Kip Hagopian

The Making of a Perfect Storm:

CAUSES OF THE GREAT MORTGAGE MELTDOWN OF 2008

Kip Hagopian

“…increasing numbers of ever-larger mortgages being granted to cover a rising percentage of the cost of houses bought at rising prices by borrowers of declining creditworthiness.”

Howard Marks

CEO, Oak Tree Capital

March 18, 2008

1. VERY LOW INTEREST RATES (EASY MONEY):

• EASY MONEY LED TO LOW INTEREST RATES

• LOW RATES RESULTED IN LOW MONTHLY PAYMENTS ON MORTGAGES.

• LOW MONTHLY PAYMENTS RESULTED IN HUGE INCREASES IN HOME PURCHASES AND REFINANCINGS.

• LOW INTEREST RATES ALSO INDUCED INVESTORS IN ALL ASSET CLASSES TO REACH FOR HIGHER RETURNS AND ACCEPT HIGHER RISK (OR OVERLOOK THE RISK THEY WERE ASSUMING).

2. PRESSURE ON FANNIE AND FREDDIE:

IN AN EFFORT TO INCREASE HOME OWNERSHIP BY MINORITIES AND OTHER LOW-INCOME CITIZENS, MEMBERS OF CONGRESS WITH SOME HELP FROM THE WHITE HOUSE PUT HEAVY PRESSURE ON REGULATORS AND BANKS (PARTICULARLY “FANNIE MAE” AND “FREDDIE MAC”) TO LOWER CREDIT STANDARDS. THIS RESULTED IN AN EXCEPTIONALLY LARGE NUMBER OF MORTGAGES BEING ISSUED TO POOR CREDITS IN A SHORT PERIOD OF TIME. THE ISSUANCE OF “SUBPRIME MORTGAGES” INCREASED FROM ALMOST NONE TO ABOUT 7% OF FANNIE’S AND FREDDIE’S PORTFOLIOS.

3. SECURITIZATION:

IN PURSUIT OF HIGHER PROFITS, INVESTMENT BANKS BEGAN PACKAGING LARGE NUMBERS OF RESIDENTIAL MORTGAGES INTO POOLS WHICH BECAME SECURITIZED, “RESIDENTIAL MORTGAGE-BACKED SECURITIES” (RMBS). THE POOLS INCLUDED SUBSTANTIAL NUMBERS OF SUBPRIME LOANS. THESE POOLS WERE SUPPOSED TO BE SAFER THAN THE UNDERLYING INDIVIDUAL LOANS BECAUSE OF THE SPREADING OF RISK OVER A LARGE NUMBER OF MORTGAGES. THE RMBS POOLS WERE FINANCED WITH MULTIPLE TIERS OF CAPITAL, WITH THE TOP TIERS BEING THE SAFEST (WHICH GOT AN ‘AAA’ RATING).

INVESTMENT BANKS CALCULATED THEIR RISKS USING MATHEMATICAL MODELS THAT WERE FAULTY. THE MODELS DID NOT ANTICIPATE “THE BLACK SWAN”.

4. CREDIT      INSURANCE:

IN ORDER TO SELL ALL TIERS OF THE RMBS PACKAGES (PARTICULARLY THE LOWER TIERS), THE INVESTMENT BANKS NEEDED TO FURTHER REDUCE THE RISK. THEY DID THIS BY INSURING AGAINST LOSS BY BUYING “CREDIT DEFAULT SWAPS” (CDS) FROM INSURANCE COMPANIES (CDS ARE A FORM OF LOSS INSURANCE). OF COURSE THE VALUE OF THE INSURANCE WAS TOTALLY DEPENDENT UPON THE STRENGTH OF THE INSURERS’ BALANCE SHEETS. AIG WAS THE LARGEST INSURER OF MORTGAGE BACK SECURITIES.

THE INSURANCE COMPANIES CALCULATED THEIR RISKS USING MATHEMATICAL MODELS THAT WERE FAULTY. THE MODELS DID NOT ANTICIPATE “THE BLACK SWAN”.

5. RATING AGENCIES:

THE RMBS COULD ONLY BE SOLD AT HIGH PRICES IF THEY HAD HIGH RATINGS FROM THE ESTABLISHED RATING AGENCIES. THE RATING AGENCIES OBLIGED, BELIEVING THE COMBINATION OF PORTFOLIO DIVERSIFICATION AND CREDIT INSURANCE LOWERED THE RMBS RISK ENOUGH TO MAKE THEM WORTHY OF HIGH RATINGS. THE RATINGS DIFFERED DEPENDING UPON THE TIER BEING RATED.

THE RATINGS AGENCIES CALCULATED RISKS (AND COMMITANTLY, ESTABLISHED RATINGS) USING MATHEMATICAL MODELS THAT WERE FAULTY. THE MODELS DID NOT ANTICIPATE “THE BLACK SWAN”.

6. MARK-TO-MARKET ACCOUNTING:

NOT LONG AFTER THE REGULATORS AND THE CONGRESS PRESSURED FANNIE AND FREDDIE TO LOWER CREDIT STANDARDS, THE GOVERNMENT REGULATORS, RELYING ON ADVICE FROM THE FINANCIAL ACCOUNTING STANDARDS BOARD, (THE “FASB”), MANDATED THAT FANNIE AND FREDDIE, AND ALL OTHER REGULATED BANKS, “MARK-TO-MARKET” THEIR PORTFOLIOS OF MORTGAGES (AND OTHER TYPES OF LOANS), WITH “MARKET” BEING DEFINED AS “FAIR MARKET VALUE” (FMV). UNFORTUNATELY, FMV MEASUREMENT WAS NEITHER PROPERLY DEFINED NOR WELL-SUITED FOR VALUING THESE KINDS OF ASSSETS. WHEN THE MARKETS FOR RMBS FROZE, BIDS ON BOTH RMBS AND WHOLE MORTGAGES (INDIVIDUAL MORTGAGES) DECLINED PRECIPITOUSLY, EVEN IN CASES WHERE THE MORTAGES WERE FULLY PERFORMING AND THE UNDERLYING COLLATERAL EXCEEDED THE PAR VALUE OF THE LOAN.

7. INADEQUATE REGULATORY STANDARDS FOR BANKS:

THE MINIMUM EQUITY REQUIREMENT FOR A TYPICAL BANK WAS NOMINALLY 8% OF ASSETS, MEANING ASSET WRITEDOWNS OF 8% OR MORE TECHNICALLY WIPED OUT THE BANK’S EQUITY, RENDERING THE BANK INSOLVENT. BANKS AND S&Ls ARE INSTITUTIONS THAT BORROW SHORT AND LEND LONG, SO THEY ARE DEPENDENT UPON THE CONFIDENCE OF THEIR LENDERS (THE DEPOSITORS) AND ON THE FDIC WHICH INSURES DEPOSITS (UP TO A $100,000 LIMIT PER ACCOUNT) AND ACTS AS A DETERANT TO A “RUN ON THE BANK”. WHEN CONFIDENCE DECLINED PRECIPITIOUSLY, DEPOSITORS WITHDREW CASH, NECESSITATING THE IMMEDIATE SALE OF MORTGAGES, GENERALLY AT DEPRESSED PRICES, WHICH REDUCED EQUITY; IN COME CASES CAUSING BANKRUPTCIES.

8. SEPARATION OF THE LOAN ORIGINATORS FROM THE OWNERS OF THE LOANS:

IN THE “OLDEN DAYS”, THE ORIGINATOR OF A LOAN BECAME THE OWNER OF THAT LOAN. NOWADAYS BANKS ORIGINATE MORTGAGES, GENERATE AN ORIGINATION FEE AND THEN SELL OFF THE LOANS TO FANNIE OR FREDDIE, TO OTHER BANKS, OR TO INVESTMENT BANKS FOR PACKAGING AND RESELLING. USUALLY THESE ORIGINATORS ALSO TAKE BACK A CONTRACT TO SERVICE THE LOANS BUT DON’T RETAIN OWNERSHIP, AND THUS, THE RISK. ACCORDINGLY, THE NEED TO MAKE SAFE LOANS BECAME LESS IMPORTANT THAN THE NEED TO MAKE FEE INCOME.

9.  EXCESS LEVERAGE:

MOST INVESTMENT BANKS AT THAT TIME, SEEKING EVER HIGHER RETURNS AND RELYING ON FLAWED RISK MODELS, WERE WAY OVER LEVERAGED. SO, IT WAS FANNIE AND FREDDIE. AND UNDER WHAT TURNED OUT TO BE AN EXCEPTIONALLY UNUSUAL CIRCUMSTANCE, SO WERE THE BANKS.

10. HUMAN NATURE:

INVESTORS WANTED HIGHER RETURNS ON THEIR INVESTMENTS. MANAGERS OF INVESTMENT BANKS WANTED HIGHER FEE INCOME. COMMERCIAL BANK MANAGERS WANTED TO ORIGINATE LOANS SO THEY COULD MAKE MORE ORIGINATION AND SERVICING FEES. MORTGAGE BROKERS WANTED TO CLOSE MORE LOANS SO THEY COULD MAKE MORE FEE INCOME. HOUSE “FLIPPERS” WANT TO TAKE OUT MORTGAGES FOR LITTLE MONEY DOWN SO THEY COULD MAKE HIGHER RETURNS ON THEIR INVESTMENTS.

ARE THESE PEOPLE “GREEDY” OR JUST RATIONAL? PERHAPS SOME OF BOTH.

WHAT ABOUT DEREGULATION?

THE ONLY GOVERNMENT INTERVENTION THAT APPEARS TO HAVE

INFLUENCED THIS DEBACLE WAS IN THE FORM OF PRESSURE APPLIED TO REDUCE CREDIT STANDARDS. WAS THIS “DEREGULATION” OR BAD REGULATION?

WHAT ABOUT FRAUD?

IT APPEARS THAT FRAUD PLAYED ONLY A MINOR ROLE, IF ANY, IN THE MELTDOWN. IN ANY EVENT, FRAUD WASN’T NEEDED TO CREATE THIS PERFECT STORM.

CONCLUSION:

EASY MONEY, GOVERNMENT PRESSURE TO REDUCE CREDIT STANDARDS, MARK-TO-MARKET ACCOUNTING, FAULTY RISK MODELS AND A VISIT FROM THE BLACK SWAN (A ONCE-IN-A-100-YEARS EVENT) = ECONOMIC DEBACLE.

THIS RESULTED IN—

PERHAPS THE GREATEST PLUNGE IN PUBLIC CONFIDENCE IN STOCK MARKET HISTORY

[1] This was a presentation to the Board of Governors and guests of the Pardee RAND Graduate School of Public Policy on the November 14, 2008 on weekend of the RAND “Politics Aside” public policy forum.