The subprime mortgage crisis and the failure of Bear Stearns are two painful examples of vulnerabilities in our financial system. I’ll explain both of these events using kitchen table examples. I’ll then discuss what went wrong and what can be done about it.
The Subprime Mortgage Crisis
Fundamentally, the subprime mortgage crisis is a liquidity crisis. Financial institutions are reluctant to write loans and they have less ability to buy and sell the loans they already own.
Loans are tremendously important in our financial system. Most people could not afford to own a house or a car without them. Most businesses could not be created and could not function without them. So when loans are more difficult to obtain, many other areas of our economy will take a hit.
So what causes a bank to become reluctant to write loans? Imagine that you buy a $200,000 home. You put a down payment of $40,000 and take out a loan for the remaining $160,000. Now imagine that the value of your home goes up to $220,000. You now have $18,000 in equity against which you can borrow (most home equity loans require that you hold at least 20% equity in your home). You might decide to enhance the value of your home by reinvesting that $18,000. Maybe you would remodel your kitchen or build a deck.
But what happens if the value of your home goes down? Say it’s only worth $180,000 now. You still owe your bank $160,000 so your equity is only $20,000. Since you have less than 20% equity, you probably won’t try to borrow more money against the value of your house. Now you have to wait until you make enough payments so that you have more than $36,000 in equity OR the value of your house goes back up before you can think about a home equity loan again.
For the last 20 years, the housing market has been going up, and therefore most of the financial institutions that wrote mortgages were making money and happily borrowing more money to reinvest (like you remodeled your kitchen in the first secenario).
But right now, most financial institutions are in a position that’s analogous to the latter case. Their equivalent of “percent of equity” is below where they want it to be. They feel overextended and therefore they will try to build up their equity and/or reduce their debt. So the only loans they want to write in this situation are those where the down payments are relatively high. In fact, the only real difference between financial institutions and you is that they set their target of debt to equity arbitrarily. The 20% figure that they apply to you is typically more like 12% for them. In the case of Bear Stearns, it was more like 2% … but I’ll get to that later.
So why are they all in this situation? There is a two-part answer to this question. First, financial institutions wrote a lot of low down payment loans. The housing market was generating good returns and a lot of folks we’re speculating (aka “flipping”). Furthermore, the mortgage market was such that most mortgages were written and then immediately sold so that the actual mortgage writer often didn’t do due diligence. Second, the housing market turned downward, and then homes purchased using low down payment loans were underwater. For example, someone might have paid $10,000 down and financed $190,000 on a $200,000 house. But then the value of the house went down to $180,000. So, now the homeowner has a $180K house and a $190K loan. In this situation, default on the loan becomes much more likely. Of course in a default, the financial institutions then get to foreclose and recoup some of the losses, but they often lose a substantial amount of the value of the loan in the process.
The bottom line on all this is that the assets (and therefore the equity) held by all the institutions participating in this market took a huge hit. The total loss has been estimated at around $400 Billion. The other problem is that the mortgage market is huge and just about every bank in the country was participating to some extent. So now most banks are feeling that they are over-extended and therefore that they don’t want to write any low down payment or otherwise risky loans. And now this problem is starting to be felt in other areas of the economy.
A detailed analysis of all of this can be found here:
http://www.brandeis.edu/global/rosenberg_institute/usmpf_2008.pdf
Bear Stearns
Bear Stearns was of course a big participant in the mortgage market. What made their situation catastrophic was that they were heavily leveraged. In other words, they were doing the very same thing that the low down payment house flippers were doing. They borrowed billions of dollars with a “down payment” (aka corporate equity) of only 2% as I alluded to earlier. So when they lost 10-15% of the value of their mortgages, they were tens of billions of dollars underwater.
Much like the homeowner that owes much more than his house is worth, Bear wanted to declare bankruptcy. But unlike the homeowner, Bear Stearns manages retirement accounts for tens of thousands of citizens. These accounts could not be frozen for 10 years while all the Bear stakeholders fought over Bear’s Assets in bankruptcy court. Also, Bear Stearns has Billions of dollars of obligations to other banks and so if Bear were allowed to fail, a chain reaction could occur.
So the FOMC re-wrote their rules to allow themselves to step in and engineer a buyout of Bear Stearns. In the process, the Fed had to guarantee tens of Billions of dollars in risky loans. The terms of the buyout were that the stock would be sold for $2/share which in theory was going to punish Bear shareholders (aka be the “moral hazard” for Bear’s bad investments).
