The 2007-2009 Financial Crisis What Went Wrong and What Went Different? ISBN: 978-80-223-2954-5 Podporujeme výskumné aktivity na Slovensku/Projekt je spolufi nancovaný zo zdrojov EÚ The 2007 – 2009 Financial Crisis What Went Wrong and What Went Different? Zsolt Gál Bratislava 2011 Projekt „Globálne a lokálne procesy na Slovensku: rozvoj spoločenských inovácii v podmienkach internacionalizácie Európskej únie“ je podporený v rámci opatrenia 4.1 „Pod- pora sietí excelentných pracovísk výskumu a vývoja ako pili- erov rozvoja regiónu v Bratislavskom kraji“. Viac informácii o Operačnom programe Výskum a vývoj nájdete na stránke: http://www.asfeu.sk/operacny -program-vyskum-a-vyvoj. This book was writen fulfilling the project “Global and Local Challenges in Slovakia: Social Innovation under the European Un- ion‘s Internationalization “ with the support of operation program Research and Development financed by European Regional Devel- opment Fund (ERDF). Review/Recenzenti: Dr. Richard Connolly (University of Birmingham), Dr. Nathaniel Copsey (Aston University), Radovan Geist, PhD. (EurActiv.sk), Daniel Gerbery, PhD. (Comenius University). Language editing/jazyková redakcia: Peter Barrer, PhD. (Comenius University) Publisher/Vydavateľ: Univerzita Komenského v Bratislave ISBN: 978-80-223-2954-5 Copyright © Zsolt Gál (2011) To Annabelle, who heroically lived through the convulsions of the (writing) crisis Contents Executive summary . 10 Introduction . 14 Chapter 1 The housing boom encouraged by the perception of “safe” investment . 31 Chapter 2 The “culture of debt”: rising indebtedness, expanding risky mortgage lending . 40 2.1. Deteriorating quality of mortgage loans . 43 2.2. Homes as ATMs – frequent refinancing, easy walk away . 49 2.3. The foreclosure tsunami . 54 Chapter 3 Financial innovation: securitization funding the credit and housing boom . 60 3.1 American securitization was exceptional in many ways . 62 3.2 From financial innovation to financial alchemy . 69 3.3 Banks in shadow – a huge but fragile and opaque network . .77 Chapter 4 The role of the government: the road to hell paved with good intentions again . 87 4.1 The government wants everybody in America to be a homeowner . 90 4.2 The Fed kept interest rates too low for too long. 105 4.3 Too lax regulation, too high leverage and too many “too big to fail” firms . 109 Chapter 5 The “great moderation” in the world economy enlarged and prolonged the US bubble . 127 Conclusions . 134 Annex: Glossary . 145 Timeline – main events of the crisis . 155 References . 164 List of Boxes, Figures, Tables and Maps Boxes: 1. Historic Development of American Housing Finance . 64 2. The Special Status of Fannie Mae and Freddie Mac . 100 3. The Fragmented Regulatory Structure of US Financial Markets . 111 4. The Main Causes and Consequences of the Financial Crisis. 135 Figures: 1. FHFA House Price Index History for USA . 33 2. Residential Mortgage Debt to GDP Ratio in Selected European Countries . 42 3. Residential Mortgage Originations by Product in the USA . 44 4. Delinquency Rates: 90 Days Past Due (US residential mortgages by type) . 57 5. ABS and CDO Issuance in the United States . 76 6. The Originate to Distribute Model and its Main Actors . 83 7. Federal Funds Rate and Inflation Targets . 107 8. Selected American Financial Institutions’ Leverage Ratios . 117 9. Rising External Imbalances of the American Economy . 130 10. Current Account Balances of Some Major Economies and a Group of Countries. 130 11. Official Reserves of Emerging and Developing Economies . 131 Tables: 1. House Price to Income Ratio in Selected OECD Countries… . 36 2. Selected Large US Metropolitan Statistical Areas with Highest Rates of Population Growth between 1990 and 2007 . 38 3 US Subprime Loan Characteristics at Origination for Different Vintages . 47 4. Mortgage Terms across Different Countries (around 2002 – 2005) . 50 5. State-Level Trends in Foreclosures Starts and Selected Market Factors . 55 6. Main Actors of the (Private-label) Securitization Process . 79 7. FHA as a Leader in Relaxing Mortgage Origination Standards (development of FHA loan characteristics) . 92 8. GSE Affordable Housing Goals since 1993 . 102 9. Equity Asset Ratios and Tier 1 Ratios of Major US and European Banks in 2007 . 116 10. Payments to AIG Counterparties Mostly from Taxpayer Money . 125 11. Occupational Distribution of Workers Ages 25 to 64 in the USA by Nativity . 132 Maps: 1. Percent Change in Population in the USA for Counties and Puerto Rico Municipios: 1 April 2000 to 1 July 2007 . .39 2. Share of Mortgage Loans with Negative Equity (%, third quarter 2010) . 