FIXING FINANCE SERIES – PAPER 3 | NOVEMBER 2008 The Origins of the Financial Crisis Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson The Initiative on Business and Public Policy provides analytical research and constructive recommendations on public policy issues affecting the business sector in the United States and around the world. The Origins of the Financial Crisis Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson The Initiative on Business and Public Policy provides analytical research and constructive recommendations on public policy issues affecting the business sector in the United States and around the world. TH E O R IGI ns O F T H E F I N A N CIA L Cr I S I S CONTENTS Summary 7 Introduction 10 Housing Demand and the Perception of Low Risk in Housing Investment 11 The Shifting Composition of Mortgage Lending and the Erosion of Lending Standards 1 Economic Incentives in the Housing and Mortgage Origination Markets 20 Securitization and the Funding of the Housing Boom 22 More Securitization and More Leverage—CDOs, SIVs, and Short-Term Borrowing 27 Credit Insurance and Tremendous Growth in Credit Default Swaps 32 The Credit Rating Agencies 3 Federal Reserve Policy, Foreign Borrowing and the Search for Yield 36 Regulation and Supervision 0 The Failure of Company Risk Management Practices 2 The Impact of Mark to Market 3 Lessons from Studying the Origins of the Crisis References 6 About the Authors 7 NOVEMBER 2008 TH E O R IGI ns O F T H E F I N A N CIA L Cr I S I S SUMMARY he financial crisis that has been wreaking ing securities backed by those packages to inves- havoc in markets in the U.S. and across the tors who receive pro rata payments of principal and Tworld since August 2007 had its origins in an interest by the borrowers. The two main govern- asset price bubble that interacted with new kinds of ment-sponsored enterprises devoted to mortgage financial innovations that masked risk; with compa- lending, Fannie Mae and Freddie Mac, developed nies that failed to follow their own risk management this financing technique in the 1970s, adding their procedures; and with regulators and supervisors guarantees to these “mortgage-backed securities” that failed to restrain excessive risk taking. (MBS) to ensure their marketability. For roughly three decades, Fannie and Freddie confined their A bubble formed in the housing markets as home guarantees to “prime” borrowers who took out prices across the country increased each year from “conforming” loans, or loans with a principal below the mid 1990s to 2006, moving out of line with fun- a certain dollar threshold and to borrowers with a damentals like household income. Like traditional credit score above a certain limit. Along the way, asset price bubbles, expectations of future price the private sector developed MBS backed by non- increases developed and were a significant factor conforming loans that had other means of “credit in inflating house prices. As individuals witnessed enhancement,” but this market stayed relatively rising prices in their neighborhood and across the small until the late 1990s. In this fashion, Wall country, they began to expect those prices to con- Street investors effectively financed homebuyers tinue to rise, even in the late years of the bubble on Main Street. Banks, thrifts, and a new industry when it had nearly peaked. of mortgage brokers originated the loans but did not keep them, which was the “old” way of financ- The rapid rise of lending to subprime borrowers ing home ownership. helped inflate the housing price bubble. Before 2000, subprime lending was virtually non-existent, Over the past decade, private sector commercial but thereafter it took off exponentially. The sus- and investment banks developed new ways of se- tained rise in house prices, along with new financial curitizing subprime mortgages: by packaging them innovations, suddenly made subprime borrowers into “Collateralized Debt Obligations” (sometimes — previously shut out of the mortgage markets — with other asset-backed securities), and then divid- attractive customers for mortgage lenders. Lend- ing the cash flows into different “tranches” to ap- ers devised innovative Adjustable Rate Mortgages peal to different classes of investors with different (ARMs) — with low “teaser rates,” no down-pay- tolerances for risk. By ordering the rights to the ments, and some even allowing the borrower to cash flows, the developers of CDOs (and subse- postpone some of the interest due each month and quently other securities built on this model), were add it to the principal of the loan — which were able to convince the credit rating agencies to assign predicated on the expectation that home prices their highest ratings to the securities in the high- would continue to rise. est tranche, or risk class. In some cases, so-called “monoline” bond insurers (which had previously But innovation in mortgage design alone would concentrated on insuring municipal bonds) sold not have enabled so