Chapter 1. The Fed Sentences the Consumer to Debtor’s Prison

If you approached someone on the street and he was old enough to recall where he was on November 22, 1963, he probably could tell you what he was doing at the moment he heard that John F. Kennedy had been shot. The same could be said for people of many different generations of their ability to recall profound historic events ranging from the fall of the Berlin Wall on November 9, 1989 to the terrorist attacks of September 11, 2001. On the other hand, if you asked someone what he was doing on June 25, 2003, you would likely get a blank stare. That is because unless you were employed in some finance-related business, or were a regular observer of the financial markets, the day the Federal Reserve lowered its Fed Funds rate to 1.0% was just another day. Far from it. This event played a discernible role in sparking a chain of events that would come to affect hundreds of millions of people’s lives the world over, a little more than five years later.

June 25, 2003 was symbolic of an effort that the Federal Reserve and its leaders had undertaken to cushion the blow from the March 2000 unraveling of a stock market bubble that had in its own right reached historic proportions. Fearing the pangs of excess economic capacities, rising unemployment, and deflation, the Fed was then in the final steps of its assault on the fallout from the burst stock market bubble. In fact, beginning with the 6.0% Fed Funds target rate in March 2000, the June 25 rate cut represented a 500 basis point reduction in this key rate from which all other financial contracts take their cue. At the time this move represented the most aggressive accommodative interest rate policy since the 1950s and was the economic equivalent of slamming a sputtering automobile’s gas pedal firmly into the floorboard. As it were, the world’s largest economy proved up to the challenge and responded in kind. In a relatively short time, Americans were accepting the Fed-induced economic incentives to borrow at low interest rates and forgo saving in favor of consumption. In sum, the interest rate policy worked according to plan, and the U.S. economy began to accelerate in the third quarter of 2003 on the back of higher consumer spending.

An Economic Recovery Built on Borrowed Money

The battle-tested U.S. consumers who had performed so well in the wake of the 2000 stock market bust and September 11 attacks were once again stirred by the Fed’s call to arms. They grabbed their wallets, ready to charge ahead. They did not disappoint. Third quarter 2003 gross domestic product (GDP) growth of 8.2% represented the fastest growth in twenty years for the U.S. economy. The policy makers were quick to take credit for what on the surface appeared to be a virtuous recovery in U.S. economic growth. In what seemed trivial rather than prophetic at the time, consumer spending was led by a surge in home and car sales.

So although many financial observers took comfort in the resumption of economic growth during late 2003, a longer-term perspective suggested that the latest economic activity instead represented a resumption in the long-running story of ever-higher household debt and lower personal savings rates for the American consumer. In fact, the personal savings rate in the United States had been in a steep multidecade decline beginning in the early 1980s, as shown in Figure 1.1.

Figure 1.1. U.S. personal savings rate as a percentage of disposable personal income

Source: Bureau of Economic Analysis

As mentioned, the decline in savings was accompanied by a steady rise in household debt since the early 1980s. To bring the rising debt level into focus, Figure 1.2 presents it as a percentage of GDP as it stood in 2003.

Figure 1.2. U.S. household debt as a percentage of GDP

Source: Federal Reserve

Despite the flimsy nature of this lower-saving, higher-borrowing economic paradigm, policy makers soon grabbed their pom-poms and joined in a self-congratulatory pep rally of economic sentiment. By the end of 2003, consumer sentiment had rebounded in the United States, and a new feeling of optimism was taking hold. Based on the University of Michigan’s Consumer Sentiment Index, which showed a reading above 90 by year-end, Americans had turned nearly giddy when compared to the dark mood back in March 2003 surrounding the U.S. invasion of Iraq. Still, in spite of the good news on consumer sentiment, something was amiss in this economic rebound.

Upon closer inspection, an observer could see that as the economy accelerated in late 2003, it was not supported by the usual accompaniment of increased payrolls or higher personal income. The absence of an improvement in these variables represented a puzzling departure from the previous six recessions and subsequent recoveries. Instead of being propelled by a more wholesome expansion in the fundamental drivers of the economy, this recovery was being driven by an expansion in consumer spending backed by increasing levels of household debt.

As it turns out, the low interest rates provided by the Fed created a strong incentive for Americans to buy homes, because the low Fed Funds rate translated into low mortgage rates as well. As this home-buying activity accelerated due to the persistence of low interest rates, home prices began to rise due to the increasing demand. When Americans saw the prices of their homes increase, they felt wealthier, which was a natural reaction. As Americans felt wealthier, they sought ways to utilize their wealth to consume more. In order to consume more, they began to borrow against the higher value of their home and, in turn, meet their goal of spending a little of that new wealth. As consumers spent more, U.S. GDP improved (nearly 70% of U.S. GDP was consumer spending), and, voila, the economy was again growing. As U.S. GDP picked up from consumer spending, world GDP growth also accelerated, because Americans were avidly buying goods imported from many different countries. All was right, and everyone felt good, because it was an economic miracle. Policy makers again marveled that the U.S. economy was so resilient and that growth had rebounded so soon after the economic shocks of the 2000 dotcom bust and the September 11, 2001 attacks. On the other hand, a closer look at the data suggested that Americans were now attempting and at least temporarily succeeding at borrowing their way into economic prosperity. From a commonsense perspective, this prompts the following question: Why did Americans believe they could borrow their way to better times and continuously higher standards of living? The answer lies in one of the most expensive financial myths ever floated off a tongue:

House prices do not fall in value.