However, the Bear bond holders went unpunished for making those “2% down” loans to Bear. This is analogous to the Government stepping into the subprime mortgage crisis and allowing borrowers to be foreclosed on, but then reimbursing banks for any money that they lost.
Conclusions
Loans are an important tool in our financial system and therefore we need to be very careful with respect to any kind of regulation.
However, clearly we need to understand how loans go wrong and minimize the associated risks. Bear Stearns and the subprime mortgage crisis are both examples of the kind of failure that can occur when a borrower has no stake in the repayment of a loan. This situation is MUCH more likely to occur when the borrower’s initial stake in a loan is low. But it can also occur if the lender overvalues the collateral of the loan.
I don’t think that we want to limit what lenders can do across the board. Lenders need to be able to take risks and fail. But in markets where many banks are exposed to large losses should a downturn happen, risks need to be mitigated. The 30 year fixed mortgage model seems to have stood the test of time. A borrower should have to put 20% down or buy payment insurance. Perhaps there needs to be some legal recourse against loan originators if collateral has been overvalued and the loan has been re-sold.
Bear Stearns points out the need to legally insulate retirement accounts from the failure of the financial institution that manages them. Furthermore, a means for punishing lenders to a failed institution without doing major damage to the financial system has to be put in place.
The insulation of retirement accounts should be straightforward. The punishment of lenders needs to be stretched out over time to soften the blow to the system. Perhaps in the event of another Bear Stearns, the Fed could immediately create a pool of cash that could be used for no-interest loans to bond holders to be repaid over a 5 year period. Thus, bond holders would still lose their money but it would happen much more slowly.
The Subprime Mortgage Crisis
Fundamentally, the subprime mortgage crisis is a liquidity crisis. Financial institutions are reluctant to write loans and they have less ability to buy and sell the loans they already own.
Loans are tremendously important in our financial system. Most people could not afford to own a house or a car without them. Most businesses could not be created and could not function without them. So when loans are more difficult to obtain, many other areas of our economy will take a hit.
So what causes a bank to become reluctant to write loans? Imagine that you buy a $200,000 home. You put a down payment of $40,000 and take out a loan for the remaining $160,000. Now imagine that the value of your home goes up to $220,000. You now have $18,000 in equity against which you can borrow (most home equity loans require that you hold at least 20% equity in your home). You might decide to enhance the value of your home by reinvesting that $18,000. Maybe you would remodel your kitchen or build a deck.
But what happens if the value of your home goes down? Say it’s only worth $180,000 now. You still owe your bank $160,000 so your equity is only $20,000. Since you have less than 20% equity, you probably won’t try to borrow more money against the value of your house. Now you have to wait until you make enough payments so that you have more than $36,000 in equity OR the value of your house goes back up before you can think about a home equity loan again.
For the last 20 years, the housing market has been going up, and therefore most of the financial institutions that wrote mortgages were making money and happily borrowing more money to reinvest (like you remodeled your kitchen in the first secenario).
But right now, most financial institutions are in a position that’s analogous to the latter case. Their equivalent of “percent of equity” is below where they want it to be. They feel overextended and therefore they will try to build up their equity and/or reduce their debt. So the only loans they want to write in this situation are those where the down payments are relatively high. In fact, the only real difference between financial institutions and you is that they set their target of debt to equity arbitrarily. The 20% figure that they apply to you is typically more like 12% for them. In the case of Bear Stearns, it was more like 2% … but I’ll get to that later.
So why are they all in this situation? There is a two-part answer to this question. First, financial institutions wrote a lot of low down payment loans. The housing market was generating good returns and a lot of folks we’re speculating (aka “flipping”). Furthermore, the mortgage market was such that most mortgages were written and then immediately sold so that the actual mortgage writer often didn’t do due diligence. Second, the housing market turned downward, and then homes purchased using low down payment loans were underwater. For example, someone might have paid $10,000 down and financed $190,000 on a $200,000 house. But then the value of the house went down to $180,000. So, now the homeowner has a $180K house and a $190K loan. In this situation, default on the loan becomes much more likely. Of course in a default, the financial institutions then get to foreclose and recoup some of the losses, but they often lose a substantial amount of the value of the loan in the process.
