The following is an excellent excerpt from the book “AFTER THE MUSIC STOPPED: The Financial Crisis, the Response, and the Work Ahead” by Alan S. Blinder from Chapter 3 “The House of Cards” on page 64 and I quote: “Why did so many smart people believe these laissez-fairey tales? It’s a good question. Some of the blame goes to the excessive faith in free markets that was the elixir of the day. Some goes to economists who believed and extolled the efficient markets hypothesis—and taught it to their students, many of whom wound up as financial engineers on Wall Street.
Another part almost certainly came from people’s collective tendency to forget the past. When times are good, asset values are rising, and loan defaults are rare, it is all too easy to forget one of the laws of financial gravity: What goes up too fast usually comes crashing down. The late Hyman Minsky, an important but neglected economist, emphasized the forgetfulness factor in his theory of recurrent financial crises. In recent years, many Wall Streeters have taken to calling the 2007-2009 crisis a “Minsky moment.” [FOOTNOTE: The term was apparently coined by economist Paul McCulley.] It was quite a moment. Too bad traders didn’t remember their Minsky before the debacle. Too bad regulators didn’t, either.
THE EFFICIENT MARKETS HYPOTHESIS
The adjective “efficient” in “efficient markets” refers to how investors use information. In an efficient market, every titbit of new information is processed correctly and immediately by investors. As a result, market prices react instantly and appropriately to any relevant news about the asset in question, whether it is a share of stock, a corporate bond, a derivative, or some other vehicle. As the saying goes, there are no $100 bills left on the proverbial sidewalk for latecomers to pick up, because asset prices move up or down immediately. To profit from news, you must be jackrabbit fast; otherwise, you’ll be too late. This is one rationale for the oft-cited aphorism “You can’t beat the market.”
An even stronger form of efficiency holds that market prices do not react to irrelevant news. If this were so, prices would ignore will-o’-the-wisps, unfounded rumors, the madness of crowds, and other extraneous factors—focusing at every moment on the fundamentals. In this case, prices would never deviate from fundamental values; that is, market prices would always be “right.” Under that exaggerated form of market efficiency, which critics sometimes deride as “free-market fundamentalism,” there would never be asset-price bubbles.
Almost no one takes the strong form of the efficient markets hypothesis (EMH) as the literal truth, just as no physicist accepts Newtonian physics often provides excellent approximations of reality. Similarly, economists argue over how good an approximation the EMH is in particular applications. For example, the EMH fits data on widely traded stocks rather well.
But thinly traded or poorly understood securities are another matter entirely. Case in point: Theoretical valuation models based on EMH-type reasoning were used by Wall Street financial engineers to devise and price all sorts of exotic derivatives. History records that some of these calculations proved wide of the mark.
Something New Under the Sun: CDS – In the year 2000, a creative new type of derivative called a credit default swap (CDS) began to emerge. Its origins can be traced back a few years earlier, to a team of bright young financial engineers at JP Morgan in the 1990s. When I was vice chairman of the Federal Reserve in the mid-1990s, the Fed staff was just educating us about this unfamiliar new instrument, and we were trying to figure out what kind of beast it was. Little did we know that it was destined to play a huge role in the upcoming financial crisis.
A CDS is an insurance contract posing as a derivative. The seller insures the buyer against loss from the default of a particular bond. If the bond does default, the insurer pays off. In return, the “policyholder” makes periodic “premium” payments to the insurer—just as you do with your life and automobile insurance policies. If the bond never defaults, which is the usual case, the seller wins and the buyer loses. But in the event of default, the seller loses big time. It’s classic insurance: The insurer incurs very large losses, but only rarely.
Why have derivatives contracts like that in the first place? The original reason was to allow investors to hedge against the risk of nonpayment. Suppose I own a $1 million General Motors bond and become worried that GM might default. I could go to a big insurer like AIG—to pick a nonrandom example—and purchase a CDS on the bond. Under this contract, I would agree to pay AIG periodic insurance premiums. But if GM subsequently defaulted, AIG would absorb the loss. AIG would relieve me of the risk of default—for a fee, of course. That’s what insurance companies do.
In short order, however, the use of CDS for hedging became dwarfed by their use for gambling—that is, for placing bets on, for example, whether GM would default—no ownership of GM bonds required! Suppose Smith believes GM will default while Jones believes it will not; neither owns the underlying GM bond. Smith can buy a CDS on the bond, and Jones can sell one. In trade parlance, deals like those are called “naked CDS” because neither party owns the bond. And look what happens. Prior to the CDS, neither Smith nor Jones had any stake in whether GM defaulted. But after the transactions, they do. If GM defaults, Smith wins and Jones loses; and the reverse occurs if GM pays on time. Risk has been created, not extinguished. This evolution from hedging to gambling is typical of financial innovation. New instruments that are originally—or perhaps allegedly—designed to hedge away risk typically become innovative ways to create risk where none existed before. Total risk taking in society rises.