Obviously, as we turn to the present day, and the world economy has been bludgeoned by years of falling home prices, this myth has taken its place alongside the Easter Bunny and Tooth Fairy. Better still, though, plenty of people back in the early 2000s correctly predicted the oncoming housing bubble and the shortsightedness of the housing bulls. One man in particular, Sir John Templeton, described the formation of the housing bubble as early as 2001. He recalled that during the Depression of the 1930s, housing prices in some areas of the United States had declined 90%. Sir John and several other wise observers’ opinions did not matter, though, because in any financial bubble, inconvenient Cassandras are shoved aside until they later become vindicated by history.

Irrespective of the prescience of some observers, there was heavy financial incentive for Americans and their developed-market friends to buy into the hype. Incentive number one was the creation of sudden wealth from a dramatic rise in home prices. Historically, the wealth effect from rising asset values often proves ethereal to those who mishandle its psychological by-products. Nonetheless, the paper wealth that could be monetized from newly opened home equity lines of credit felt like real wealth to those involved. For that matter, all the flat-screen televisions, new cars, and around-the-world vacations purchased with the extracted equity had most Americans feeling like Donald Trump. As you can see in Figure 1.3, which shows house price data compiled by Yale University professor Robert Shiller, the sudden rise in house prices due to low interest rates, and a few other financial “innovations” that we will discuss shortly, demonstrate the magnitude of what transpired in three short years. Figure 1.3 shows the professor’s calculation of an index of home prices in the United States that is adjusted for inflation, or presented in real terms. In real terms, house prices in the 113 years leading up to 2003 had only appreciated at an annualized rate of 0.4%. However, in the three short years from 2003 to 2006, the index appreciated 32.5%. Jerry-rigging an entire economy with easy money and loose lending will do that.

Figure 1.3. Robert Shiller’s real home price index

Source: Robert Shiller, Irrational Exuberance, 2nd Edition, 2005, Princeton University Press

In light of what was transpiring in the U.S. housing market (and others), it is easy for us to armchair-quarterback the Fed and second-guess its interest rate policies. On the other hand, the Fed’s established conventions for managing the economy meant that by and large, it tended to ignore asset prices and any developing asset bubbles in favor of simply mopping up the subsequent mess with yet another round of loose monetary policy (as it did after the dotcom bubble). The Federal Reserve had made it relatively clear in its rhetoric that it would address inflation as it arose in its traditional Consumer Price Index (CPI) measure of goods and services in regard to setting interest policy. House prices made for a hearty academic discussion, or maybe a lunchtime speech to a club, but they would not figure into policy-making decisions.

Some consider the housing bubble an obvious form of runaway inflation resulting from aggressive interest rate policy. For those people, the distinctions between the price actions in the thoroughly massaged components of the CPI compared to what is often the most important purchase a person can make in his or her lifetime ring hollow. With that said, the alternatives would be having the Fed inflating and pricking asset bubbles as it sees fit in any of the various markets—equities, real estate, commodities—or simply having no Fed and allowing the market system of banks and lenders to determine interest rates. The first alternative implies that the Fed can “time” asset markets with its policies, no differently than speculative market timers attempt to do in the stock market. Chances are the government would prove to be a terrible market timer, alongside all the other pundits who try it in the stock market. The second alternative was actually in place for some time in the United States and occasionally led to various liquidity and solvency panics, such as the Panic of 1907. Of course, it goes without saying that the current Fed managed to steer us into a liquidity and solvency panic also. So perhaps no one-size-fits-all banking system can please everyone or avert occasional disaster.

Returning from that brief digression, if we consider that the Federal Reserve was primarily focused on the CPI at the time, we can appreciate that from its perspective it saw mostly sunny skies on the horizon and had little reason to adjust interest rate policy. So during the course of late 2003 and the first half of 2004, the Federal Reserve saw more possible risk in economic growth stalling and producing some possible deflation, as opposed to a risk of acceleration in economic activity creating upward pressure on prices. To some extent, this was true in the traditional economy of goods and services at the time, where there was still apparent slack in the productive resources regarding employment and capacity utilization. However, this perspective ignored what was occurring in asset prices, such as residential and commercial real estate. In turn, this phenomenon of steadily growing GDP and low inflation measured in the CPI rekindled the often-used term “Goldilocks” economy.