many subprime borrowers to protection insurance to CDO investors that would access credit without other innovations in the so- pay off in the event that loans went into default. called process of “securitizing” mortgages — or the In other cases, especially more recently, insurance pooling of mortgages into packages and then sell- companies, investment banks and other parties did NOVEMBER 2008 7 TH E O R IGI ns O F T H E F I N A N CIA L Cr I S I S the near equivalent by selling “credit default swaps” average rolling over a quarter of their balance sheet (CDS), which were similar to monocline insurance every night. During the years of rising asset prices, in principle but different in risk, as CDS sellers put this short-term debt could be rolled over like clock- up very little capital to back their transactions. work. This tenuous situation shut down once panic hit in 2007, however, as sudden uncertainty over as- These new innovations enabled Wall Street to do set prices caused lenders to abruptly refuse to roll- for subprime mortgages what it had already done over their debts, and over-leveraged banks found for conforming mortgages, and they facilitated themselves exposed to falling asset prices with very the boom in subprime lending that occurred after little capital. 2000. By channeling funds of institutional investors to support the origination of subprime mortgages, While ex post we can certainly say that the system- many households previously unable to qualify for wide increase in borrowed money was irresponsible mortgage credit became eligible for loans. This and bound for catastrophe, it is not shocking that new group of eligible borrowers increased housing consumers, would-be homeowners, and profit- demand and helped inflate home prices. maximizing banks will borrow more money when asset prices are rising; indeed, it is quite intuitive. These new financial innovations thrived in an en- What is especially shocking, though, is how insti- vironment of easy monetary policy by the Fed- tutions along each link of the securitization chain eral Reserve and poor regulatory oversight. With failed so grossly to perform adequate risk assess- interest rates so low and with regulators turning ment on the mortgage-related assets they held and a blind eye, financial institutions borrowed more traded. From the mortgage originator, to the loan and more money (i.e. increased their leverage) to servicer, to the mortgage-backed security issuer, to finance their purchases of mortgage-related securi- the CDO issuer, to the CDS protection seller, to ties. Banks created off-balance sheet affiliated enti- the credit rating agencies, and to the holders of all ties such as Structured Investment Vehicles (SIVs) those securities, at no point did any institution stop to purchase mortgage-related assets that were not the party or question the little-understood com- subject to regulatory capital requirements Finan- puter risk models, or the blatantly unsustainable cial institutions also turned to short-term “collater- deterioration of the loan terms of the underlying alized borrowing” like repurchase agreements, so mortgages. much so that by 2006 investment banks were on 8 The Initiative on Business and Public Policy | THE BROOKINGS INstitutiON TH E O R IGI ns O F T H E F I N A N CIA L Cr I S I S A key point in understanding this system-wide fail- One part of the reason is that these investors — like ure of risk assessment is that each link of the secu- everyone else — were caught up in a bubble men- ritization chain is plagued by asymmetric informa- tality that enveloped the entire system. Others saw tion – that is, one party has better information than the large profits from subprime-mortgage related the other. In such cases, one side is usually careful assets and wanted to get in on the action. In addition, in doing business with the other and makes every the sheer complexity and opacity of the securitized effort to accurately assess the risk of the other side financial system meant that many people simply did with the information it is given. However, this sort not have the information or capacity to make their of due diligence that is to be expected from markets own judgment on the securities they held, instead with asymmetric information was essentially absent relying on rating agencies and complex but flawed in recent years of mortgage securitization. Com- computer models. In other words, poor incentives, puter models took the place of human judgment, the bubble in home prices, and lack of transparency as originators did not adequately assess the risk of erased the frictions inherent in markets with asym- borrowers, mortgage services did not adequately metric information (and since the crisis hit in 2007, assess the risk of the terms of mortgage loans they the extreme opposite has been the case, with asym- serviced, MBS issuers did not adequately assess the metric information problems having effectively risk of the securities they sold, and so on.