Three other key features of CDS are worth noting because they, too, are typical of derivatives. First, the deal embeds huge synthetic leverage. If the CDS buyer makes just a few premium payments before GM defaults, she wins a huge multiple of her investment, and the CDS seller suffers a commensurate loss. So the stakes can be very high.
Second, taken together, the two deals are zero-sum. What Smith wins, Jones loses, and vice versa. Enthusiasts of derivatives often trumpet this fact to argue that such bets between consenting adults pose no dangers to society as a whole. That seems right until you ask what happens if the loser can’t pay. Who insures the insurer? That became the nasty question of the day in 2007-2008, when perceived counterparty risk soared. In September 2008, the government concluded that AIG would not be able to pay off its vast cadre of CDS counterparties and, in essence, nationalized the company—turning its huge liabilities into taxpayer liabilities rather than let AIG collapse.
Third, derivatives dealers make money on both ends of the trade. Smith and Jones probably don’t even know each other. To buy or sell a CDS, they go to one of the big swaps dealers, who will find someone to take the other side of the bet—charging a fee for their work. In practice, the dealer bank will probably take the other side of the trade itself and then look to sell it. In the crisis, many of them got stuck with unsold inventory.
While there are certainly exceptions, each of these features is typical of customized derivatives, so it’s worth keeping them in mind. The huge synthetic leverage embedded in derivatives enabled quantum leaps in risk taking during the boom. The huge profit margins on customized derivatives drove dealer banks into feeding frenzies to expand volume. And when things started going off track, rampant fears of counterparty default played major roles in shutting down markets.
CDS were perhaps the derivatives markets’ biggest boom-bust story. ISDA data on the notional value of CDS outstanding begin only at year-end 2001—at a mere $919 billion. Before that, activity was small. By the end of 2007, CDS volume topped $62 trillion, for a staggering compound growth rate of 102 percent per annum over six years. In 2008 it was estimated that about 80 percent of CDS outstanding were “naked”–that is, were pure financial bets rather than hedges. This is a major reason why such a seemingly small corner of the credit markets—subprime mortgages—caused such widespread damage. The underlying mortgage risk was greatly magnified, not reduced, by trillions of dollars of CDS sitting atop the rickety house of cards.
Thus was the stage set for 2007. We had a financial system with serious vulnerabilities. We had deregulation-minded regulators who were more enamored of innovation than safety. We had no federal mortgage regulator at all. We had a huge and almost entirely unregulated shadow banking system that was growing like mad, both in size and in scope. We had a wild and woolly world of derivatives into which regulators were not allowed to set foot. And we had lots of subprime mortgages, already going bad. A risky brew, to say the least. As it turned out, every American, unfortunately and without knowledge or consent, had a stake in the complex gamble.
The hints for future financial reform here are clear enough; they are all embedded in the last paragraph. We need better bank regulation. We need to regulate the shadow banking system and the markets for derivatives. And we need a federal agency watching out for predatory mortgage practices. This last point brings me to the next villain in this dismal story.
VILLAIN 4: DISGRACEFUL PRACTICES IN SUBPRIME MORTGAGE LENDING – It is no secret that subrpime mortgages led us into the mess. Many of them were inherently crazy, and they became the basis for even greater zaniness in the wild worlds of mortgage-backed securities and derivatives. Regulators never should have allowed so many of these disgraceful mortgages to be written. So, blame the regulators. But what about the reckless banks and nonbank lenders that granted them, and the irresponsible securitizers who bought them and then peddled dodgy mortgage-backed securities to gullible or unwary investors? Blame them, too. The tragedy begins, however, with the huge volume of risky mortgages that should never have been created in the first place.
Consider the sad case of Alberto and Rosa Ramirez, a pair of Mexican American strawberry pickers in California whose annual income was in the $12,000 to $15,000 range and whose English was marginal at best. Egged on and assisted by an unscrupulous real estate agent looking for a big commission, the Ramirezes obtained a $720,000 mortgage from the notorious (and now bankrupt) New Century Financial Corporation to buy a $720,000 house. Yes, you read that right: They didn’t put a penny down, and the mortgage was forty-eight to sixty times their annual income! The real estate agent apparently recorded their income as $12,000 per month and their occupations as “field technicians.” Slight errors. The Ramirezes moved into their McMansion with another family, and somehow, including receiving financial help from the real estate agent, managed to hang on for a few years before defaulting and losing their home to foreclosure.
Now, here’s a simple test of banking IQ: Should that mortgage have been granted? You may not be an experienced banker, but your no answer is correct. Unfortunately, New Century got the answer wrong in 2005 when it actually made this loan and many others like it. Other banks made similarly disgraceful loans. Yes, you are asking the right question: What were these guys smoking? Apparently, the weed was called greed. Make the loan, pocket the commission, pass it downstream, and let someone else worry about the consequences.
