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There is a storm. Hurricane Florence is hitting me. It is expected to hit the Carolina coast as a Category 3 or 4 hurricane Thursday. I'm 125 miles inland, so the winds should not be hurricanes when they arrive, but the rain and power outages could be severe.
Ten years ago, there was another storm of longer duration: a financial storm caused by the bankruptcy of Lehman Brothers. However, the root causes occurred earlier in many different sources that came together as a perfect storm.
Context
On September 15, 2008, Lehman Brothers, a major Wall Street investment bank, declared Chapter 11 bankruptcy. This bankruptcy remains the largest corporate bankruptcy in American history. Many experts attribute this crisis to a financial crisis that the federal government and the Federal Reserve have tried to contain. Lehman had been away from his investment bank roots and had accumulated risky assets on his balance sheet, including many subprime mortgages. It also took advantage of its balance sheet to extreme levels, which translated into a net worth of only about 3% of assets in 2007. This means that if 3% of their assets deteriorated, they were roasted. Given the degree of risk of their assets, it was only a matter of time.
The 2007-2009 recession had two main causes. The crisis of high-risk mortgages was the most important. At-risk mortgages were residential mortgages that were primarily for families or individuals. Between 2004 and 2006, the number of subprime mortgages skyrocketed. This coincided with a similar rise in real estate speculation, namely houses bought to be returned instead of living. Most of these mortgages had a low initial rate before adjusting to the market interest rate. They generally had less income verification and were often entrusted to borrowers whose credit was lower than normal. This article will focus primarily on why risky loans have grown so fast and who was to blame.
An interesting aspect is that most of the victims of risky loans in the banking world were the largest banks. In this case, the so-called smart money (the big boys) were the ones who suffered the most losses. Community banks, including the one I worked for, also took out risky loans, but almost always sold them as quickly as possible. The big banks kept them and bought more.
The second cause of the 2007-2009 recession is the same as the one that triggered the 1990-91 recession, the bad commercial real estate loans. In the 1980s, savings and loans were given new powers to make these loans. They piled up without understanding the risks. The result has been the crisis of savings and loans and more than 1,000 S & L and many banks have sunk. The situation in 2007-2009 was similar, but the number of banks and S & L decreased. The memories of bad loans from 1990 to 1991 had disappeared in banks and S & Ls. Loans are cyclical and the further away bad loans are, the more memories fade and the risks increase. The real problem is that there are too many banks, which means too much competition (demand) for loans. Hundreds of banks and S & Ls also fell under this period. All the banks and S & L that were underutilized due to bad commercial real estate loans were community banks and not big banks. As I mentioned earlier, few community banks or S & Ls have had significant exposure to risky loans.
Causes of the subprime crisis
Listed in my order, the worst first.
- Mortgage creditors: Politicians will never tell you because they insult their constituents. Economists and the media will never tell you because it insults their readers. Lenders will never tell you because they insult their customers. But at least half of the blame must go to people who have accepted mortgages with conditions that they could not afford. The purchase of a home is one of the most important decisions that most people take during their lifetime. This is a simple mathematical calculation to find out if you can afford payments on a loan. The only calculations needed are basic addition and subtraction. In addition to those who buy homes to live in, many people have been caught in speculation and frenzy. Some did so knowing the risks, but most did not. They just knew other people who were making a lot of money. It was an unsustainable craze. House prices were rising, fueled by easy credit, and nobody kept thinking about what would happen when the music stopped. In addition, most subprime loans experienced a moderate purchase rate for a few years. Too many people have not figured out if they could afford the mortgage when she adapted.
- Rating agencies: The entire subprime bubble would not have happened without the rating agencies. They were facilitator number 1. Most subprime mortgages were sold to companies that bundled them into large mortgage-backed securities. These titles were often divided into different slices. The last tranches were the riskiest, the first to absorb losses. These securities and tranches have been reviewed and rated by S & P, Moody's and Fitch. They burdened the investment notes on most of them. Buyers of these securities were mainly institutions (insurance companies, large banks, mutual funds, pensions, etc.). They have rarely looked under the hood for two reasons. First, they trust rating agencies that have a good reputation. The second was that it would have been a huge job to examine a large sample of the underlying mortgages. Without these premium notes, there would have been no demand for most of the titles sold. These ratings created demand among buyers who wanted a higher interest rate on a premium security (assumed to be safe). As a result, most mortgage companies and even banks were willing to make underlying high-risk loans. Even though they knew that the loans were risky, they could find a buyer and make a quick profit. Part of the problem is that the employees of the rating agencies made a small fraction of the money that the employees were collecting the mortgage-backed securities. The smartest people worked for Wall Street and the other securities companies and they were able to play the rating agencies to some extent.
- Wall Street: Wall Street is the favorite boy when there is a financial crisis. There is no doubt that this deserves some blame, but certainly not at all the blame. Wall Street companies did several things that made the situation worse. First and foremost, they were among the largest packagers and sellers of mortgage-backed securities at risk. They also created something called credit default swaps. These were mainly insurance policies on the losses resulting from these subprimes, mortgage-backed securities. Since credit rating agencies rated most of the quality of mortgage-backed securities, credit default swaps were cheap. The Big Short book talks about these exchanges that exploded when risky loans started to go wrong. The hardest part was actually AIG, an insurance company. All Wall Street businesses have taken too many risks to keep a large amount of risky loans on their books. Most also sold credit default swaps. All Wall Street companies were over-indebted, which amplified the impact of losses incurred.
