party has more information than the other in a transaction; in this scenario, the financial institutions had more information about the creditworthiness of the borrowers than the investors do. Investors who were buying MBS were unaware of the risks involved in the investments, especially when a portion of the MBS was given AAA rating (explained in the video). The financial institutions were making lots of money from selling MBS and had no incentive to provide investors with information on the risk they were taking.
Furthermore, by selling securitized loans to investors, the financial institutions had shifted the credit risk off their balance sheets to the investors. The financial institutions had little incentive to monitor the creditworthiness of borrowers since they do not bear the burden of the credit risk. This led to the problem of moral hazard, where the financial institutions are engaging in higher-risked activities by lending to borrowers with no ability to pay back, and imposing this risk on the investors. The financial institutions perceived themselves to be “too big to fail”, so when they ran into trouble, they expected the government to bail them out, as did Bear Stearns, Fannie Mae and Freddie Mac. Hank Paulson attempted to teach a lesson on moral hazard when he let Lehman fail, trying to proving a point that the financial institutions should take responsibility for their own actions. However, this turned out to be one of the biggest economic policy mistakes, resulting in the onset of the GFC.
The process of securitization itself is not a problem, but asymmetric information and moral hazard that arises from securitization can cause problems and have caused problems, as we have seen in the sub-prime mortgage crisis. In the sub-prime mortgage crisis, the financial institutions were borrowing to purchase the mortgage loans. The problem of asymmetric information and moral hazard can be minimized by requiring the financial institutions to hold a portion of MBS on their balance sheet. If the financial institutions are also exposed to the credit risk, they will have more incentive to properly assess the creditworthiness of borrowers. The financial institutions were also highly leveraged, borrowing to purchase mortgage loans from mortgage lenders, thus imposing a capital adequacy ratio would also reduce the risk taken. The sub-prime mortgage crisis could be prevented with these necessary measures, however once the defaults began, with the downwards spiral of the house prices, it is difficult to tell if the credit crisis could have been avoided.
As far as repercussions go, Goldman Sachs was charged US$ 500mln in 2010 and The Guardian recently reported that JP Morgan Chase and Credit Suisse have been fined US$416.9mln for “alleged negligence and other wrongdoing in the packaging and sale of risky MBS”, which is still a far cry from the billions of dollars in investment fund losses, the families and homeowners that were eradicated and the effects of the GFC that ensued.
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