Underpricing Risk

The meltdown that occurred in the market was triggered by subprime mortgages, which allowed people with low incomes and tarnished or no credit histories to buy homes. At the height of the subprime craze, one Los Angeles mortgage broker told me, mortgages were being handed out by banks and mortgage providers to anyone who could “fog up a knife.” People with incomes of $15,000 to $20,000, with no credit ratings, or in some cases without even a steady job or citizenship papers were granted mortgages to buy $300,000 and $400,000 homes—with nothing down. What is staggering is precisely how much we and others binged on these “subprime” mortgages, as though they were U.S. savings bonds, not hugely risky financial instruments. How did this happen?

According to Peter J. Wallison, an expert in financial policy and co-director of the American Enterprise Institute’s project on financial policy, as of September 2008, there were roughly twenty-five million subprime and other nonprime mortgages outstanding, with an unpaid principal balance of over $4.5 trillion. Subprime mortgages, Wallison explained, are mortgages made to people with blemished credit and low scores on the standard measures used to estimate credit quality. Other nonprime mortgages—also known as Alt-A loans—“are mortgages that have adjustable rates, no or low down payments, and were made to people who did not have to state their income or their income was not verified,” he added. These were often referred to as “liar loans,” because you could cover up your financial weaknesses, still get a loan for little or nothing down and little to pay at first, and then the big payments would only kick in—or “reset”—later, in a year or two. In other words, the term “subprime loans” referred to the quality of the borrower—people known to be at risk of default from day one. “Alt-A loans” referred to the quality of the loan itself: the borrower may have a good or bad credit record, but these loans themselves were inherently risky because they were extended with little or nothing down, or with little or no credit history, or would reset at a much higher rate in the future, so there was always a good chance the buyer would not be able to meet the mortgage payments as a result of one or more of these conditions. As long as housing prices were going up, though, those holding Alt-A loans could just flip the house when the rate reset, as many speculators riding the boom did, and earn more than the original mortgage value. And brokers were not above telling people: “No worries: Buy now and if you can’t meet your mortgage payments, just sell the house. Prices will only go up. It will be worth more tomorrow than it is today—for sure.” When housing prices started to go backward, though, and the Alt-A or subprime payments really kicked in, many people holding them were crushed by debt. Their mortgages went up and their home values went down, so they could not escape.

It is stunning how many people got caught up in this. According to Wallison, the twenty-five million subprime and Alt-A loans amounted to almost 45 percent of all single-family mortgages in the United States in 2009.

Not so long ago, this was the norm: Your parents saved long and hard to make a 10 or 20 percent down payment on their home and took out a thirty-year mortgage for the balance from a bank or a credit union, and that institution held the mortgage for its life. You were tethered together. There was a sense of mutual accountability. The new system introduced a new norm: These subprime mortgages were extended by banks and mortgage brokers and then immediately sold to bigger financial firms, like Citibank, Merrill Lynch, or Fannie Mae and Freddie Mac—the government-sponsored institutions set up to work with primary mortgage bankers and brokers to help ensure they had funds to lend to home buyers at affordable rates. These investment banks and securities firms earned big fees by bundling thousands of these mortgages together into bonds—known as mortgage-backed securities—and then selling them to buyers all over the world. It seemed to make sense to take a bunch of home mortgages that had a predictable cash flow and package them together into a single bond offering that collected all the monthly mortgage payments and then used that cash flow to pay the interest and principle on the bond to the person who bought it. Presto—you have just created an asset-backed security. Fund managers all over the world bought these bonds. Why not? They were paying interest rates better than your average T-bill, and this fattened the balance sheets of those banks or funds that held them, and they seemed as secure as any AAA corporate bond. After all, the rating agencies gave them good marks and Americans—at least our parents’ generation—had a long track record of paying off their mortgages.

“This was certainly true when almost all mortgages were prime — made to people with jobs and down payments and at fixed interest rates for thirty years,” said Wallison. “Even in the worst downturns, foreclosure rates rarely reached 4 percent.” The boom in subprime mortgages was something entirely new, though, he added. Subprimes had always existed, but were traditionally a small part of the total mortgage pool. There was good reason for this—they are very risky. Some projections of total foreclosure rates in the current downturn are 30 percent, he said. Then why did we go on such a binge? A key factor, said Wallison, was a deliberate United States government policy to foster homeownership and to encourage quasi-government entities that had access to endless cheap capital, particularly home-lending entities like Fannie Mae and Freddie Mac, to make mortgages available to more and more people through “flexible underwriting standards.”

