[academic] Understanding Financial Instruments
[academic] Understanding the Financial Instruments in the 2008 Crisis
2 November 2016
SOC 120 Paper #2
Describe the financial instruments involved in the financial crisis including mortgages, sub- prime mortgages, and mortgage backed securities, cdo, and cds. How was the crisis created by the production of these instruments?
Despite being several years removed, the 2008 financial crisis still remains opaque to most Americans. This lack of clarity is a testament to the foreignness of finance to the average American, as well as the technical complexities of the financial market. In this paper, I identify the four primary financial instruments that were involved in the crisis. The origins, logic, and implications of each instrument is examined in detail. I first examine mortgages. I then explore the invention of securities and how mortgages became securitized. I then turn to CDOs and CDMs. I finally look at CDSs, and synthetic CDOs using CDSs. I argue that the crisis occurred due to the proliferation of these instruments and the system wide lack of understanding in regards to the kinds of risks they carried. Specifically, many were unaware how these instruments created a lack of information for financial product buyers, and a lack of accountability for sellers. This theme of unaccountable product sellers and unaware product buyer runs throughout all of these four instruments despite their various internal intricacies.
The Initial Rise of Mortgages
The story begins in the 1970s as an entire generation of America sought homeownership. McLean writes, “The baby boom generation was growing up.. But given their vast numbers- there were 76 million births between 1949 and 1964- many economists worried that there wouldn’t be enough capital to fund all their mortgages.” Purchasing a home through monthly payments spread over thirty years had been in practice prior to the 1970’s. But S and L banks could no longer fund these mortgages due to structural interest rate changes. McLean writes, “The thrifts financed their loans by offering depositors saving accounts, which paid an interest rate set by law at 5.75 percent. Yet because the late 1970s was also a time of high inflation and double-digit interest rates, customers were moving their money out of S&L’s and into new vehicles like money market funds, which paid much higher interest.”...Ranieri would later recall, “The funding mechanism was broken.” (McLean, 5)
A key player in mortgages was Fannie Mae, “born during the Great Depression. Its original role was to buy up mortgages that the VA and Federal Housing Administration were guaranteeing, thus freeing up capital to allow for more government-insured loans to be made.”
In response to the above mentioned macroeconomic shifts, in 1968, Fannie Mae split into two. Ginnie Mae “continued buying government-insured loans and remained firmly a part of the government.” Fannie Mae however, “was allowed to do several new things: it was allowed to buy conventional mortgages (ones that had not been insured by the government), and it was allowed to issue securities backed by mortgages it had guaranteed...In the process, Fannie became a very odd creature. Half government enterprise, it had a vaguely defined social mandate from Congress to make housing more available to low-and middle income Americans. Half private enterprise, it had shareholders, a board of directors, and the structure of a typical corporation.” (McLean, 7) Another related institution that was involved was Freddie Mac which was created by Congress to “buy up mortgages from the thrift industry….allowing S&Ls to make more mortgages.” Freddie went public in 1989. Prior to 1989 it was owned by thrift industry and regulated by FHLBB. (McLean, 7)
I have described certain basic changes within American demographics, macroeconomic conditions, and consequently the organizational landscape. The discussion proceeds with an examination of securities and how they further modified the process of purchasing a home.
The Invention of Mortgage Securities and CDO/CMOs
It is important to note that within modern capitalism, there is a constant imperative to invest accumulated capital profitably. This has supposedly been one of the greatest achievements of the financial industry. Capital that would have otherwise have lain idle, can now be used towards mutually beneficial, productive ends. To reiterate, financial markets work by connecting parties that have surplus funds, with parties that require funds. This has always been a basic feature of capital markets. In this section, the application of financial markets to mortgages is explicated.