The Fed’s Potion of Low Rates and Rising Home Prices Becomes an Economic Elixir

The term “Goldilocks” when used in reference to an economy alludes to low inflation and modest economic growth. In other words, it’s not too hot and not too cold, just like the young girl’s favored bowl of porridge. This economic environment is clearly ideal for a number of activities, but the Goldilocks economy of the early 2000s was far from ideal. The problem was that the Fed held rates too low for too long, waiting until mid-2004 to edge up the Fed Funds rate to 1.25%. By holding rates in this aggressive range—for instance, below 2% from late 2001 through late 2004—the Fed provided a multiyear period of economic incentive to consume rather than save. Consumers typically see little reason to sock money away at such painfully low rates of interest. Put another way, people do not feel like they are giving up much in the future by consuming in the present when interest rates are exceedingly low. When interest rates are high, people recognize the potential income to be gained from saving, and typically they respond to this market signal. Because policy makers want GDP to grow, and U.S. GDP is heavily tilted toward consumer spending, they viewed low interest rates to spur consumption as a natural solution. As we alluded to earlier, consumers began to view their homes as an economic panacea to nearly all their financial problems. For instance, we know from our earlier discussion that wage growth in the United States did not rebound in its typical fashion coming out of the 2001 recession. This was of little consequence in the Goldilocks economy, because as house prices increased in value, homeowners awarded themselves with a raise by extracting the increased home value out of the house through a home equity line of credit. This meant in effect that homeowners could treat their house like an ATM (as long as prices continued rising). So, economic problem number one, which was stagnating income levels, was solved by the low interest rates that spurned home purchases, which in turn continued to drive home prices higher. Problem number two with the U.S. consumer also draws back on our earlier discussion regarding the ever-diminishing personal savings rate. Given that homeowners were tying up increasing amounts of financial resources in their homes, and these same homes were steadily increasing in value, these consistent capital gains were thought to be doing all the saving on behalf of the homeowner. Extending this linear reasoning into time meant that when retirement came, homeowners could simply sell their house to downsize into a smaller home and thereby save the capital gains from the transaction to provide funds for future income. To be fair, a home can be an adequate store of value over time and provide some protection from inflation, but it rarely makes sense from a risk standpoint to place all your financial resources into a single asset, whether a house or a single stock. It also goes without saying that you should not use too much leverage to obtain an asset, whether a mortgage or a stock, unless you can handle the downside. In this case, though, any conception of risk management was ignored in favor of getting in on the game. Homeownership had left the sphere of utility and had become a key driver of the U.S. economy. Rising home prices were leading to increased wealth and higher standards of living. Figure 1.4 shows the net worth of U.S. households. It is easy to see that Americans had every reason, based on the supposed value of their balance sheets, to feel wealthier with each year that passed in the housing boom. With every passing year, Americans were getting wealthier and wealthier without lifting a finger—or so it seemed.

Figure 1.4. Net worth of U.S. households

Source: Federal Reserve

A Chicken in Every Pot? Try a Hummer in Every Garage

Every time period or era has a set of images or symbols from popular culture that stick in people’s minds. The 1970s gave us sideburns and endless shades of orange and brown. The 1980s offered neon colors and white suits with rolled-up sleeves. The 1990s provided the drab Seattle grunge look. In the 2000s, American culture shamelessly flaunted the height of its self-indulgence with an array of gluttonous icons, including a Hummer parked in front of a McMansion (or crib, if you prefer). Fair or not to the owners of these beasts, the Hummer became emblematic of a culture that was embarking into a bold new frontier of wasteful excess. Originally it was adapted from the U.S. military vehicle called a Humvee, which rumbled into living rooms around the world during the live broadcasts of the U.S. military’s Operation Desert Storm in Iraq. This vehicle was famously enthused among suburban warriors through its endorsement and ownership by Arnold Schwarzenegger. The imposing, heavy SUV eventually became reviled among environmentalists due to its significant thirst for gasoline and brash presence on the road (the originals were basically too wide for most standard lanes and parking spaces). Mr. Schwarzenegger, demonstrating his political skills, sufficiently sniffed out the green backlash against his favorite toy and retrofitted one of his half dozen or so Hummers to accept biofuels. As if wasting corn instead of oil makes it better. Turning to the data, we can see how quickly the Hummer became popularized as a key accessory to the red-hot McMansions selling around the country. In Figure 1.5, data from General Motors illustrates that in 2001, a mere 768 Hummer vehicles were sold, but by 2006, GM was selling 82,000 of these vehicles per year.