“Fannie and Freddie were the enablers,” said Wallison. They first stimulated the development of a subprime and Alt-A market on Wall Street by buying huge amounts of AAA tranches of subprime mortgages from different investment banks, and holding the bonds. Then, in late 2004, they began to buy these primary junk loans in large amounts and bundled them into bonds themselves, competing for product with Wall Street. “The fight between Wall Street and Fannie and Freddie,” said Wallison, “drove down the price of junk mortgages, drove up the housing bubble, and filled it with unprecedentedly low quality mortgages … This is a story about how a well-intended government policy caused a substantial decline in the quality of U.S. mortgages and ultimately the financial crisis we are living with today.”

By the way, what are AAA tranches? This is important. Imagine that you had a pile of dishes in your sink and each of those dishes represented a group of mortgages of different qualities that were all being packaged into one bond offering. The worst BBB and CCC dishes were at the bottom of the sink and paid the highest interest because they were the riskiest. The best, with the most secure borrowers—AAA—were at the top. Then you started to fill the sink with water—the Great Recession of 2008/9. The riskiest tranches of mortgage-backed securities quickly went under water. The best, the AAA tranche, would normally remain above water. Usually, those tranches of mortgage-backed securities never got wet. But this Great Recession was not usual and today many of those AAA tranches are also under water and worth either nothing or only a fraction of their original value.

This subprime frenzy, though, was abetted by more than just a U.S. government desire to promote homeownership and construction. It was also abetted by a broader easing of credit and low interest rates—too low for too long—under the Federal Reserve leadership of Alan Greenspan in the early 2000s. This easing of credit by the Fed, in turn, was enabled by the massive amount of dollars sloshing around the global economy from all the high-saving countries, particularly the Asian Tigers, Middle East oil exporters, and China. Many economists now believe that it was this huge pool of Asian savings and Middle Eastern petrodollars — managed by sovereign wealth funds in all these different countries and reinvested back in America—that depressed interest rates on U.S. Treasury securities and spurred investment bankers and financial wizards to come up with “innovations” that would produce higher yields. This led them to offer more and more subprime mortgages and more and abstruse and exotic derivatives and insurance products surrounding them.

I like the way Sherle R. Schwenninger, director of the Economic Growth Program at the New America Foundation, summarized the situation. Writing in The Nation (December 23, 2008), he noted: “The root cause of this unbalanced world economy was the enormous pool of excess savings generated by China, Japan and, more recently, the petrodollar states of the Persian Gulf. This global savings glut, as Federal Reserve chairman Ben Bernanke called it, helped fuel a succession of asset bubbles in the United States, culminating in the expansion of easy credit and the rapid run-up of housing prices following the collapse of the tech-stock bubble,” notes Schwenninger. “These housing and credit bubbles in turn helped inflate consumption by enabling households to take on more debt; household debt as a percentage of disposable income rose from 90 percent in the late 1990s to 133 percent in 2007.”

To put it in simple terms, the banks and sovereign wealth funds holding Mrs. Tanaka’s savings in Japan, Mr. Zhou’s savings in China, and Mr. Abdullah’s savings in Kuwait shipped them to Wall Street, where some of America’s best rocket scientists designed financial products to get them a higher rate of return—without greater risks, or so they were told. With all that money chasing all that yield, it was inevitable that the financial houses managing all that money would lobby Washington to give them more and more “flexibility” to design investment instruments that could produce higher and higher yields. And Washington accommodated. With the end of the Cold War and the intensification of globalization, market-friendly presidents (Ronald Reagan, George H. W. Bush, Bill Clinton, and George W. Bush), along with congressmen and senators whose palms had been greased by Wall Street through campaign donations, rolled back banking regulations that had limited risk-taking. Some of these regulations had been on the books since the Great Depression.

So more and more money flowed into a less and less regulated financial system, and the banks took greater and greater risks with it—not just on subprimes but on all kinds of instruments—in more and more places using more and more exotic instruments and greater and greater leverage, making transactions that fewer and fewer people understood and were less and less transparent.

