The business model that commercial banks employed from the Great Depression to the Reagan Era ended in the 1980’s. The financial services sector had long hated the Glass-Steagall Act which placed strict limits on a bank’s ability to expand interstate or participate in the securities industry, not to mention the many restrictions placed on banking by the various state governments. As mentioned before, heavy lobbying received sympathetic ears from both the President and Congress, resulting in the complete dismantling of depression-era safeguards, and the continuation of monetary stimulus.
The products that affected the “Great Recession” were tied to mortgages in the following way: Let’s say that John Doe buys a house. He then goes to his local bank and takes out a mortgage. His bank sells (assigns) the mortgage to another bank which acts as servicer of the loan. The mortgage is then sold (assigned) to the investment banking division of another bank who consolidates his mortgage with hundreds of other mortgages. All of these mortgages will be securitized into a mortgage-backed bond. The bond will then be turned over to stockbrokers who sell them as securities. Meanwhile, the Investment banking group has created a new company called a “Special Purpose Vehicle” (SPV). To expand on this example, the investment banking group sells the bond, along with the underlying mortgages, including the income stream from mortgage payments made by the mortgage borrowers, packaged with hundreds of other bonds, to the SPV. The SPV then creates and issues a funded (collateralized) credit instrument (which is a form of mortgage-backed bond), called a “Collateralized Debt Obligation” or (CDO). Each CDO is sliced into “tranches.” These catch the cash flow of the interest and principal payments based on the seniority of the tranche.
The capital structure of a tranche fell in different investment classes from: Equity Class to Unrated Subordinated, to BB to BBB to AA to AAA to AAA Plus to Super Senior AAA. These classes were established by credit reporting agencies. If the underlying mortgages defaulted, the lowest or Equity Class would suffer the first losses, then the next lowest all the way up to Super Senior AAA tranches. The lower rated tranches received a higher interest rate based on the higher risk taken by the investor. Therefore, all the combined mortgages that had been consolidated into a bond, actually transferred to the investors, who owned pieces of the CDO. These instruments were sold to investors, including financial institutions all around the world. As new mortgages were made, the process was repeated over and over.
When the banking industry introduced a large number of bad or “toxic” mortgages into this process, you can see how these toxins were distributed worldwide, eventually collapsing the entire system, which, as we will see later, required several governments — primarily the United States — to bail them out.
Banks were not the only mortgage loan originators. A whole new industry evolved during the 2002–2008 real estate boom. In fact, the country’s largest mortgage lender was Countrywide Financial, who by 2008 was near bankruptcy when Bank of America swooped in and bought the struggling mortgage company. There were thousands of less scrupulous firms and mortgage brokers who would make loans, pretty much to anyone who had a breath. No Income No Job (NINJA Loans)? That was okay. Bad credit? That was okay too. You needed more money than the lendable value of your house? No problem, they had real estate appraisers who would submit a falsified report, which exaggerated the value of your house.
Looking at all this strictly from an investment perspective, these sub-prime, nonconforming mortgages (meaning that they did not conform to the underwriting requirements of “Freddie Mac” or “Fannie Mae”) carried a higher interest rate which was attractive to investors. And they held rising collateral values that, under normal circumstance, would protect investors from foreclosure losses. In fact, if you look at a United States chart of real estate values from 1900 to 2008, you will see an almost continuous unbroken rise in real estate values that had been accelerating since the early 1990’s. Therefore, investors expected only a minimal risk of loss, even by investing in the lowest equity class.
The practice was easily rationalized by mortgage lenders. After all, everyone wants to buy a bigger, better house in a nicer neighborhood. And no one put a gun to the heads of home buyers and forced them into contracts that they could not afford. And, the lenders were only giving these borrowers what they wanted.