Figure 1.5. Annual sales by unit of the GM Hummer

Source: General Motors

One of the more puzzling sidebars to the explosive growth in sales of Hummers relates to their notoriously bad gas mileage and how this rise in sales coincided with substantial increases in the cost of oil. The gas mileage data for the larger Hummer H2 and H1 models (the H1 was discontinued in 2006) is not published, but it is anecdotally pegged at around 10 miles per gallon in the city and 14 on the highway. Needless to say, the same loose monetary policy propelling house prices had also infiltrated automobile financing, since these cars cost upwards of $50,000. But with the teaser “zero-percent” financing carrot dangled, many consumers chased the bait. If it was a stretch to afford one, no matter; the house could be sold for a large profit sometime in the future and would pay for everything. So although oil prices rose from approximately $18 per barrel in 2001 to $77 per barrel in 2006, a mere 328%, sales of Hummers gurgled ahead every step of the way. Under normal conditions these types of increases in the price of oil help put the brakes on an economy and conspire to bring on a recession. Although it is difficult to conclude that oil price shocks are the cause of postwar recessions, they always seem to be hanging around the scene of the crime. For evidence, consider the coinciding oil shocks and global recessions of 1973 to 1974, 1979 to 1980, and 1989 to 1990. The underlying factors of geopolitical-induced supply disruptions underscored those prior supply shocks (think Iran hostages, Gulf War) and spurred rapid price increases in the preceding periods. However, the 2001 to 2006 run-up was more likely due to surging demand in the emerging markets, coupled with an utter stagnation of production in the Organization for Economic Cooperation and Development (OECD) countries. Nevertheless, a quadrupling of oil prices over six years is a serious matter for a group of consumers who witnessed little growth in their income over the corresponding time horizon. This should have presented a major problem for the economy, but U.S. consumers had a trick up their sleeve: borrow more money. The answer was to offset these rising expenses by obtaining a raise in income—negotiated not with an employer, but with a banker who extended more credit as needed. Figure 1.6 shows that the amount of debt households were taking out to maintain a supersized lifestyle grew at a steady double-digit rate from 2000 to 2006.

Figure 1.6. Year-over-year growth in total household debt

Source: Federal Reserve

In the wake of this behavior, a new pattern of financial success came into acceptance: maximizing the amount of money you could invest in residential real estate. The old models of working harder or advancing through self-improvement were tossed aside in favor of the game of continuously taking out loans, buying homes, and selling them at a profit. This easy path to wealth creation has been tried and has failed so many times in the history of the world’s financial markets that the events have gained notoriety, ranging from tulips in the seventeenth century to technology shares in 2000. The reality is that these financial events occur frequently over time and are just a function of human nature. The time and location change, but this script, like others before it, was followed with precision. What began as an easily discernable bull market in real estate soon transformed into near hysteria. Any stock day traders who were bold enough to get off the mat following the dotcom meltdown were the perfect candidates to jump aboard the Fed’s latest amusement park ride—flipping homes in a housing bubble. For anyone who was unknowledgeable on the subject, this was of little consequence, because a seemingly endless number of self-help real estate seminars, infomercials, and cable TV shows were dedicated to showing you how to cash in on the real estate bonanza. The numerous TV shows were surprisingly entertaining. Most often they documented a novice flipper of some variety, a person or couple, purchasing a somewhat rundown or neglected property (for what appeared to be way too much money). The show then followed their progress as they attempted to install granite countertops, stainless-steel appliances, huge spa-like master bathrooms, or whatever superficial high-end touches would distract the buyer from the smell of mold or the sagging foundation and help them flip the house for a quick buck. Invariably, the show’s subjects always discovered that not just anyone can knock out walls, install cabinetry, hang drywall, rewire a room, or replace rotted window frames, all while staying on budget and completing the job in a few weeks. Usually some outside help (such as a brother-in-law or cousin who was a contractor) had to be called in to help get the job done as its complexity, cost, or scale predictably spiraled out of control for the greenhorns. Still, the flippers would manage to complete the job, stage the house, and make the sale, usually at a much smaller profit than anticipated, but nonetheless at a profit. When asked about their experience at the show’s conclusion, they always replied, “I can’t wait to do it again!” Interest-only mortgage: $12,000. Appliances: $20,000. Paint: $300. Confusing a bull market with genius: priceless!

The Three Cs of Credit Give Way to Financial Innovation

If American consumers were addicted to easy credit and all the assorted highs that resulted from buying more stuff, surely some dubious counterparties were supplying this stream of never-ending credit. Time to meet their drug dealers.

In 1912, the famous American financier J. Pierpont Morgan was called in front of Congress to offer testimony during some variety of Congressional investigation into Wall Street practices. The senators questioned Mr. Morgan on his practice of extending credit. Mr. Morgan famously discussed, to the senators’ dismay, the role of integrity and character in the lending process. The senators were digging for a response that uncloaked “good ol’ boy, make the rich richer” types of lending criteria. To their surprise, the senators received a far different answer regarding the profile of people to whom Pierpont Morgan sought to lend money. He answered, “He might not have anything. I have known a man to come into my office, and I have given him a check for a million dollars when I knew that he had not a cent in the world.” His point was, know your customers, and know their character. This practice in banking, knowing your customers and lending on character alongside collateral, was followed as a best practice in banking for many decades.

Unfortunately for the few austere bankers left in the world, several financial “innovations” that occurred in the latter part of the twentieth century gashed a deep void where the role of character once stood. The opening salvo of financial innovation was first heard in 1970 as the capital markets were introduced to the securitization of mortgage loans. Simply put, this meant that loans that had normally been held on the bank’s books were packaged alongside a group of similar loans that the bank then sold to an outside investor in the form of a tradeable security. That same year, the song “We’ve Only Just Begun” by the brother-sister singing duo The Carpenters raced up the charts. However apropos, the song was probably not directed at the burgeoning market of structured finance, but it may as well have been. The game of packaging home loans and nearly every other type of credit into a tradeable security was set to ascend from financial novelty to global infamy over the course of the next thirty-plus years.

