While the origins of the 2008 financial collapse have been well reported — the reckless repackaging of toxic mortgages, the unscrupulous lending, the lack of government oversight — author Howard B. Hill proposes a different explanation. Hill brings a unique perspective to these familiar events; as a 25-year veteran of the securitization market, Hill was on the front lines of introducing many of the analytic techniques that played a decisive role in the crisis.
In Finance Monsters, he divulges the full narrative of how these sophisticated tools were developed, incorporated, and misused by the industry. His book is an urgent, riveting chronicle of innovation that outpaced regulation, and a thrilling blow-by-blow account of how the leading institutions in the field brought about a global crash.
In the following excerpt, Hill recalls the early days of the crisis, in which panic overtook prudence with devastating results.
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As the structured finance credit crisis unfolded, two of the most popular words used to describe it were “contagion” and “contained.” Although both these words share the Latin prefix “con,” meaning “with,” the first word was used to throw gasoline on the fire and the second word was used in an attempt to throw water on the fire that was spreading out of control.
It was common throughout 2007 to hear business leaders, our Federal Reserve Chairman, and a stream of politicians all using the word “contained.” By repeating the mantra “the subprime mortgage problem is contained,” the containment team hoped they could convince the market and the public that it was only those little subprime people who had a problem.
Arrayed against the containment team were the reporters and hedge fund bears who shouted “contagion” every chance they got.
It was enough to make you wonder if either team knew how the capital markets really work. The belief they had in common was that creditworthiness (or the lack thereof) is contagious. The analysis was presented as if they thought that sharing an elevator with a person with poor credit might make a responsible person go home and default on their obligations.
The fact is that simple exposure to subprime borrowers does not make good borrowers turn into bad borrowers. Nor does one investment turn bad just because another does. That kind of contagion is an imaginary malady, like the “humours” doctors thought caused disease before they discovered bacteria.
The containment team looked to all the other classes of debt to assure themselves that credit problems were contained, pointing out that credit card bills, prime mortgages and car loans were still being paid on time. At the same time, the contagion team looked everywhere for evidence that other classes of debt were collapsing.
Meanwhile, the real contagion both should have been worried about was taking hold. The relentless focus in both the financial press and the general press on what they liked to call “the subprime meltdown” was leading investors to do everything they could to avoid any exposure to this sector of the debt market. Some investors automatically sold the stock of banks, insurance companies, mortgage lenders or any entity that might have exposure to subprime mortgage debt, no matter how small, and regardless of whether that exposure reflected any genuine risk or not.
Fire sales took place for financial products containing no genuine risk, such as a bond with top priority for payments and a huge percentage of the structured deal subordinated to it. We sometimes saw these kinds of bonds with 70 percent or 80 percent of the deal in junior positions in a credit “waterfall.”
Let’s see what actually happens in a deal such as this when a mortgage loan in the pool is foreclosed. After the house is sold, selling expenses, legal fees, repairs, etc. are repaid to the mortgage servicer who advanced those costs. Then the proceeds from the sale are forwarded to the Trustee for the securitization. Any loss is recorded as a reduction of principal (“write off”) for the lowest priority bond in the deal structure. Finally, the money that is recovered is used to pay down principal on the highest priority bond. A bond with 80 percent of the deal subordinated underneath it could withstand having every single house in the mortgage pool foreclosed and sold at a small fraction of its former value. Where I was working, we called these bonds “bulletproof,” because they actually get paid no matter what happens, and they could be paid off even faster if there are more foreclosures.
When investors avoid bonds like these, and force them to be sold for very high spreads, they essentially force every other bond to offer the same or higher spread. This is capital markets contagion, and it has nothing to do with creditworthiness.
Billions of dollars worth of subprime debt was being sold for a song, even the bulletproof stuff. The result was that borrowing became much more expensive. This affected both prime mortgage borrowers and foreign governments. Corporate entities also had to borrow operating capital at much higher rates than they would have otherwise.
Soon, investors who bought mining company stocks, agricultural companies or fast-growing foreign companies were disappointed by earnings that came in lower than expected. Lower earnings should have been no surprise, given the fact that the asset-backed commercial paper programs were among the biggest suppliers of trade financing used to cover the cost of metal ores or agricultural commodities until delivery.
When the market avoided buying that commercial paper, those who relied on that funding had to locate new sources of financing. Many good borrowers in the commodities business had to turn to bank loans for their short-term financing. That was already a more expensive source, but became even more expensive as the banks themselves paid higher spreads due to worries about mortgage exposure.
Selling good bonds dirt cheap and making all financing too expensive is the result of true contagion. It was a natural outgrowth of the avoidance of subprime mortgage bonds, no matter what the flavor or concentration. And it makes no more sense than wholesale slaughter of every livestock breed around the world following an outbreak of Avian Flu in chicken flocks in just one country.
One underlying cause for the eventual collapse of our debt markets was the policy reaction to the first recession of the new millennium – an extraordinary period of negative real interest rates.
We witnessed nearly unprecedented government spending increases at the same time that government revenues (taxes) decreased. The net result was huge inflation for assets that could be easily financed and exhaustion of savings to support current spending.
Trusting history, mortgage lenders believed the collateral value of the houses they lent against would not decline in any meaningful way, and certainly not nationwide. The capital markets enabled funding of mortgage loans, even subprime mortgage loans, only 30 to 50 basis points above LIBOR.
With LIBOR as low as 1.10 percent after the Fed lowered short term rates to 1%, a subprime borrower was paying a full 5 percent premium above funding costs even after taking expenses into account. Since the prior peak for loss rates on subprime mortgage loans was only 2 percent to 3 percent annually or 6 percent to 7 percent over the life of the deals, it seemed that there was plenty of cushion against losses.
Homeowners responded to this environment by taking an unprecedented amount of cash out of their homes, either by selling them, or by refinancing. By 2005, “cash out refi’s” were estimated to have added as much as $600 billion a year to the American economy. That was nearly 4 percent of the economy at the time.
The Federal Government was doing much the same, borrowing about $400 billion a year from Social Security and Medicare payroll taxes to spend on current projects, in addition to several hundred billion a year in deficit spending. As a nation and as households, we were trying to borrow our way to prosperity.
At some point, schemes that involve borrowing to support current consumption run out of assets or future income to pledge, or run out of lenders willing to lend. In the case of US housing, both effects combined to help the market “roll over” precipitously.
Effects are often compounded when two unfortunate events occur simultaneously. Virtually all the creditworthy potential home owners (as well as many who weren’t creditworthy) had acquired their first homes. At the same time, the increase in home values came to a halt and this latent source of future income to pay debt service disappeared.
This latent income had actually bailed out many of the subprime borrowers who paid their mortgages, credit cards and car loans by taking out cash through refinancings as the value of their homes increased much faster than the rate of inflation.
The open question is to what extent this latent income also made prime and near-prime borrowers appear to be able to handle their debt loads better than their earned income would allow.
The politicians and talking heads that fell into the “contained” camp spent most of 2007 focusing on the good performance numbers for credit card debt, prime mortgages, auto loans, and other debt. They concluded that the rising tide of mortgage delinquencies was limited to the typical subprime borrower, a borrower who lived as little as one or two paychecks away from defaulting on their debts. The “contagion” camp was watching the same statistics, looking for an uptick in problem credits to justify their view of worldwide credit destruction.
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Excerpt from Finance Monsters by Howard B Hill. Copyright © 2014 by Howard Hill. Published on November 6, 2014. All rights reserved.
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