- lendersMortgage companies and banks made the majority of subprime loans. As I mentioned earlier, most recognized how risky these loans were and sold them immediately thanks to the demand created by the rating agencies. Some lenders, mainly non-banks, went further and gave their borrowers mortgages that they knew they could not afford. This was not the norm but was common.
- The Federal Reserve: Alan Greenspan received the rare rock star treatment for an official. Without a doubt, he appreciated the public attention that he was getting. As president of the Fed, the easiest way to keep people happy is to keep rates low. The ruling party politicians love you because you stimulate the economy. Borrowers like you because you reduce their costs. Lenders like you because there are more borrowers. The previous recession from March to November 2001 was short and relatively moderate. The Fed lowered the Fed funds rate from 6.50% to 1.75% in December 2001. It then kept the rates relatively unchanged until June 2004, when it began raising rates again, although slowly.
- FNMA and FHLMC: Fannie Mae and Freddie Mac were two publicly traded quasi-public companies created by the federal government. Their purpose was to buy mortgages from banks and S & L and to keep or package them in mortgage-backed securities and resell them. They were historically extremely exploited. The reason being that there had been no real estate credit crisis since the Great Depression. However, both made the situation worse by taking more and more risky loans. The federal government was complicit because it put pressure on them to do it. They were placed in government guardianship on September 8, 2008, a week before the Lehman bankruptcy.
Were there heroes?
Yes, there was one, and you would not believe who it was!
On October 3, 2008, the federal government, led by Treasury Secretary Hank Paulson, approved the Disaster Relief Program, or TARP. The intention was originally to buy troubled assets from banks, which would have been a very messy process. It was quickly modified to inject capital into banks by buying preferred shares and warrants from banks. Banks in good health and good health have no choice, they must accept the government as a preferred shareholder. The weakest banks were left to die. The total spent was $ 205 billion. Timothy Geithner succeeded Paulson in early 2009 and completed this effort.
This program has been universally analyzed. Banks are still unpopular, but they have become the bane of government, the media and the public. The polls revealed a negativity of nearly 90% of the public towards the program, the two parties having criticized it. This was seen as a bank bailout. In reality, it was the most effective way for the government to stabilize the financial system. The reason for success is that allowing a bank to go bankrupt costs taxpayers at least five times more than keeping it alive with sufficient capital. This is because the prices realized in a liquidation are very low. Preferred share investments have not only stabilized the banking system, but makes money for the government. I do not remember any government program that has been successful and that has also made money.
Where are we today?
The public has become much wiser and more conservative in taking mortgage loans. Many Generation Y members have even delayed the purchase of their first home based on lessons learned by friends or family members. This has significantly slowed the current expansion of new and existing home purchases. New home sales remain below historical averages.
Rating agencies continued without consequences. Agencies now have a history of damage from higher risk, higher leverage and lower home prices that they can use in their models. They are unlikely to repeat their mistakes anytime soon, at least with mortgage-backed securities.
Wall Street was saddened by its near-death experience. Wall Street investment banks, as well as community banks and S & L have been forced by the government to increase their capital levels and reduce their risk-taking activities. They are much better capitalized now. In fact, banks and S & Ls are probably the best capitalized. There will always be problems with Wall Street, but the systemic risk is much lower today. Incidentally, many believe that the derivatives market for interest rate swaps, currency hedging, futures and options are so important that they contributed to the last recession. This market is huge but well covered. In fact, only credit default swaps posed real problems during the last recession, and they do not pose as many problems.
The subprime loans have not recovered much from the 2007-2009 recession. This has resulted in a decline in home sales due to a credit crunch.
Sounds good until here?
The Fed kept interest rates lower during this cycle. The Fed Funds rate was below 1% between 2008 and 2017, an extremely long period. Will there be consequences? Well, non-financial corporate debt now stands at 45% of GDP, the same level as in 2008. Companies have accumulated debt for acquisitions and share buybacks due to low interest rates. Student debt reaches a record level. It currently stands at $ 1.5 trillion, compared to about $ 671 billion in 2008, according to the Federal Reserve Bank of New York. This is partly because people who have lost their jobs during the last recession have acquired new skills. But part of it is also due to low interest rates. The worst, of course, is the debt of the federal government. Republicans have ceased to be the party of no and are racing with Democrats to find ways to increase our budget deficit. There are no more tax conservatives in Washington. We are expecting a $ 1 trillion deficit shortly, in a time of a strong economy. This is as important as during the last recession. We could consider a $ 2 trillion deficit in the next recession. This deficit was made possible by extremely low interest rates, kept low for too long by the Fed.
If we go into recession in the next year, the Fed may not have enough ammunition to fight it, as the rates are still too low and their balance sheet too heavy. It's now the third cycle that the Fed has kept its rates too low long. You may remember Alan Greenspan's statement of irrational exuberance in 1996. But they did not start raising the Fed funds rate for at least two years, which contributed to the dot-com bubble. Even worse, other central banks around the world have followed the Fed with accommodative policies in the long run, some exceeding the Fed. There will be repercussions.
Disclosure: I / we have no position in the actions mentioned and we do not plan to enter positions in the next 72 hours.
I have written this article myself and it expresses my own opinions. I do not receive compensation for this (other than Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.
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