The supposed virtues of the securitization market relied on the fact that loans of all varieties could be marketed to a considerably larger investor base, beyond the traditional balance sheets of a lending institution. These securities were effectively assimilated into the bond market, so from that point on nearly any type of investing entity from almost anywhere in the world could hypothetically become a creditor in these asset markets. These could range from a bond mutual fund in the United States, to a pension fund in Europe, to a hedge fund in Asia. The result was that there was much greater demand for these loans than likely imagined and, in time, the market grew to be large. Forever opportunists, U.S. government institutions such as Congress quickly grasped the social benefits of these investments. They recognized the ease with which more and more Americans could attain the goal of home ownership through this innovative financing process. To the U.S. government, this looked like a nobrainer. The rapid proliferation of the American dream created happy voters, so the U.S. government had plenty of incentive to grease the wheels of this financial machine. One way the U.S. government greased the wheels of the securitization market was to implicitly backstop the loans securitized and sold by Fannie Mae and Freddie Mac. For instance, banks around the United States were able to sell their loans to Fannie and Freddie, who then for an extra fee would guarantee that the securities they created were protected against default from the respective homeowners. Obviously, investors liked this aspect. Although Fannie and Freddie were privately held by shareholders, the U.S. government—and therefore the U.S. taxpayers—were understood to ultimately back the two firms against financial catastrophe. This mix of privately held profits and publicly held risk for loss between the firm’s shareholders and U.S. taxpayers created a situation that was ripe for disaster. Before we get ahead of ourselves, though, Congress first began its formal meddling in this structured finance scheme by passing the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. It sought to replicate the effects of the Community Reinvestment Act of 1977 through Fannie and Freddie in the securitization market. The Community Reinvestment Act was legislation that mandated that banks must make a certain percentage of their loans to low-income or blighted communities. The Act was a policy tool that could be used to penalize lenders who did not make what Congress, through its banking regulators acting as its policemen, deemed the appropriate number of low-income demographic loans. In the end, it was just a law that literally forced banks to make risky loans to borrowers in low-income areas. If a bank did not comply, the penalties included disallowing the violating bank from opening new branches. When this policy was extended to cover Fannie and Freddie in 1992, it created the regulatory necessity for a considerable amount of suspect credit to flow into the world’s capital markets, on an exponentially larger scale—all guaranteed against default by the U.S. taxpayer, no less.

Naturally, though, if money can be made by issuing securities, this is a job better left to the pros, such as Wall Street and its assortment of investment banks. So although the U.S. government facilitated a great deal of this lower-income securitization activity through Fannie and Freddie, and the Fed provided aggressive interest rate policies, they both eventually had to share a crowded stage with the investment banks in this financial tragedy. In 2003 government-sponsored entities controlled 76% of the mortgage-backed securities market, but by 2006 their share had fallen to 43%. This rapid shift in market share coincided with Wall Street’s share of the mortgage-backed securities market jumping from 24% to 57% over the same time period. Wall Street had figured out the new game in town.

The acceleration in the issuance of mortgage-backed securities over this time horizon is unmistakable in the data. From the beginning stages of the low-interest policy following the dotcom fallout in 2000 and through the en masse involvement of the investment banks in mortgage securitization in 2003, mortgage-related securitization grew at a compound annual growth rate of 15.4% (see Figure 1.7).

Figure 1.7. The mortgage-related securities market

Source: SIFMA

At the same time, this market was not relegated to mortgage activity alone. The asset-backed securities market, shown in Figure 1.8, covered loans and credits of multiple varieties, including automobiles, credit cards, and student loans, to name a few.

Figure 1.8. The asset-backed securities market

Source: SIFMA

In contrast to the mortgage-backed securities market, the broader category of asset-backed securities was “only” growing at just under 11% per year. Figure 1.8 sheds some light and relevance on our earlier discussion about how so many consumers could readily afford those $50,000 Hummers. The answer ostensibly rests in the fact that it was easy to get a loan to buy one. Particularly since the lender was some random investor, sitting behind a Bloomberg screen, possibly on the other side of the world.

As we examine what for all intents and purposes appears to be the profile of a growth market erupting in the fundamental backdrop of the world’s largest mature developed-market economy, the essential question arises: Who was buying all these securities?

The term “hedge fund” has become a catchall for a wide range of similarly legally structured financial vehicles, as well as assorted images of financial risk taking, wealth, greed, and, unfortunately, scams. No matter what your impression is of a hedge fund, it is a matter of empiricism that one segment of the hedge fund industry that was focused on fixed income and its derivatives played a heavy role in the consumption of mortgage and asset-backed securities issued into the market. The allure of these securities for launching an asset-backed hedge fund strategy was the simple employment of borrowing money at one low rate and investing in these asset-backed securities to earn a higher rate. The major emphasis in this equation was indeed accessing the low interest rates available from the prime broker in order to borrow and employ, on average, $10 for every $1 that an investor gave the manager. Thanks again to the Fed, whose low interest rates paved the way for rampant speculation on borrowed money. The Fed cannot take all the blame, though. Now we must also acknowledge that the leverage was provided by the prime brokerage department of the investment bank, which in some way probably facilitated the creation of the securities itself. Put more simply, the investment banks in many cases had subsidiaries originate the loans for the securities. Then they packaged the securities and lent money to their clients to buy them. The investment banks were making money coming and going in these cases. Still, as long as interest rates were low, everyone in this picture got what they wanted. The home purchaser got more house than he or she could otherwise afford. The lending institution or mortgage broker got a fee for consummating the loan. The investment bank got a fee for creating the security. The rating agency collected a fee for its stamp of approval on the credit. The hedge fund got a security it would borrow large sums of money to buy, in the hopes that it would collect 20% or more of the investment returns for itself (and it often did). Finally, the fund investor received a stable supply of investment returns with low volatility and low risk of default—or so the investor thought. In predictable fashion, once financiers find something that works, it is replicated, piled into, and exploited until every last penny is wrung out of the opportunity. The credit markets in 2003 to 2007 are a sparkling example of how finance truly is a commodity business. One good example comes from a 2007 survey performed by Greenwich Associates, a hedge fund consultancy. It found that asset-backed strategy hedge funds had come to represent 30% of all fixed-income trading volume, which was double the 15% recorded at the same time a year ago. Given the tandem of low interest rates and a powerfully efficient machine of financial securitization, the volume of mortgage-backed securities and their derivatives proliferated across the globe. As late as 2005, though, public officials such as Alan Greenspan were extolling the virtues of this creation, and how financial risk was now being spread into the larger system, versus remaining on the books of the lending institutions.

In April 2005, Greenspan delivered the following rhetoric in a speech on consumer credit:¹

Effectively, the policymakers were generally sanguine on the role of securitization in the capital markets. They actually praised its virtue of opening the mortgage market and homeownership to less creditworthy borrowers. Had they understood better what was occurring on a more granular level in the market, they might have been less glib on the double whammy of low interest rates and rapid securitization.

The problem at hand returns us to our earlier comments on the role of character in lending and Mr. Morgan. The act of securitization changed the process of originating loans in this easy credit environment so profoundly that it nearly toppled the global financial system in a matter of five years. In the past, a lender simply had to know its customer in order to ensure that a safe loan had been extended and that the bank was likely to be repaid its principal and interest. In the early 2000s, however, advances in technology and financial engineering capsized the role of character in lending. Because the financial institutions were unlikely to hold the mortgage on their books due to the ease with which securitization could be transacted, this paved the way for a number of nonlending, sales-driven financial players to enter the game. Mortgage brokers were primarily in the business of originating mortgages and then selling them to a larger distributor such as a commercial or investment bank, which could then securitize the loan and sell it into the capital markets. Mortgage brokers had tremendous financial incentive to make a sale but very little financial incentive to make sure it was a wise sale. Put another way, the majority of transactions that initiated the creation of these securities were based on a mere ability to complete some paperwork rather than a more thorough examination of a borrower’s character or creditworthiness. This shift in the market created a lending backdrop that was dominated by hitting sales targets at the expense of creating a safe loan portfolio. At the outset, the process of mortgage brokering and securitization in the early 2000s was as innocent as just another way of sourcing mortgages and mortgage-backed securities. Financially responsible homeowners or purchasers tapped into the market to refinance or realize their goal of becoming a homeowner. As interest rates remained enticingly low for several years, though, more and more players were drawn into the mortgage finance industry. All were competing for a dwindling number of financially conservative, creditworthy borrowers. Once the supply of these conservative borrowers was exhausted though, they began targeting a new set of borrowers in order to maintain the growth in sales and originations.

The mortgage finance industry and the securities that resulted operated no differently than the local butcher making hamburger meat. At first the butcher uses only the best ingredients to run through the grinder and place on the shelves. The butcher starts with the finest ground chuck, which he calls his “prime” selection. As demand continues to surge for these delicious burgers, he eventually realizes that with only a limited supply of chuck roast, he must start to fill the package with some still quality but less demanded cuts such as sirloin. With customer demand still surging for ground chuck, as well as ground sirloin, the butcher realizes that he has no more of these cuts. But he can process some other cuts. Even though they aren’t part of his prime selection, he can still legitimately label the package “hamburger meat.” His customers, still coming back for more of the ground chuck and sirloin, buy the lesser “hamburger meat” on his good reputation and the great results from his prior packages, as well as the fact that his product was inspected and U.S. Department of Agriculture (USDA)–approved. Not ready to consume this meat right away, his customers store it in the freezer for later. All the while, customers continue to pile into the shop and the butcher had nearly exhausted his supply of cuts, but feels that he must take advantage of this boom in business either way—he knows it will not last forever. He begins to scrape up whatever he can find from his trimmings, off the floor and counters. He runs it through the grinder and packages it for sale as less than prime, or “subprime,” hamburger meat. He thinks it is possible that this meat is not fit to sell, or may go bad, but he makes the sale nonetheless. Some customers begin to question this latest product, saying it does not look the same as their earlier purchases and smells funny. The butcher explains that if the customers are concerned, they can simply take their other packages of ground chuck, ground sirloin, and hamburger meat, and combine them with this new meat. He says that by combining these various cuts and packages of meat, you can produce an outstanding burger, and you will not be bothered by the poorer quality of the subprime meat. Taking him at his word, and unwilling to ask exactly what was ground up in this latest offering of subprime meat, his customers continue to buy and mix together the various forms of meat into one of the butcher’s “structured” burgers. In the beginning, the butcher proves somewhat right, in that his customers do not notice much of a difference when just a bit of the subprime meat is mixed into the patty. In time, though, the customers begin to run out of the prime meat and start mixing the so-called “hamburger meat” with the subprime meat. This concoction, although still approved by the USDA, not surprisingly results in food poisoning, E. coli, trips to the hospital, and even some deaths. If this metaphor seems ridiculous, we can agree that the world of structured finance transgressed into practices that were somewhat ridiculous. Nevertheless, some bright financial minds fell into this trap and willingly gobbled up this garbage, applying similar threads of logic. Much of what was believed in “high finance” about the investment attributes of collateralized debt obligations (CDOs) rested on a line of reasoning that said combining a magic formula of good and bad credits into an investment, in a certain manner, somehow negates the downside. Common sense, on the other hand, says not to expect magical results when buying bonds containing cash flows tied to bad credits. In particular, packaging bad credits as good credits mixed in with bad credits amounts to a pool of bad credits—common sense. Diversification works only if a pool of assets is actually diversified.