The following is a loose analogy: I worked with a couple of bank branch managers back in the mid-seventies. They were given adequate lending authority and profit responsibilities over their branches. Naturally, there was a constant push to grow the bank’s business; so, these two managers started competing with each other to see who could make the most car loans. They both decided to throw generally accepted credit standards out the window and make car loans to anyone of legal age that walked in the door. One of the managers would lecture the loan applicants that went something like this: “Now, you normally wouldn’t qualify for a loan, but I can see that you are a good person and need this car, so I am going to take a risk and make you the loan.” Then he would ramble on about the importance of a good credit rating and would emphasize the great opportunity he was giving them to turn around their credit ratings; and finally, the banker would obtain a promise that all payments would be made on time. He even took the time to cross-sell other bank services. The strategy worked great — at first. Word of mouth spread and both bankers had customers lining-up for loans. Upper management gave them both accolades and never questioned their methods. In, fact they were so successful that the younger, more aggressive banker was promoted from Branch Manager to Assistant Vice President. Then the delinquencies started piling up, which led to repossessions and losses to the bank. The older manager was asked to retire and the younger manager was fired. And all the high-risk bank customers that temporarily had cars — but didn’t make their payments — lost them to the bank.
Now, if the managers had been humanitarians and were risking their own capital then I would applaud their efforts to help their fellow citizens in need; however, it wasn’t their money to risk, it was the bank’s capital. And if this practice had been widespread, it wouldn’t have just been the bank’s capital at risk, but also the depositor’s savings, which was insured by the federal government, so ultimately it would be the taxpayer’s money at risk.
To summarize the mortgage crises: Shady lenders accumulated a portfolio of worthless loans, which were transferred to a special purpose company (SPV). Stock brokers would sell securities to investors, who incorrectly believed that the underlying mortgages were good loans, letting the original lenders completely off the hook. This may surprise you, but the above described process would have been a relatively minor historical event if not for the widespread misuse of derivatives.
Any discussion of the Great Recession would not be complete without the topic of “derivatives.” A derivative is a financial instrument that derives its value from an underlying asset. Let’s take a simple example: A farmer agrees to sell one ton of barley to a brewery for $150. This creates a simple contract (offer, acceptance, and consideration).
For the next example, we simply introduce the element of time: the farmer anticipates having one ton of barley in 90 days, but the price of barley fluctuates every day. Let’s assume that the farmer is happy with today’s price and would rather not risk a lower price in 90 days. Fortunately for the farmer, a commodities trader comes along and offers a “Futures Contract,” which guarantees him $150 for one ton of barley, 90 days in the future. Therefore, the trader has assumed his risk, sort of like an insurance policy against the potential of a price drop. If the price of barley goes up to $160, the trader makes a profit of $10. If it goes down to $140, then he suffers a $10 loss. The futures contract is an example of a derivative, because its value is derived from the fluctuating price of its underlying asset, in this case, barley.
You can see that investors in the various derivatives markets are speculators. To be successful, they must become experts in understanding the fundamental and/or technical aspects of the markets in which they speculate. There are two differences between these speculators and gamblers: first, the speculators, in most cases, add stability to the markets in which they participate (however, we will see that in 2008, a certain breed of derivatives contributed greatly to the meltdown.) Second, through research, speculators are able minimize their risk, whereas gamblers are at the mercy of “Lady Luck.”
Derivatives — Bankers Gone Wild
Back to Collateralized Debt Obligations (CDO’s): for our next example the mortgage loan originator sells the debt to the Special Purpose Vehicle (SPV), the SPV subsequently forms a “Credit Default Swap” (CDS), which is a synthetic Collateralized Debt Obligation. Synthetic CDO’s are derivatives. In the case of CDS’s, the mortgage originators would keep the debt, but purchased protection on it, sort of like an insurance policy and similarly paid a premium to the CDS that was relative to the perceived risk. The lender would be paid par (his original investment) in case of any mortgage defaults in his portfolio. The losses instead would fall on the investors distributed through the capital structure of the tranche (Equity Class through AAA Plus). Remember, however, that the debt did not transfer, only the risk. Therefore, the bank had the ability to write multiple securitizations on the same portfolio. This is because the bank didn’t have to actually transfer anything. Keep in mind that no due diligence was performed on any of these instruments, because the rating agencies assumed them to be extremely low risk.