McLean writes that, “The mortgage market was highly inefficient. In certain areas of the country, at certain times, there might be a shortage of funds. In other places and other times, there might be a surplus. There was no mechanism for tapping into a broader pool of funds. As Dick Pratt, the former chairman of the Federal Home Loan Bank Board, once told Congress, “It’s the largest capital market in the world, virtually, and it is one which was sheltered from the normal processes of the capital markets.” (McLean, 5) Ranieri coined the term “securitization” to describe the process because it was a “technology that in essence enables us to convert a mortgage into a bond.” (McLean, 5)
But this story of the rise of the rise of securities must be heavily qualified. It is easy to depict securities as the exclusive invention of one particular agent, but in actuality it relied on a confluence of factors. “The truth is, though, that the creation of mortgage-backed securities was never something Wall Street did entirely on its own...they would never have succeeded if the government hadn’t paved the way...More important, they couldn’t have done it without the involvement of Fannie Mae and its sibling, Freddie Mac, the Federal Home Loan Mortgage….a story of alliances and feuds, of dependency and resentments.” (McLean, 6)
Securities clearly exemplify the theme of an information disconnect between buyers and sellers. Ginnie and Freddie Mac were both government sponsored entities and therefore was able to take on risk in ways that a traditional market agent might not be able to. Furthermore, institutional investors purchased securities knowing that their government affiliation implied triple A status even though this might not necessarily be the case. “ In 1970 Ginnie first sold FHA and VA loans as securities, guaranteeing payment of principal and interest. “A year later, Freddie Mac issue the first mortgage-backed securities...in doing so it was taking on the risk that the borrower might default, while transferring the interest rate risk from the S&Ls to a third party: investors.” “Volume grew slowly. It was not a huge success.” (McLean, 7)
Yet investors still were wary towards purchasing these mortgage backed securities. An innovation that appeared in response to these reservation was the CDO/CDM. A primary features of CDMs was their ability to mitigate risk related to interest rate change, a risky loan period in which the consumer may default, and the possibility of prepayment. This mitigation was achieved primarily through tranching. Larry Fink and First Boston in 1983 presented the first collateralized mortgage obligation with three tranches 1) short term five year debt 2) medium term twelve year 3) long term thirty year. Prior to tranching, this class of financial products totaled around 350 billion in 1981. By 2001, over 3.3 trillion dollars worth of CDMs were in circulation.
Critical to the success of CDMs were the willingness of the credit rating agencies to rate them. Companies like Moody’s, Standard and Poors, and Fitch Rating were the primary NRSROs. McLean writes, “At first, they resisted rating these new bonds, but they eventually came around, as they realized that rating mortgage-backed securities could be a good secondary business, especially as volume grew.” It is clear that rating agencies arguably no longer reflected true risk. Yet institutional investors likely were unaware of these changes in ratings practices, and furthermore took their government affiliated status as a guarantee. In this way, buyers suffered from critical misinformation. The impact of securities on risk is summarized succinctly by McLean, “Historically, he noted less than 2% lost their homes to foreclosure...but the new securitization market threatened to change that, because once a lender sold a mortgage, it no longer had a stake in whether the borrower could make his or her payments.”19
The Rise of Subprime Mortgages
Nonbank Originators played a crucial role in furthering the risks inherent in mortgage securities related products by issuing subprime mortgages. Because these originators were not affiliated with banks and and would not be affected by defaults and long term complications, they had no incentive to properly vet loan requests. Nonbank mortgage companies rose from 19% to 52%. Within the industry, three of the largest and most infamous are known as the Big 3 Hard Money Lenders- Roland Arnall, Long Beach Mortgage, Ameriquest. The lenders were enabled by a raft of deregulation like the 1980 Depository Institutions Deregulation and Monetary Control Act, the Alternative Mortgage Transaction Parity Act, the Resolution Trust Corporation, and the appearance of Credit Enhancements like letters of credit, overcollateralization, and senior/subordinated structures. All these deregulations functioned to reduce barriers towards lending. Reduction in capital market regulation might generally be considered beneficial, but when many of the products are risky and ‘flawed’, deregulation may serve to fan the flames.
Several other structural changes in the 1990s further exacerbated subprime mortgages. The 1990 National Homeownership Strategy was a response to the 1990s second S&L crisis, but inadvertently caused further instabilities. The Federal Reserve interests rate had had fallen and traditional tranching wasn’t working anymore which further fueled subprime. The 1992 OFHEO Bill proposed, neutered by Jim Johnson, allowed to maintain low capital requirements (McLean, 40)
The rating agencies also moved from a subscriber model to an issuer model. They no longer collected flat fees, but collected a fee per ratings issued. This clearly introduces a conflict of interests as an incentive to approve subprime mortgages for increased revenue is introduced. McLean writes that there was, “...an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to Wall Street.” (McLean, 111)
Just as we have seen in the case of mortgage securities, subprime mortgages perpetuated systematic risk by furth exposing information lacking buyers to risky products sold by sellers with no ‘skin in the game.”
