Understanding 2008 – Part 3: Financial players, subprime mortgages and leverage

This is the third of four posts explaining how the economic crisis of 2008 came about. Make sure to read Part 1 on housing bubbles and Part 2 on financial derivatives and deregulation if you haven’t already done so. 

A key problem in discussing financial issues is that too often the institutions and individuals are simply labelled ‘banks’ and ‘bankers’, which mixes up several very distinct groups. Here is a short list of a couple of the most important financial players, each with a simple definition of what they are. As usual, these definitions are for people not familiar with financial markets, and lack nuance, but allow for the broader picture to be understood.

Stock broker – This is somebody who buys and sells stocks and shares on the stock market. Shares are a portion of a publicly owned company, and may pay dividends and give voting rights, depending on the type.

Commodities trader – While seeming like a stock broker, a stock broker buys into companies, whereas a commodities trader buys raw materials themselves, looking for fluctuations in their prices to make returns on their money. They largely work around future derivatives. The four main commodity markets are agriculture, metals, meat and livestock, and energy.

Mortgage broker – A mortgage broker finds potential homebuyers and connects them to a mortgage lender and receives a commission.

Mortgage lender – a mortgage lender in a institution that lends money for people to buy real estate.

Investors – An investor is anybody putting up money with the hope of making a return on investment. A low risk investor might buy government bonds, which rarely fail, but have a low percentage return. An investor can be an individual or an organisation, including pension funds or even charities.

Ratings agency – The previous article described how tranches of a CDO might be labelled as safe or risky. However, all sorts of financial players may themselves be given a risk rating, even governments. The safest level given to anything is a AAA (said as ‘triple A’). The ratings agencies are the people who decide how risky a given investment might be. There are three main ratings agencies: Moody’s, Standard and Poor’s, and Fitch.

Insurers – An insurer is simply an organisation that provides insurance. The key role of the insurers in the 2008 crash was providing credit default swap insurances between banks. The main insurance giant in the crash was AIG.


Subprime mortgages

In very broad strokes, a prime mortgage is a ‘good’ mortgage, and a subprime mortgage is a ‘bad’ one.

In the same way that a government bond gets a rating, individuals also get rated on Consumer Credit Ratings, but rather than given a letter code, they are rated on a score of 0-1000, depending on how good they have been at paying back debts etc.

When someone goes to take out a mortgage, there a few things that may factor into what conditions they get. If, for example, Amy goes to get a mortgage on her house and her credit score is 600 or more (i.e. she has been good at paying back loans on time in the past), then she is likely to be able to get a good mortgage with a low interest rate, and will be expected to also provide a downpayment, of say $20,000.

A key problem in the crash was that mortgage brokers approached people like Bob, who had a credit score of 450, and couldn’t afford the downpayment. Since his conditions made it more likely that he would fail to make his repayments, he will have a higher interest rate, say 6%. This is an example of a subprime mortgage.

One type of mortgage is an ARM – an adjustable rate mortgage – where the first few years are paid at one rate, then there is a reassessment and the rate changes, usually to a higher rate. If someone could pay the low rate, but not the higher one, they may default on their loan, and the mortgage dealer would take ownership of the property.


The final piece of the puzzle is leverage, which thankfully is easy to understand. Simply put, leverage is borrowing money to make more. For example, if a bank had £100, and could buy Christmas trees at £80, and sell at £120, rather than buying one at a time, and making £40 per Christmas tree season, it could borrow £900 to have £1000, buy 12 trees for £960 (with £40 left over) and sell them for £1,440, repay the £900 + £100 of interest, and have a total of £480 at the end of the day. If our bank started with £100 and borrowed £900, it would be said that it has a leverage ratio of 9:1. Provided the borrowing is followed by the selling, the leverage ratio doesn’t matter. However, if someone borrows money at a high ratio to buy something, then can’t sell it on, it becomes extremely problematic, as not only will it itself go bankrupt, but the lender could potentially lose extraordinary levels of money too.

In 2004 the Securities and Exchange Commission passed a change regarding leverage. This led to the average leverage ratio growing from 12:1 in 2004 to 33:1 just before the crash. The larger the ratio, the more of an effect that one bankruptcy has on other institutions.


At this point, you should now understand what a housing bubble is, what a financial derivative is, who the different financial players are, what leverage is, and what the subprime mortgage market is. Part 4 will explain how all these came together to cause the crash.