Consider one example—derivatives. In December 2000, the U.S. Congress passed, and then President Clinton signed, legislation spurred by the financial services industry that exempted derivatives from most oversight. Derivatives are financial instruments that “derive” their value from the price of some real stock, bond, service, or good. “Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date,” according to Wisegeek.com. So a bank or insurance company could earn money selling derivatives that insured mortgage-backed securities against default. These are called credit-default swaps. The poster child for this sort of innovation turned out to be the American International Group, the insurance giant.

Gretchen Morgenson and Don Van Natta Jr. described AIG’s misadventures into risky global finance in The New York Times (May 31, 2009): “After the 2000 legislation was passed, derivatives trading exploded, helping the biggest traders earn immense profits. The market now represents transactions with a face value of $600 trillion, up from $88 trillion a decade ago. JPMorgan, the largest dealer of over-the-counter derivatives, earned $5 billion trading them in 2008, according to Reuters, making them one of its most profitable businesses. Among the companies that expanded rapidly was A.I.G. Straying from its main business of providing property and life insurance, A.I.G. wrote a type of contract known as credit-default swaps that protected holders of mortgage securities against defaults. When millions of subprime borrowers stopped paying their mortgages, A.I.G. had to provide cash collateral that it did not have to clients that had bought its insurance.”

AIG completely underpriced, and in some ways hid, the risks it was taking. AIG owned a savings and loan operation, so its banking business was regulated at the federal level. It also sold insurance, so its insurance business was regulated by insurance commissioners in every state. But its derivatives business was run out of a hedge fund it created in its London office—AIG Financial Products, or AIGFP, which was part of the vast forest of unregulated hedge funds and private equity groups that had grown up in the last two decades and today accounts for about 50 percent of global credit, dwarfing the traditional banking sector. No one global institution regulates this sector. Even though AIGFP accounted for only 1 percent of the insurance behemoth’s total revenues, the risks it took on literally brought the house down when they went bad. And because this universe is very nontransparent and unregulated, few people inside AIG or outside were aware of how big the dice it had rolled were.

“Before the crisis,” noted Morgenson and Van Natta, “few market participants knew the size of A.I.G.’s exposure. Some derivatives transactions occur on exchanges, where the value and nature of the contracts are disclosed, but many do not. Credit-default swaps trade privately. This kept risk in these trades under wraps, leaving regulators unaware of how dangerously stretched and poorly managed the market was.”

How could sophisticated global finance firms get so crazy and take on so much risk? I’d point to two reasons. First, their math wizards came up with models that told them it was not that risky. In a special report about some of those financial nerds, known as “quants,” who built these mathematical models underlying all these mortgage-backed securities, Newsweek (June 8, 2009) recalled Warren Buffett’s dictum: “Beware of geeks bearing formulas.” The magazine then went on to tell the story of über-geek David X. Li, “who, while working at JPMorgan, created the Gaussian copula function, a formula for determining the correlation between the default rates of different securities.” In theory, if one mortgage-backed security defaulted, the model gave bankers an estimate of how many others would default as well. “The apparent genius of the Gaussian copula is its abstraction,” said Newsweek. “Rather than relying on the immense amount of data used to figure the odds that a [subprime bundle of mortgages and collateralized debt obligations] might default, Li appeared to have discovered a law of correlation. That is, you didn’t need the data; the correlation was just there. Armed with it, quants could price these much faster, and traders could buy and sell them at record speeds. Gaussian was rocket fuel for the CDO market. The global volume of CDO deals went from $157 billion in 2004 to $520 billion in 2006. As more banks got in on the game, the once-large profit margins started to shrink. In order for banks to make the same kind of returns, they had to pack more and more loans into a CDO, essentially making bigger bombs.” Needless to say, Li’s benign predictions about the correlation between defaults quickly proved wrong in the subprime crisis, when subprime mortgages and their bonds toppled together like dominoes. As Newsweek put it: “Li was on his way to a Nobel Prize when the world blew up.”