Because you could put one synthetic CDO on top of another synthetic CDO, on top of another synthetic CDO (CDO’s squared and even CDO’s cubed), you put more distance between the investor and the risk — therefore they seemed safer than products without derivatives. However, as it turned out, there was simply a straight line between the toxic loans and the investors. Eventually you had trillions of dollars of risk spread by the financial system around the globe. It was inevitable that this entire “Ponzi” type scheme would eventually collapse!
The Government Bailouts
· AIG $85 billion
· Morgan Stanley $107 billion
· Citigroup $99 billion
· Bank of America $91 billion
· Goldman Sachs $69 billion
· JP Morgan Chase $68 billion
· Royal Bank of Scotland $84 billion
· Deutsche Bank $66 billion
· Foreign Central Banks $583 billion
· Fannie Mae/Freddie Mac $169 billion
· Mortgage Backed Securities $1.2 trillion
In the end, the U.S. taxpayers paid — through the Federal Reserve — bailouts totaling $3.95 trillion. Additionally, between 2007 and 2009 over $13 trillion in emergency lending went to a handful of large financial institutions. It should be noted that the U.S. banking industry has since recovered and much of the bailout money, including regulatory fines, has been reimbursed to the federal government.
In the aftermath of the crisis, the market for mortgage-backed securities completely dried up, and Freddie Mac and Fannie Mae, which were already quasi-government entities, were taken over by the federal government, including their $1.3 trillion dollars of mortgage debt. This resulted in 98% of all mortgages in the country being held by the federal government, essentially nationalizing the mortgage industry.
Banking and the Federal Reserve
Banks are required by law to maintain with the Federal Reserve System a percentage of their total deposits in United States Government Bonds. For example, if you deposit $100 with your local bank, and the bank has a reserve requirement of 10%, then $10 of your deposit will be used by your bank to purchase these bonds. The bank earns interest from the bonds, which are held on deposit at one of the twelve Federal Reserve Banks.
As you recall, taxpayers, through the FDIC are on the hook for all customer deposits up to $250,000 per individual — just in case the bank goes bust! Therefore, there are two main reasons for the reserve requirement: The Federal Reserve Board and other bank regulators consider 100% leverage too much of a risk for banks to absorb; and the banking industry sops up all of the treasury’s excess debt, as mandated by law!
To get a proper handle on the business of banking, it is important to look at two concepts: leverage and risk.
Theoretically, we could set up a bank and promise our customers a savings rate of, say, 3% that will be paid in one year. Let’s assume that we are successful in accumulating $1 million of depositor’s money. Our bank is now $1 million in debt and in one year will have to pay back depositors a total of $1,030,000 (3%). We then take $100,000 of our depositor’s money and purchase United States Treasury Bonds, held by our affiliated Federal Reserve Bank. The next step will be to find good-quality borrowers who are willing to borrow money for one year from our bank at 5%. Remember that we can only loan out 90% of our depositor’s money, so our bank kicks in $100,000 from its own equity. We then find qualified customers who will borrow from our bank the full $1 million. At the end of the year, they will have paid us back the original $1 million plus $50,000 (5%) in interest, or $1,050,000. Let’s further assume that we cash in our treasury bond and receive $102,000 (2%). So far, our bank has paid back depositors $1,030,000 and has received from borrowers $1,050,000, plus interest from the treasury bond of $2,000.
