What caused the need for a $700 Billion bailout of the financial industry? Was it really necessary? What would have happened without it? Has it been effective? Thomas F Cosimano Professor of Finance The root cause of the subprime lending crisis is the expansion of a shadow banking system which spurred the growth of mortgage back securities (MBS). From 2000 to 2006 these securities increased by 135% or $3800 Billion. 1 Most of this growth occurred outside the regulated banking system, such as Citi, Bank of America, and JP Morgan, as well as the government sponsored agencies such as Fannie Mae and Freddie Mac. 2 The MBS were used to fund mortgages originated by companies such as Countrywide and GMAC, as well as the regulated banking system. These securities were then distributed throughout the world by investment banks such as Bear Sterns, Goldman Sachs, Lehmann Brothers and Merrill Lynch. 3 To make MBS more secure the investment banks broke the MBSs into parts called tranches. The resulting securities are called collateralized debt obligations (CDO). In case of losses on the original mortgages the equity tranche would bear most of the losses and, at most, the second tranche would suffer minimal losses. Hedge funds, which could only market to wealthy investors, bought the risky tranches in return for a high rate of return. The safest tranche was the last one which would suffer losses from foreclosure exceeding more than 25% of the mortgages. 4 These safe tranches were made more secure by an insurance policy, called a credit default swap (CDS), which was sold by companies like AIG. These safe securities were then sold to the average investor including school boards, police pension plans, etc. The 135% expansion in mortgage backed securities lead to a huge increase in the demand for housing. In 2004 the price of housing in the 10 largest cities increased 20%. 5 In such an environment more individuals were convinced to take out subprime mortgages which they 1
See Adolfo Barajas (2008, IMF). The website http://www.nd.edu/~mmfe/lectures/index.html contains the introductory lecture for the course Mathematical Methods in Financial Economics which I teach with Alex Himonas. This lecture provides a more technical explanation of the subprime lending crisis. 2
Barajas reports these GSEs market share fell from 76% in 2003 to 43% in 2006. 3
Investment banks were allowed to take business from regulated banks since the SEC ruled that the investment banks did not have to hold as much equity as the regulated banks. See the NY Times article at http://www.nytimes.com/2008/10/03/business/03sec.html, This article is part of an excellent series on the participants in the subprime lending crisis. 4
There were roughly $2,000 Billion Subprime loans sold under this system. The logic of the CDOs is as follows: If 30% of loans default and each foreclosure results in a net loss of 25%, then the total loss would be 7.5%. Consequently, only the equity tranches should lose. In addition, the total losses from all subprime mortgages should not exceed $150 Billion. 5
See February 2009 Monetary Report to Congress by Federal Reserve Board. could only afford over the long term if prices continued to increase. 6 But in 2005 and 2006 the increase in the demand for housing slowed down, and housing prices fell. This led to a default rate of over 30% on subprime mortgages which were issued in 2005 and 2006. 7 These losses resulted in bankruptcy by some hedge funds that were subsidiaries of Lehmann Brothers and Bear Stearns in the summer of 2007. While these losses were substantial, it could be handled by the economy. The problem was that the safe CDOs were held by risk adverse investors, such as school boards, who started to dump their holdings. This led to a drop in CDO and MBS by 1,420 billion from quarter (Q) 2, 2007 to Q3, 2008. 8 Thus, these safe (MBS, CDO and CDS) securities became very risk. Financial institution, holding MBS, had to record losses which totaled $756 Billion from Q1, 2008 to Q1, 2009. These losses were suffered by investment banks, regulated banks and GSEs. As a result, these financial firms had to raise $572 Billion in new capital from Q1, 2008 to now. 9 These losses led to the bankruptcy or takeover of major financial institutions starting with Countrywide in December 2007 and Bear Stearns in March 2008. In September, 2008 the events which resulted in the largest decline in the stock market since the great depression transpired. Fannie Mae and Freddie Mac were nationalized in September 7, 2008, followed the next week by AIG, Lehmann Brothers was allowed to go bankrupt, and Merrill Lynch was merged with Bank of America. The subsequent week both Goldman and Morgan Stanley were turned into regulated banks. This marked the death of the shadow banking system. 10 Currently, the death of the shadow banking system has left the country and the world economy with several substantial wounds. Without substantial government intervention the problems in the financial sector will devastate the economy. The policy must account for the following issues: First, asset backed lending has to be replaced by traditional bank lending. Second, the market for commercial paper lost a significant source of funding. 11 On net commercial paper sold fell by $554 Billion from Q2 2007 to Q3 2008. 12 Finally, the commercial banks still had a 6