The Introduction of CDSs aka Insurance on CDOs/CDMs (derivatives)
Just as mortgage backed securities and CMOs had helped to overcome buyer hesitations, derivatives were yet another innovation that purportedly mitigated risk. McLean explains derivatives as, “designed to shift risk from one firm’s books to another were practically metaphysical. After the transaction was completed, the original security remained on the first firm’s books, but the risk it represented had moved.” (McLean, 52) and their essential purpose as, “ to swap one kind of risk for another.” (McLean 54) In its essence, a credit default swap is simply an IOU, a promise to pay the loan total in the case of default.
A crucial motivation behind credit defaults swaps is the desire to overcome banking regulations that limit the amount of investments and loans that can be made at any given time relative to capital holdings. McLean writes that, “ Companies searched for ways to game the Basel rules. For instance, under Basel I, banks could set up an off balance sheet investment vehicle, and so long as the duration of its credit line was less than one year, the bank didn’t have to hold any capital against that vehicle. “ (McLean, 60)
The credit default swap functioned as this type of vehicle by working as an insurance policy against the possibility of default. One of the earliest examples was how damages from the 1994 Exxon Valdez spill was insured by the European Bank for Reconstruction and Development for a sum of $4.8billion.
McLean discusses how credit default swaps while seemingly a good idea, also served to create system wide risks, “What Brickell did not talk about- or, rather, what he consistently pooh-poohed- was the fear that, in dispersing risk so widely, derivatives were transferring risk from a single institution to the entire financial system. All that hedging of derivatives...was creating an interconnectedness among financial institutions that hadn’t existed before.” (McLean, 64)
No stress tests were applied within companies holding large amounts of CDSs and even the government seemed reluctant to require them to be conducted. Darcy Bradbury, deputy assistant secretary at Treasury was quoted as saying “As a general principle, there should be a demonstration that there has been, or will be, a failure of market discipline before the need for such broad Federal regulation is advanced.” (McLean, 68) This demonstrates how much the risks associated with CDSs was not understood.
Synthetic Securities aka Pooling Credit Swaps Monthly Flows
The final financial product to be discussed combines two instruments previously described. Synthetic securities are created by combining credit derivatives with securitization. Synthetic CDOs to be clear, are perhaps one of the riskiest variations of CDOs.
McLean describes synthetics as, “Instead of having a credit default swap reference a single company like Exxon, J.P. Morgan bundled together a large, diversified basket of credit derivatives that referenced hundreds of corporate debts. It was different from other kinds of securitization in one critical way. Investors in mortgage-backed securities owned pieces of actual mortgages. But those who invested in J.P. Morgan’s invention didn’t own a piece of the actual corporate loans. Instead, they owned credit default swaps- the performance of which was determined by the performance of the underlying corporate credits…”79
Just like other CDOs, these synthetics were tranched into equity, mezzanine, and super senior AAA portions. The first synthetic security was the 1997 Broad Index Secured Trust Offering or BISTRO. Bistro contained 9.7 billion corporate credits from over 307 companies, and only required 700 million in total insurance.
Synthetics continued to flourish as they failed to be regulated by federal agencies. For example, the Commodities Futures Modernization Act in 2000 under the Clinton administration ruled that derivatives were not to be regulated by the CFTC. In this way, they were largely completely free from any sort of government oversight and sellers of these products were generally unaccountable.
This essay has attempted to provide a broad overview of mortgages, mortgage backed securities and CDOs/CMOs, subprime mortgages, CDSs, and synthetic securities. In identifying macroeconomic preconditions, changes in the organizational landscape, and political-legal changes that accompanied these instruments, it has become evident that a common trend amongst these various products is the new levels of risk they introduced to the financial economy. I argued that this risk was fundamentally rooted in unaccountable sellers, and unaware buyers. As financialization continues to penetrate global markets, it is clear that the need for government regulation which seeks to ensure that buyers of financial products are more informed, and sellers are held accountable, is as critical as ever.
McLean Bethany, Joe Nocera. All the Devils are Here: The Hidden History of the Financial Crisis. Portfolio/Penguin 2011.