When you look at what happened in the real world of mortgage finance and the types of loans that the mortgage brokers contracted and sold to the investment banks and other parties for securitization, it was no less disgusting than the hamburger metaphor. Mortgage brokers were scraping up whatever types of borrowers they could find to siphon loans into these securities, and the situation only got worse over time.

It may seem incredulous that the agents for lenders would behave so aggressively in the pursuit of brokering mortgages. But the steady deterioration in the rate of default for later loan vintages over the time span of the credit mania reveals the truth. Figure 1.9 shows default rates by the vintage of the subprime loan. It is easy to see that loans extended in 2006 and 2007 performed exponentially worse than loans made just a few years prior, in 2004 and 2005.

Figure 1.9. Actual delinquency rate (as a percentage)

Source: Federal Reserve Bank of Cleveland, NYU, from “Understanding the subprime mortgage crisis” by Yuliya Demyanyk and Otto Van Hemert, The Review of Financial Studies (May 4, 2009).

Reprinted by permission of Oxford University Press, Oxford Journals.

Aside from simply pushing the envelope on the borrower’s profile, mortgage originators were equipped with an arsenal of financial gimmicks that played right into the hands of would-be speculators and spendthrift consumers looking to maximize the amount of leverage they could employ in the transaction. For most of the twentieth century the basic premise of a mortgage loan was to put down 20% of the purchase price and borrow the remaining the 80% at a fixed rate, usually over a 30-year period. However, this convention would never suit the sales quota culture of the credit bubble. When you think about it, borrowers addicted to consumption or home price speculation would be either unqualified or tapped out rather quickly with this loan product. Instead, the mortgage originators had a stable full of innovative ways to extend more credit within the established confines of the structured finance framework. These products were shamelessly meant to entice the borrower, not unlike those carts of gluttonous sugar-coma-inducing desserts that occasionally get wheeled through a restaurant in search of an undisciplined sweet tooth. In this menagerie of financial products, many types of loans appealed to all the mortgage vices. “Oh, you want to purchase this as a second home? You’re right—people have made good money in the real estate market. I think the interest-only loan is the one for you.” Far from simple interest-only loans, though, you also had adjustable-rate mortgages (ARMs), where the loan structure had a predetermined period of one fixed rate that would later reset based on the level of a certain index, such as London InterBank Offered Rate (LIBOR) plus a fixed spread over the index. Among the ARM products, the 5/1 hybrid was one of the more popular. It represents the majority of the ARMs outstanding in the market still waiting to reset after the credit bubble. Again, the idea behind the ARM hybrid loan was to entice the buyer into a contract, this time with a low teaser rate for five years that would, in all probability, reset to a higher rate. The attractiveness of this plan rested on selling the house for a profit prior to the reset date. Once the witching hour struck, it was likely that higher payments would be necessary. This was based on the interest rate index chosen as the benchmark, either LIBOR or T-bills, and whether the contract had been interest-only before its reset versus interest plus amortization of principal. In addition to the gimmicks of interest-only loans and ARMs, there was also a healthy exploitation of Alt-A mortgages, which require little documentation of a borrower’s income. Originally they were intended to reduce an onerous amount of paperwork for self-employed individuals who might have multiple income streams. But this kind of loan became a conduit to securitizing mortgages from borrowers who tended to fit between the prime and subprime categories. These borrowers usually had some previous credit issues, but not enough to put them in the subprime category. However, armed with a valid excuse to provide little documentation of the borrower’s background, it is easy to see how these loans came to be abused and nicknamed “liar loans.” In addition to the Alt-A mortgage, there was also the balloon mortgage, which postponed the majority of the loan’s amortization payment until its end, thereby creating a lump-sum “balloon” payment. It was designed to minimize cash outlays for as long as possible, making it conducive to speculative purchases. For borrowers who needed the hard stuff, the real street drugs of mortgage finance, there was the negative amortization loan. The negative amortization loan allowed borrowers to pay less than their sticker rate of interest, but any forgone interest payments became a part of the loan balance. Therefore, at some point, after their grace period of skipping the full interest payment had expired, the borrower had to pay interest and principal on the loan’s original amount, plus the sum of all those previously skipped interest payments. In many cases the borrower taking full advantage of the negative amortization loan was gambling that she could sell the property before her monthly payments increased threefold. If all these loans seem familiar, you certainly get the picture. Keep the payments low at first, until they become nearly usurious at some predetermined, fixed point in time. The mortgage market had been jerry-rigged for speculation and was in plain view for all to see. The local mortgage office now resembled a casino full of financial games where unwitting gamblers were playing with stakes beyond their cognition. For evidence, let us turn once again to the data. As shown in Figure 1.10, in 2001, the percentage share of purchase mortgage originations derived through interest-only and negative amortization loans was just 1% of the total, probably what you would expect. By 2005, though, these types of risky loans comprised 29% of the total, representing an exponential increase in the amount of risk that borrowers were willing to take in order to make low monthly payments in hopes of unloading their house at a higher price within the next several years.