Subprime mortgages are mortgages issued to borrowers with lower credit scores and a lower down payment relative to prime mortgage borrowers. 7
See IMF Global Financial Stability Report October 2008. 8
See December, 2008 flow of funds report issued by Federal Reserve Board at the website http://www.federalreserve.gov/releases/z1/. 9
See Ralph Chami 2009. 10
See “The End” by Michael Lewis in Portfolio,com at http://www.portfolio.com/news‐markets/national‐
news/portfolio/2008/11/11/The‐End‐of‐Wall‐Streets‐Boom, for a very good discussion of the down fall of the investment banks. 11
The fall of Lehmann Brothers led to a run on money market mutual funds issued by investment banks. The investment banks used these funds to buy short term bonds called commercial paper, some of which was sold by Lehmann Brothers. Shortly after the fall of Lehmann risk adverse investors withdrew about $350 Billion from money market mutual funds (2009 Monetary Report to Congress). At this point the US Treasury stepped in to insure money market mutual funds to stop the withdrawals. 12
See December 2008 flow of funds report, Federal Reserve Board. shortfall of capital in the neighborhood of $200 Billion. This means that the banking system has to replace about $2,000 Billion of lending without sufficient capital. 13 To put this in perspective total bank credit was $8,431 Billion in Q3 2008. 14 Without government intervention the ability to borrow would fall by at least 25% of commercial bank lending, leading to a drastic reduction in production and employment. The Federal Reserve Board undertook several actions which were unprecedented including the creation of TALF (Term Asset Backed Securities Loan Facilities). TALF allowed financial institutions to borrow from the Fed using asset backed securities as collateral. However, there were legal limits on what the Fed could do to fund the financial institutions. As a result, TARP (Troubled Asset Relief Program) was created, which gave the US Treasury the authority to purchase up to $700 Billion dollars of MBS and to lend capital to the banks. The Secretary of the Treasury, Henry Paulson, decided that buying MBS was not feasible, since they could not agree on a price for the MBS. As a result, on October 14, 2008 the U.S. Treasury announced a program to buy up to $250 Billion of preferred shares of financial institutions which promise a return of 5% for five years and increase to 9% after that. 15 The purpose of this loan was to make up for the short fall between recorded losses and capital raised by the financial institutions in the financial market, yet it did not address the offer issues. Total lending by commercial banks has decreased by 2.5%, since the TARP program was passed. 16 The main problem with the implementation of the TARP program is that it bandaged the wound but did not address the underlying problem of the missing $2,000 Billion in lending capacity. The Homeowner Affordability and Stability Plan announced by President Obama is designed to shore up mortgages, so that the expected losses on MBS fall. Eventually, the value of MBS should return back to the value of the underlying houses. On February 10, 2009 Treasury Secretary Geithner announce several initiatives: An expansion of TALF by $1,000 Billion; A new stress test of the major financial institutions; and require the financial institutions to adhere to stricter conditions. Finally, he announced a new private‐public institution to buy up to $2,000 Billion of asset backed securities. 17 So far the financial markets have not reacted favorably, since no one knows which financial institutions will fail the stress test and how effective the new public/private institution will be. Whether or not these steps are sufficient to replace the 13
Under current regulations banks would have to increase equity and long term bonds by an additional $200 Billion to support such lending. 14
See the December 2008 flow of funds report. 15
See the press release at http://www.treas.gov/press/releases/hp1207.htm. 16
From the data base FRED at Federal Reserve Bank of St. Louis. 17
The Press release can be found at http://www.ustreas.gov/press/releases/tg21.htm. The web site http://www.ustreas.gov/initiatives/eesa/ has been created to make these programs more transparent. missing credit is not known at this time. The cost to the US tax payer will not be known for several years when the MBS return to fundamental values. 18 18
In the case of the Resolution Trust Company set up to clean up the S & L had to liquidate $394 Billion in assets from 1989‐1993 at an estimated cost of $125 Billion. See “The Cost of the Savings and Loan Crisis: Truth and Consequences,” by Timothy Curry and Lynn Shibut at http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf.