The Tent of Sherlock Holmes

Sherlock Holmes and Watson pitch their tent and go to sleep.  Hours later, Holmes jogs Watson awake and commands: “Look up and tell me what you see.”  Dutifully, Watson gathers his thoughts.  “I see countless stars,” he begins, “in the immeasurable vastness of the heavens.”  He ponders how tiny he and his friend are in comparison and can say no more.  “What is it you see, Holmes?” he asks.  “I see some scoundrel stole our tent.”

Watson sees the concept he always sees, Holmes sees what changed.   This post examined finance’s mechanisms – securities, credit and insurance.  Now we can focus on what changed to make the 2007 economic collapse possible.  Because human nature did not change, we will defer to a future post how what did change was exploited.

The combination of several changes led to the 2007 perfect financial storm.

The root cause was the Basel I agreement in 1988 which, following the messy liquidation of a German-based bank, set minimum capital reserve requirements for all G-10 banks based on the relative risk of five classes of assets.  Domestic sovereign debt required zero reserves, corporate debt 8%, intermediate types 0.8%, 1.6% and 4%.  Residential mortgages required 4%.  That got bankers thinking.  How could they keep making more loans without increasing their capital reserves?

Mortgage securitization was the first answer.  It had been developed in small steps associated with the growth of Fannie and Ginnie Mae then heavily promoted by Washington in response to the 1980s Savings and Loan Associations (S&L) crisis.  Very high interest rates established to quell inflation had caused almost a quarter of Savings and Loan Associations to fail.  Securitization attracted big investors and helped stabilize the residential mortgage market.  Now commercial banks began using securitization to get mortgages off their balance sheets so they would need no corresponding capital reserves.  They could keep the origination fees and keep issuing more mortgages.

Capital reserves could also be avoided using Citigroup’s 1988 invention of off-balance-sheet entities, e.g., SIVs, Structured Investment Vehicles, which at their 2007 peak had over $400 billion of assets.

The new mechanism for securitizing mortgage loans, the Collateralized Debt Obligation (CDO), was invented in 1987 by now-defunct Drexel Burnham Lambert to securitize mortgage-backed loans for a savings institution that later became insolvent.  Their issuance exploded to more than $180 billion by Q1 2007.  The credit quality of CDOs declined as subprime and other non-prime debt grew from 5% in 2000 to 36% of CDO assets in 2007 but the credit ratings of CDOs did not change.

Rating agencies ignored the risk of a nationwide collapse of housing values when giving CDOs the highest grade.  They also tended to give high ratings to all CDOs because they were paid for those ratings by the CDO originators.

CDOs are complex instruments.  Investors worried about the risk of default on the underlying loans.  The answer was JP Morgan’s 1994 invention of the Credit Default Swap (CDS).  In return for a small payment, the buyer of a CDS would get the full amount of the loan if the borrower defaulted (the seller of the CDS would get possession of the loan).

A CDS is different from an insurance contract because it pays off  whether or not the CDS buyer suffers an actual loss.  Unlike life or fire insurance, you can buy a CDS on a loan made by someone else.  More dangerous, the seller of a CDS is not required to have capital reserves.  And there was no oversight because CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.

Credit Default Swaps soon came to be used for purposes very different from risk mitigation.  For a small outlay you could buy a CDS to collect the entire face value of a CDO if it collapsed.  Multiple CDSs could be stacked on the same CDO and CDOs began to be collateralized by other CDOs.   It was easy to see that betting against CDOs whose underlying loans would default could generate big profits, and if you borrowed enough money to make huge bets your winnings could be gigantic.

Speculative frenzy drove the total “value” of outstanding Credit Default Swaps over $60 trillion by the end of 2007, four times as high as GDP, almost the size of the entire global economy.

Meanwhile, the Fed was holding interest rates very low to maintain investor confidence after the dotcom bubble’s collapse in 2000-2001.  That enabled lower income buyers to enter the housing market, encouraged refinancing and led to lower and lower underwriting standards that culminated in NINJA (no income, no job, no asset) loans to people who would inevitably default, but not within the 90 days it took to securitize and resell their mortgage on which the originator would keep the origination fee.

The last regulatory change for the perfect financial storm is the Fed’s relaxing of the 1933 Glass–Steagall Banking Act which limited banks’ size and barred commercial banks from securities activities.  Looser “interpretation” of the Act that began in the early 1960s was far advanced by 1998 when Citibank merged with Salomon Smith Barney, one of the largest US securities firms.  In 1999 the Act was repealed altogether.

The financial system was soon dominated by behemoths.  In 1990, the 10 largest US banks had almost 25% of the industry’s assets.  That grew to 44% in 2000 and almost 60% in 2009.  The two biggest banks in housing finance had 44% of US mortgage originations in 2009.  Oversight, or indeed management, of these giants whose operations are global, complex and opaque became, and still is, little more than a hypothetical possibility.

When the $22T housing bubble burst in 2007, around $5T was very rapidly lost.  Financial institutions had too little capital reserved to cover such a loss and unknowable inter-dependencies.  They had traded so much with each other that failure of one would likely bring down others.  The CDS insurance sold by AIG and others to mitigate the risk was useless because they had no reserves to compensate those whose assets were suddenly worthless.

That was when the final change took effect, a non-regulatory one.   In 1998, Long-Term Capital Management, a hedge fund that used 100:1 leverage to buy over $100B of emerging market bonds and $1T of derivatives, had lost $5B when Russia defaulted on its debt.  Fearing market panic, the Fed pressured the banks that lent the $100B to buy LTCM’s assets so it could be promptly liquidated.  Wall Street executives learned from that event.  They would likely be bailed out, too, if their bad bets were big enough to shake the markets.

When the banks and shadow banks bets did go bad in 2007, Washington stepped in with $2 trillion of tax-payers’ money to halt what was fast shaping up to be a potentially economy-wide bank run.

Financial institutions had come under stress because of bad bets, which their high leverage turned into a crisis with potentially huge domino effects.  We cannot know how serious the results would have been if the crisis had been allowed to play out.  We do know the leaders of the giant financial institutions got the one critical bet for their own future right, the Federal Reserve and Treasury did bail them out.

I will next explore how that financial moral hazard developed; how Washington came to be Wall Street’s savior and made financial and economic crisis inevitable.

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