Now we can calculate how our bank performed. At the end of the year we took in $1,050,000 plus $102,000, totaling $1,152,000. We then paid pack our depositors $1,030,000. And finally, put back into the vaults our equity of $100,000; leaving our bank with a profit of $22,000. If you assume that the bank’s Return on Investment (ROI) was 2% of $1,000,000, you would be way off, because the bank’s real investment was only $100,000 taken from its equity. Therefore, the actual rate of return was a whopping 22%! This is because the bank was able to leverage its actual investment 10 times — thanks to our depositor’s money.
Now let’s change the scenario and assume that our bank was successful in loaning all $1,000,000, however, we made some shaky loans and $100,000 (10%) of the bank’s original portfolio never got paid back. Therefore, instead of receiving $1,050,000 at the end of the year, our bank only received $945,000, which is $900,000, plus interest of $45,000. However, we still had promised to pay our depositors back the full $1,030,000, even though we only received a total of $945,000. This means that we have to dip into our $102,000 of equity, which is still on reserve.
At the end of the year, we took in $945,000, plus $102,000, totaling $1,047,000; then we paid back our depositors $1,030,000 and finally, we put back into the vaults what is left of our $100,000 equity, leaving our bank with a loss of $83,000. Yes, we lost 83% of our equity! Therefore, leverage is a double-edged sword that can earn huge profits, but can also inflict great losses.
Assuming that banks earn a positive return on their loan or investment portfolios, they can use their leverage to dramatically increase profitability. On the other hand, as was discovered in 2008, if they suffer a negative return, through either bad loans or bad investments, they can lose money just as dramatically. And, in 2008 leverage wasn’t just ten-to-one, it was twenty and even over thirty-to-one! After banking deregulation, there were still capital requirements to which all of the investment banks needed to adhere; however, in 2004, under pressure from the “Big Banks”, the Net Capital Rule allowed the brokerage divisions of banks with assets over $5 billion the flexibility of unlimited leverage on investments. And of course, their investments of choice were mortgage-backed securities.
Even in 2013, the largest bank in the United States, JP Morgan Chase Bank, had total assets of $2.42 trillion while its total liabilities were $2.2 trillion, leaving a positive net worth (or equity) of $211 billion. Therefore, its debt-to-worth ratio was 10.4 to 1, or looked at another way, the bank has leveraged its equity, with debt, over 10 times!
To give you a base of comparison: traditionally, if you were a bank credit analyst and you were reviewing the financial statements for one of your business customers, you would like to see a 1 to 1 debt-to-worth ratio, even though several large companies carry higher ratios, 10 to 1 would be considered ridiculously leveraged. In other words, to qualify for a bank loan, the loan officer wants your company’s leverage to be one times your equity. A banker may justify this apparent hypocrisy by explaining that bank assets are very secure — and protected by the federal government. Chase can say to its depositors: “don’t worry, your money is safe with us,” and it is true, up to $250,000, thanks to the taxpayer-backed FDIC (and, if needed, the likelihood of a Washington bailout); and the borrowers don’t care how safe the bank is once they have some of its money. It is the taxpayers of America that care about the safety of our banking system, because if it fails, then the economy crumbles and down comes the entire international house of cards.
It has always been difficult for banks to successfully solicit enough high-quality loans to maximize the leverage on their deposits, which are liabilities on their balance sheet. They therefore successfully lobbied to repeal the Glass-Steagall Act, which separated commercial banking activities from investment banking, and the direct investment in securities. This gave banks a new avenue to create and invest in securities like stocks, bonds and a plethora of new exotic investment packages. During the Glass-Steagall era, banks could package and sell their loan portfolios to other banks, called “Loan Participations.” However, even that had its risks, as evidenced by the Penn Square Bank fiasco where the bank sold huge participations in bad real estate loans to other unsuspecting banks.
You can see that banks are a heavily leveraged business, and since our tax dollars are paying to insure their deposits it is in our best interests that government regulations assure a safe and financially sound banking system.
(From the Book Greed, Power and Politics, the Dismal History of Economics and the Forgotten Path To Prosperity, by Daniel Cameron)