The second reason they so underpriced the risk was simpler. It is something that happens in every bubble: people who are apparently smart turn out to be really dumb — in large numbers. They buy into a notion that nothing can go wrong. In this case the notion was that housing prices in America would never go down again. As Michael Lewis pointed out in a piece on AIGFP in Vanity Fair (August 2009), the AIG unit was originally used by Wall Street investment banks to insure piles of loans to IBM and GE. Then, in the early 2000s, AIGFP started insuring “messier piles”: securities backed by credit card debt, student loans, auto loans, and prime mortgages—anything that generated a cash flow. As Lewis noted, these loans were of such a diverse nature and to so many different parties that the usual risk logic applied: they couldn’t all go bust at once. Originally, there were very few subprime mortgages in these piles. But that changed toward the end of 2004. “From June 2004 until June 2007,” wrote Lewis, “Wall Street underwrote $1. 6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans.” This expansion was made possible, in part, because AIGFP was ready to insure many of these piles of loans—and made billions of dollars doing it.

Why not? These different piles of loans all seemed so diversified that nothing really big could go wrong. And so AIG gorged on them, but without noticing that these piles of consumer loans it was insuring were changing, said Lewis. After 2005, subprime mortgages went from 2 percent to 95 percent of the consumer loan packages that AIGFP was guaranteeing, without maintaining anywhere near the capital required to cover them if there were widespread defaults. No problem. AIGFP officials were confident that housing prices, even if they fell, could never fall everywhere at once and thereby trigger massive defaults requiring the insurance giant to fork over cash to all the holders of subprime bonds at once. Lewis quotes Joe Cassano, who headed AIGFP at the time, on an investor conference call in the summer of 2007, as the subprime crisis was just starting to unfold: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 on any of those transactions.”

A few months later, housing prices across the land started falling like dominoes and AIGFP’s bets were on their way to bankrupting the entire company. That, ladies and gentlemen, is what you call massively underpricing risk.

IBG/YBG

It is a lot easier to underprice risk when you can take your percentage quickly and then pass off the bad loan to someone else. All that global capital that flowed into Wall Street in search of higher returns in the early 2000s arrived not only at a time of a loosening of credit and a loosening of traditional regulatory constraints in America, but also at a time of a loosening of ethics. Actually, it was worse than that. The Great Recession was caused in part by a broad-based breakdown in ethics by key players—bankers, rating agencies, investment houses, mortgage brokers, and consumers. You can have all the regulations in the world, but when greed tempts large numbers of people to lose sight of any kind of long-term thinking and sense of accountability, regulations won’t help you. It was not the illicit behavior that caused the Great Recession. It was all the stuff going on in plain sight by people who should have known better but suspended their beliefs and values and norms and skepticism to get in on the party. Yes, they had “principles.” Unfortunately, the whole credit bubble that destabilized the global economy was built on the “principles” known in the banking world as IBG/YBG—“I’ll be gone” or “You’ll be gone” when things go bad.

Here’s how it worked. The mortgage broker who first sold a family a mortgage and then passed it off to a bigger financial institution, like Fannie Mae or Citibank, knew that he would be “gone” if and when the family holding the mortgage defaulted: He would no longer own the mortgage—Fannie or Freddie or some investment bank would. So there was no risk for him personally in the high-risk deal. And he told the family that the same was true for them. There would be no problem if it turned out they couldn’t make the payments because “you’ll be gone”— because housing prices would always go up, they could just flip the house for more than they paid for it, or just walk away. The rating agencies, whose fees and revenues depended on how many of these bonds of subprime mortgages they got to rate, had a great incentive to give them high ratings so they would sell more easily and therefore more investment houses and banks would want to use their rating services. And if those bonds blew up, well, said the raters, IBG—“I’ll be gone.” The investment banks had a great incentive to bundle more and more mortgages into bonds and sell them around the world, because the fees were huge, and as long as they didn’t hold too many on their own balance sheets, if they blew up, who cared? IBG—“I’ll be gone.”

To put it another way, the whole system depended upon people who originated the risk profiting from that origination, then transferring that risk to someone else and never having to be responsible for it afterward. So people who never should have been taking out mortgages took them out, people who never should have granted them granted them, people who never should have bundled them bundled them, people who never should have rated them AAA rated them AAA, people who never should have sold them to pension funds and other financial institutions worldwide sold them. And companies that never should have been insuring them, like AIG, insured them, without setting aside sufficient assets to cover a massive default. Everyone just assumed they could profit personally in the short term and never have to worry what happened in the long term after they passed the bond along.

President Obama, in unveiling his own plan to regulate markets after the 2008 crash, put it well when he pointed out that Wall Street developed a “culture of irresponsibility,” which involved one person passing on risk to another until a risky financial product was finally bought by someone who didn’t understand either the risk or even how the bond or derivative actually worked. “Meanwhile,” said the president, “executive compensation—unmoored from long-term performance or even reality—rewarded recklessness rather than responsibility.”

Privatizing Gains and Socializing Losses

If the true risks involved in these subprime mortgages or default insurance had been priced into these products, they never would have been rated the way they were. Investors would have been much more wary and demanded much higher yields before buying them, which would have forced the mortgage brokers to be more careful in deciding to whom to give these mortgages and the banks to be much more careful in choosing which ones to bundle. But the money was just too good, the temptation to underprice the risk and privatize the gains just too tempting for everyone involved. And rare was the banker who could resist joining the party. As the former Citigroup CEO Charles Prince told the Financial Times on July 9, 2007, just weeks before the credit markets started nosediving: “as long as the music is playing, you’ve got to get up and dance.” Shareholders, board members, and market analysts were all saying to these financial houses and bosses: Why are you not as aggressive as the other guy? Why are you not bundling mortgages and CDOs? Why are you not bringing in these big returns? All the incentives for CEOs pushed them to take more risk. And boy, were there incentives. In December 2007, with the credit markets already badly shaken, Goldman Sachs Group Inc.’s chief executive officer, Lloyd Blankfein, was granted a $67.9 million bonus, the biggest ever awarded to the CEO of a Wall Street firm.

And if things later went bad for a CEO’s firm? No problem. Typically the CEOs’ contracts, written in the seven fat years, ensured that the worst they would get were golden parachutes. On November 1, 2007, Merrill Lynch CEO Stan O’Neal quit and received a golden parachute worth $161.5 million, despite the fact that his firm’s subprime investments would eventually result in over $2 billion of losses.

Some of our biggest financial firms got away from their original purpose—to fund innovation and to finance the process of “creative destruction,” whereby new technologies that improve people’s lives replace old ones, said the Columbia University economist Jagdish Bhagwati. Instead, he added, too many banks got involved in exotic and incomprehensible financial innovations that ended up as “destructive creation.”

Only when the whole edifice cracked in September 2008 with the collapse of Lehman Brothers, which forced Congress to establish a $700 billion emergency fund for the Treasury to prevent the financial system from melting down, did people grasp what had happened: TWG— “They were gone”—the bankers who piled up these risks and privatized the gains, but WWSH—“We were still here.” We had allowed Wall Street investors and executives to underprice risks and privatize their gains, but then force taxpayers to bail them out when the losses threatened a systemic breakdown.

Why were We the People left holding the bag? Because the economy depended on it. Key financial services companies had become too big to fail, and had we let them go down, we all would have gone down with them. You and I would have gone to our ATMs to withdraw money from our banks and nothing would have come out. That actually happened for a while to depositors in America’s oldest money market, Reserve Primary. The $64.8 billion fund held $785 million in short-term commercial paper, issued by Lehman Brothers. When Lehman filed for bankruptcy in September 2008, Reserve Primary couldn’t pay back its customers in full—$1 for every $1 they had on deposit—and had to close its doors for a period. “When the balance sheet of a company does not capture the true costs and risks of its business activities, and when that company is too big to fail, you end up with them privatizing their gains and socializing their losses,” Nandan Nilekani, a founder of the Indian technology company Infosys, said to me. That is exactly what played out. Thanks to its huge losses in the derivatives market, AIG alone required more than $170 billion in taxpayer support of one kind or another to stay afloat, as of summer 2009.

Alas, though, we Americans were not alone in thinking that we could fly. Other countries quickly copied us. It was inevitable. In a flat world, where connectivity is getting tighter and faster every day, and where the electronic herd of capital is moving around everywhere and anywhere looking for higher and higher returns, lots of people wanted in on this game. And it did not matter how small you were; anyone could open a global casino in their garage. Just ask Iceland.