Understanding 2008 – Part 2: Financial derivatives and deregulation

This is the second of four posts explaining how the economic crisis of 2008 came about. Make sure to read Part 1 on housing bubbles if you haven’t already done so. 

A very significant part of the financial world today revolves around the use of products called financial derivatives. This post will examine what they are, the two most important ones for the crash (CDOs and credit default swaps), and a brief history of their deregulation.

Firstly, what is a derivative? Essentially, it is a type of contract that itself is not worth anything, but derives its value from something else, like an asset or an index. An easy-to-understand example is one called a future. In a future, farmer Andrew and seller Bethany agree in September that come April, Andrew will sell Bethany 100 cows. Now, cows currently cost £100 each, but Andrew is concerned about the crop blight. Maybe it will kill off his neighbour’s crops, and his cows will be fatter and worth much more. At the same time, maybe his cows will be underfed and worth much less than £100. Bethany and Andrew’s future agreement means that Bethany will pay £100 per cow no matter which way the price goes. By doing this, both Bethany and Andrew can lower the risk that they will lose a lot of money over the agreement.

Now the two most important derivatives to the 2008 crash: CDOs and credit default swaps. Bear in mind that these are much more complicated contracts than I can hope to describe accurately, indeed it had been suggested that they were deliberately created to be needlessly complicated so that law makers would be unable to understand them and thus unable to ban otherwise dodgy practices. If you have never heard an explanation of these before, I personally would recommend reading their explanations several times, until you are confident enough that you could explain it to a friend; when I first learnt about them, I only half understood and had to repeatedly go back and check again.

CDOs – Collateralised Debt Obligations

To start, it should be noted that a CDO by itself is not a derivative, but more a specialised form of corporate bond. However, it becomes a derivative when combined with the CDSs below, and is then known as a ‘synthetic CDO’. Whether it is a derivative or not is irrelevant to understanding the crash, but is worth noting for those more interested in the fine details of corporate finance. So on with the definition.

A CDO is when organisation A brings together a large number of loans and pools together to create one big CDO. The CDO now sliced into ‘tranches’, lets call them safe, medium and risky. Other financial players may now invest in these three tranches, as they are sold on the bond market alongside conventional bonds. The three tranches can be imagined as three rock pools, where the highest one flows into the middle and the middle flows into the bottom one. When organisation A collects money from the various sources that make up the CDO, they first pay off money into the top rock pool, and assuming everyone pays, then then fill up the medium pool, and then the ‘risky’ bottom pool. However, if the stream of money lessens, for example when a risky loan is not paid back, the stream may fill up the top and middle pools, but only a little bit of the bottom pool. To compensate for the likelihood of failure to get the money back, each of the three pools gets a different return on investment. Investors in the safe pool may only get back 4% of their investment, whereas the medium investors may get back 6% and risky investors 8%. An important feature of the CDO is that although the loans are still passing through the bank, their ownership technically passes on to the investor in that tranche. Therefore, the bank no longer has those ‘risky’ loans on their books, and allows their business to appear more stable than it really is, were the bank to be audited.

Essentially, provided there aren’t too many failures of people to repay their loans to organisation A, things will go smoothly. Unsurprisingly, prior to 2008, there were too many unpaid loans. As you can see below, prior to the crash, the amount of money involved in these products grew staggeringly high:

CDOS

Credit default swaps

The CDS, although technically complicated, can simply be thought of as a type of insurance on loan repayments. If bank A is receiving loan repayments from housing developer B, it would lose its money were B to default on that loan. As a result, it takes out a CDS from bank C, and just like any other type of insurance, they pay regular small fees, with the potential of a large payout should B default. By doing this, A lowers the amount of risk they are taking by giving B a loan.

Now, the big change from normal insurance occurs in that fact that the CDS is so complicated that it was not regulated, and so it allowed people to take CDSs out on things they weren’t involved in. For example, in our situation above, bank D could also take the CDS out from C, getting money if B doesn’t repay A. To explain why this is bad, imagine Fred takes out fire insurance on his house. He can only receive money if he loses his house, so his interests are balanced out. However, it is illegal for George to take out the same insurance on Fred’s house, because he has no balanced interest: he doesn’t live in Fred’s house, so he can only win from the house burning down, and obviously we don’t want a situation where people have financial incentives to burn down each others’ house. Moreover, the banks got wise to the fact that they could give a bad loan to homeowner X, take out a CDS, then benefit from the homeowner defaulting, which prior to 2008 became commonplace. Like the CDO market, this became ridiculously lucrative – by 2007, the outstanding CDS amount was estimated to be around $62 trillion.