58 The 2007 – 2009 Financial Crisis What Went Wrong and What Went Different? Executive summary The aim of this book is to discuss the main reasons that lead to the largest financial crisis since the Great Depression as well as to compare the development in the United States with other advanced economies. We are seeking answers to the questions of what went wrong and what went different prior to this crisis in America (why it happened and why it started in the United States). The latest large financial crisis has been triggered by rising delinquencies and foreclosures on American (initially mostly non- conforming) mortgage loans. There was a huge (but internation- ally not unprecedented) housing boom in the American property market, which lead to a price bubble and later to a substantial sup- ply overhang. This resulted in falling house prices which became the trigger of the crisis. While US residential property prices were falling (beginning in 2006), an increasing number of borrowing households found themselves in negative equity and reacted by defaulting on their mortgages. As most mortgages had been se- curitized (i.e. transformed into Mortgage Backed Securities – MBS – and sold to investors in volumes of trillions of dollars), the ris- ing, internationally unprecedented wave of delinquencies and foreclosures lead to a domino effect. Securitization created a chain of risk transfer from original mortgage lenders to MBS investors and insurers. Therefore, defaulting households were just the first domino to fall, followed by mortgage lenders, holders of mortgage- backed securities and their guarantors and insurers. As a matter of fact, a regional problem in the American housing market – through the channels of financial innovation (securitization) – threatened to tear down the whole global financial system. American mortgage borrowers faced probably the most consumer-friendly environment in the world, they could choose from a wide variety of mortgages with different interest rates and amortization periods, usually with attractive terms and low down payments. American mortgages differed from those in all other ad- vanced countries in two major aspects: (1) it was easiest to refinance a mortgage in the United States, and (2) most mortgages were de jure or de facto non-recourse, secured just by the house as collat- eral. Borrowers had no personal liability for the debt. These features lead to a decreasing prudence of borrowers prior to the crisis. 10 The 2007 – 2009 Financial Crisis What Went Wrong and What Went Different? The quality of American mortgages originated before the cri- sis has deteriorated in an unprecedented way. Mortgages in the United States (especially subprime and Alt-A mortgages) were given to borrowers of whom most would have been rebuffed in any other country. A crucial number of American borrowers took mortgages that they – as it turned out later – could not afford (i.e. they did not manage to pay them back). They hoped that house price appreciation would continue and as a result they would be able to easily refinance their existing mortgages, which were very favorable short-term but unaffordable long-term. The con- tinuous appreciation of residential property prices before 2006 masked the looming problems inside mortgage finance (especially in the case of non-conforming loans), but these hidden problems were revealed once house prices started to fall, dramatically limit- ing the possibility of mortgagors to refinance. Prior to the financial crisis, the United States of America uniquely became the first country in the world where the majority of housing finance funding came from capital markets, and instead of the traditional depository-based funding (referred to as the ori- ginate to hold model) securitization became a dominant source of funds for US residential mortgages (referred to as the originate to distribute model). In this new model, mortgage loans are sold by their originators to big financial institutions (often parts of the so- called shadow banking system) which then transform the pool of mortgages into Mortgage Backed Securities (MBS) or other similar debt securities (a process referred to as ‘securitization’) and sell them to investors. The cash flows from the mortgages are trans- formed into cash flows (interest and coupon payments) for secu- rity holders, who basically buy the right to receive borrowers’ pay- ments. Because of securitization, a growing fraction of financial intermediation migrated outside the traditional banking system to the shadow banking system (also known as the parallel banking system). In America, this system, made up of Government Spon- sored Enterprises (GSEs), bank, broker-dealer and asset manage- ment subsidiaries and off-balance sheet entities (conduits, SPVs and SIVs) of large financial holding companies and investment banks, significantly surpassed the traditional banking system. Shadow banking