In fairness, not every subprime mortgage was as crazy as the Ramirezes’. Indeed, the basic ideas behind subprime lending are not bad per se. Subprime borrowers are people whose credit histories do not qualify them for conventional “prime” mortgages. For the sake of concreteness, that means their FICO scores below 620. But, of course, some borrowers just miss the cutoff; they are “almost prime” borrowers. Some of them fall into the next category, the so-called Alt-A mortgages. Others have special mitigating circumstances (e.g., no borrowing history), or are good bets for other reasons, despite their low FICO scores. It is not necessarily foolish or irresponsible to lend money to such people, especially if house prices keep on rising. And the government was not necessarily wrong-headed to help some of these people become homeowners.
But there is a difference between serving “almost qualified” borrowers who want to own homes they can probably afford and seeking out anyone who can sign his or her name on a mortgage document. You can have too much of a good thing—and we did. The volume numbers speak for themselves. Subprime mortgage originations were a mere $35 billion (under 5 percent of total originations) in 1994 but reached a stunning $625 billion (20 percent of the total) in 2005—almost an eighteen-fold increase in just eleven years. Two possible explanations for this explosive growth suggest themselves: Either a huge number of creditworthy subprime borrowers suddenly appeared out of nowhere, or underwriting standards dropped like a stone. Take your pick.
In case you need a hint, let me tell you that “low-doc” mortgages (loan files with little documentation), “no-doc” mortgages (files with no documentation at all), and even “liar loans” (you can probably figure out what that means from the Ramirez case) became prevalent in the early-to mid-2000s. It has been estimated that almost one third of all subprime mortgages were of either the low-doc or no-doc variety. My own personal favorite candidates for the hall of shame were the so-called NINJA loans—granted to people with no income, no jobs, and no assets. No one seems to know how many NINJA loans were actually granted, but Banking 101 tells us that the prudent number was zero.
Lending to high-risk borrowers is one thing, but the structures of many of these subprime mortgages made things worse. Indeed, economist Gary Gorton, a consultant to AIG, has argued that many subprime mortgages were “designed to default.” The most popular such example was the “2/28 ARM.” These were 30-year adjustable-rate mortgages (ARMs) with, say, a barely affordable “teaser rate” like 8 percent for the first two years that would reset to a presumably higher rate (say, LIBOR plus 6 percent) after that. [FOOTNOTE: LIBOR, the subject of a huge financial scandal in 2012, is the London Interbank Offer Rate. In 2006 it averaged over 5 percent. Hardly any subprime borrowers had any idea what LIBOR was or on what factors it depended. When the crisis struck, LIBOR soared at first.]
Very few holders of such mortgages could afford to pay the higher rates they would likely face in two years. In true bubble mentality, they were essentially betting on rising house prices. If their house values rose enough, they could refinance their mortgages two years later, pay off their old ARMs (thus avoiding the higher interest rates), and even take some cash out of the deal. But if not, they’d be unable to pay. At that point, the lender—not the borrower—would decide whether to issue a new mortgage or to keep the collateral. People of modest means should not subject themselves to such large financial risks. If they want to, their bankers should just say no.”
(THE FOLLOWING IS FROM THE INSIDE JACKET COVER AND I QUOTE:
“One of our wisest and most clear-eyed economic thinkers offers a masterful narrative of the crisis and its lessons. Many fine books on the financial crisis were first drafts of history—books written quickly to fill the need for immediate understanding. Alan Blinder, the esteemed Princeton professor, Wall Street Journal columnist, and former vice chairman of the Federal Reserve Board, waited, taking the time to think his way through to a truly comprehensive and coherent narrative of how the worst economic crisis in postwar American history happened, what the government did to fight it, and what we must do from here—mired as we still are in its wreckage.
With bracing clarity, Blinder shows us how the U.S. financial system, which had grown far too complex for its own good—and too unregulated for the public good—experienced a perfect storm beginning in 2007. Things started unraveling when the much-chronicled housing bubble burst, but the ensuing implosion of what Blinder calls the bond bubble was larger and more devastating. Some people think of the financial industry as a sideshow with little relevance to the real economy—where the jobs, factories, and shops are. But finance is more like the circulatory system of the economic body: If the blood stops flowing, the body goes into cardiac arrest. When America’s financial structure crumbled, the damage proved to be not only deep, but wide. It took the crisis for the world to discover just how truly interconnected—and fragile—the global financial system is.”
WHEN THE HOUSING MARKET COLLAPSED, IT HAPPENED BECAUSE THERE WERE NO MORE REAL ASSETS. THE DERIVATIVES MARKET WAS WORTHLESS. AIG WAS SELLING CREDIT DEFAULT SWAPS ON THE COLLATERALIZED DEBT OBLIGATIONS (CDOs) WHILE ALL THE WHILE, FED CHM BEN BERNANKE SAID THE MARKET WAS GOOD. WHAT YOU HAVE ARE LIES PILED ON MORE LIES.
LaVern Isely, Progressive, Independent, Overtaxed Middle Class Taxpayer and Public Citizen and AARP Members