The bottom line on all this is that the assets (and therefore the equity) held by all the institutions participating in this market took a huge hit. The total loss has been estimated at around $400 Billion. The other problem is that the mortgage market is huge and just about every bank in the country was participating to some extent. So now most banks are feeling that they are over-extended and therefore that they don’t want to write any low down payment or otherwise risky loans. And now this problem is starting to be felt in other areas of the economy.
A detailed analysis of all of this can be found here:
http://www.brandeis.edu/global/rosenberg_institute/usmpf_2008.pdf
Bear Stearns
Bear Stearns was of course a big participant in the mortgage market. What made their situation catastrophic was that they were heavily leveraged. In other words, they were doing the very same thing that the low down payment house flippers were doing. They borrowed billions of dollars with a “down payment” (aka corporate equity) of only 2% as I alluded to earlier. So when they lost 10-15% of the value of their mortgages, they were tens of billions of dollars underwater.
Much like the homeowner that owes much more than his house is worth, Bear wanted to declare bankruptcy. But unlike the homeowner, Bear Stearns manages retirement accounts for tens of thousands of citizens. These accounts could not be frozen for 10 years while all the Bear stakeholders fought over Bear’s Assets in bankruptcy court. Also, Bear Stearns has Billions of dollars of obligations to other banks and so if Bear were allowed to fail, a chain reaction could occur.
So the FOMC re-wrote their rules to allow themselves to step in and engineer a buyout of Bear Stearns. In the process, the Fed had to guarantee tens of Billions of dollars in risky loans. The terms of the buyout were that the stock would be sold for $2/share which in theory was going to punish Bear shareholders (aka be the “moral hazard” for Bear’s bad investments).
However, the Bear bond holders went unpunished for making those “2% down” loans to Bear. This is analogous to the Government stepping into the subprime mortgage crisis and allowing borrowers to be foreclosed on, but then reimbursing banks for any money that they lost.
Conclusions
Loans are an important tool in our financial system and therefore we need to be very careful with respect to any kind of regulation.
However, clearly we need to understand how loans go wrong and minimize the associated risks. Bear Stearns and the subprime mortgage crisis are both examples of the kind of failure that can occur when a borrower has no stake in the repayment of a loan. This situation is MUCH more likely to occur when the borrower’s initial stake in a loan is low. But it can also occur if the lender overvalues the collateral of the loan.
I don’t think that we want to limit what lenders can do across the board. Lenders need to be able to take risks and fail. But in markets where many banks are exposed to large losses should a downturn happen, risks need to be mitigated. The 30 year fixed mortgage model seems to have stood the test of time. A borrower should have to put 20% down or buy payment insurance. Perhaps there needs to be some legal recourse against loan originators if collateral has been overvalued and the loan has been re-sold.
Bear Stearns points out the need to legally insulate retirement accounts from the failure of the financial institution that manages them. Furthermore, a means for punishing lenders to a failed institution without doing major damage to the financial system has to be put in place.
The insulation of retirement accounts should be straightforward. The punishment of lenders needs to be stretched out over time to soften the blow to the system. Perhaps in the event of another Bear Stearns, the Fed could immediately create a pool of cash that could be used for no-interest loans to bond holders to be repaid over a 5 year period. Thus, bond holders would still lose their money but it would happen much more slowly.
3 comments:
I've never understood how the questionable loans spread so far and so fast in the financial system. Is there any indication that there was actual fraud at that level (i.e. not at the level of loan origination, but beyond that)? Or maybe the smart financial boys knew they were buying and selling dogs but thought they were smart enough to time the market 100% of the time?
I've been meaning to research that aspect, but haven't had time. Of course it would not be surprising if this situation was exploited by what some have called "predatory lenders". I don't know to what extent that happened.
Well, from my light reading of newspaper articles, it looks like there was a certain amount of actual fraud by the loan orignators, but most of the cases involve borrowers doing something stupid and the orignators going along with it. It's unethical, perhaps, to let someone screw themselves to your benefit, but that doesn't necessarily entail fraud.
"Predatory lending" is kind of problematic to define. A borrower getting a worse deal from a particular lender than they could get elsewhere could be called predatory, but it seems that most of the time we're actually talking about people who CAN'T get a better deal elsewhere.
My real question isn't about the bad loans themselves, though, it's about these packages of loans that got bought and sold enthusiastically throughout the financial system, i.e. by smart knowledgeable people. Clearly, the risky loans were mispriced, but is that because smart people were stupid or because smart people were trying to stick other smart people with bad loans?
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