Figure 1.10. Interest-only and negative amortization share of mortgage originations

Source: Brookings Institute, Credit Suisse, LoanPerformance

Figure 1.11 illustrates the explosion in subprime loans, Alt-A loans, and home equity loans in comparison to the sharp decline in conforming, conventional mortgages. From this data, it is relatively clear that the steady growth in mortgage securitization we described earlier was being fueled by a growing number of financial gimmick loans. In sum, the growth in these types of risky loans, coupled with the decline in the bread-and-butter 30-year conforming fixed-rate mortgage, suggested a powder keg of default risk. The risk lay in the likelihood that across the mortgage industry and the securities it spawned, borrowers were by design not planning on seeing the contracts through. Instead, they were paying a carry in order to obtain short-term profits. Another perspective worth considering on the financial risk that borrowers were assuming in these transactions is the two sides of their balance sheet post transaction. On the left side, the asset side, the speculator was placing a traditionally long-term asset designed to be held for many years, or even forever. On the right side, the liabilities side, the home speculator was placing a debt that financed the asset. With a conventional 30-year fixed-rate mortgage, the contract on the debt matches the asset’s time horizon. However, the ARM financing structure in effect has two sets of financing contracts. One provides a low rate of interest set to expire. A second contract takes over after the first expires. This contract contains a high probability of attaching a higher rate of interest. Most of the speculators were chasing higher prices, or already-high prices, and likely could not afford to service the debt once it reset at a new interest rate. Therefore, we can call this game what it really was: using short-term debt to purchase long-term illiquid assets. This risky financing game has a history of toppling entire countries and famous hedge funds, as we saw with the Asian Financial Crisis of the late 1990s and the Long Term Capital Management episode. If the borrower is too leveraged, and the composition of its assets are too illiquid to raise cash quickly to meet the debt payment, and it cannot obtain new short-term funds from new borrowing, it is often game over. The ARM contracts that were so popular among borrowers were designed to cancel out and give way to more onerous long-term contracts. In this case, if the rate reset at a higher level that forced payment demands exceeding a combination of the borrower’s cash reserves, incoming cash flows, or ability to access short-term financing from credit cards, their game would be over. At its core, everyone in the housing speculation game needed two conditions to stay in place—rising house prices and a liquid market through which they could sell the house and extinguish the debt. If house prices fell, or the speculator could not sell the property in a timely manner, severe consequences might result. These potential risks were ignored, though, as homebuyers and speculators used these loans to chase prices higher with short-term bets on the housing market.

Figure 1.11. Subprime, Alt-A, home equity, and conventional loans as a percentage of mortgage originations

Source: Brookings Institute, Inside Mortgage Finance

In addition to assuming the risk of an interest rate reset and higher payments, the borrowers in these products were also pushing the envelope on the loan to value, or the amount of equity they would place in their purchase. As suggested by the sharp decline in the percentage of conventional loans taken as a percentage of originations, as well as the surge in home equity lines of credit, the amount of equity that homeowners had in their asset was falling precipitously (see Figure 1.12.) This implied that these borrowers were becoming more and more vulnerable to a decline in housing prices and the possibility of owing more than the house was worth in that scenario.

Figure 1.12. Household owners’ equity as a percentage of real estate assets

Source: Federal Reserve

Of course, this behavior could be seen as risky only if housing prices declined in value. Because most speculators “knew” prices had never declined on a nationwide basis, there was little cause for concern.

Endnote

¹ U.S. Senate, Committee on Banking, Housing and Urban Affairs. Federal Reserve Chairman Alan Greenspan. “Regulatory Reform of the Government-Sponsored Enterprises,” April 6, 2005, http://www.federalreserve.gov/boarddocs/testimony/2005/20050406/default.htm.