Financial deregulation – a brief history

Financial deregulation is when the government loosens the restrictions on what financial institutions can do. There is a huge amount to say here, but for brevity, a few examples will be given so readers can get a general picture of how the situation has developed.

One early shift, and perhaps the birth of the modern finance sector was the changes for investment banks after the second world war. Initially, investment groups were collections of, say, a dozen wealthy businessmen, who pooled their own money and worked out where they thought the markets were growing. The rules were lifted and allowed banks to invest their clients’ money, and unsurprisingly, people are more willing to risk other people’s money than their own.

The real period of financial deregulation began in the ’80s under Thatcher and Reagan, but continued right up until 2008. One problem was that in the US, former bankers of huge institutions were repeatedly appointed to positions like chairman of the federal reserve or secretary to the treasury. Men like Donald Regan (not Ronald), Alan Greenspan, Larry Summers, Henry Paulson, Robert Rubin and others exacted undue influence on presidents who didn’t understand the complexities of the issues involved.

In 1982, the Garn – St Germain Act allowed savings banks to give out credit cards and issue non-residential real estate loans, which previously only commercial banks were allowed to do.

In the UK, in 1986, Thatcher passed a number of laws allowing more freedom for the financial services. For example, the barrier between stockbrokers and stockerjobbers was removed, allowing the creation of integrated investment banks, and foreign companies were now allowed to buy City of London firms.

A key instance of deregulation in the US is the Gramm- Leach- Bliley Act of 1999, repealing the Glass- Steagall Act from the 1930s. The latter banned the merging of retail and investment banks. When Citigroup and Travelers merged in 1998, they were given an exemption until the GLB Act passed the next year.

The following year, the Commodities Futures Moderization Act (passed under Clinton, with support from both parties) banned the Commodities Future Tradings Commission from giving any regulation for a number of derivatives, including credit default swaps.

In 2004,  the final major deregulatory act before the crisis passed, where the Securities and Exchange Commission allowed various financial institutions to increase the leverage ratio (explained in the next post), essentially allowing them to use many times more money than they held in reserves, with ratios up to 50:1 in cases like Fannie Mae and Freddie Mac.

Altogether, readers should not be surprised to see why the 2008 crash was so damaging – it was the culmination of almost 30 years of removing rules that discouraged risky trading.

Part 3 deals with the differences between the different types of financial institution, leverage and sub-prime mortgages.

Understanding 2008 – Part 1: What is a housing bubble?

I originally planned to write a single post on what caused the economic crash, but as there were so many aspects that have to be understood before seeing how they combine, I have decided to split it into four shorter articles. This first article will deal with what constitutes an economic bubble, and how it might happen in the housing market. 

Although we often hear the term ‘housing bubble’ in the news, it is normally given out of context, with no explanation as to what a ‘bubble’ actually is. Thus, it is important that we have the definition of an economic bubble before examining its causes: although the term dates from the early 1700s and has no one exact definition, it is roughly defined as when the price of a certain asset deviates greatly from its intrinsic value. What we mean by this is that if a house in country X cost $100 in 2000, and correcting for inflation, cost $200 in 2010, in the perfect world, its intrinsic value would have doubled. There are many factors that determine its intrinsic value: if the price of the bricks doubled, or if the price of labour doubled, or the house were twice as big, then we could say it is fair that the house cost twice as much. While it is impossible to work out the exact intrinsic value of any particular asset, if the house built in 2010 for twice the price is identical to the house built in 2000, we can assume its price has risen beyond its intrinsic value (although other factors beyond the house itself can increase its intrinsic value, for example house location). One pair of factors that might drive the price up without intrinsically increasing the houses value is the twins of supply and demand.

Adam Smith posed the question of the paradox of water and diamonds. Why is water, something utterly necessary for us to live and therefore in high demand, so much cheaper than diamonds, something that we don’t need at all? The answer, of course, is that that water is in great supply, while diamonds are in short supply.

Consider how this applies to housing. If the housing association builds three houses, and charges £20,000, and Anna, Bob and Claire can all afford that, then the price ought to rise only with inflation. However, if only 2 houses are built, and Anna and Bob can offer more than 20,000, but Claire can’t, and all three ask for the house, it is only natural for the housing association to raise the price to £21,000 and increase their profits. This situation of under-housing is exactly what is happening in the UK today, as can be seen in the following graph:

cbi housing shortage

When you add in the migration patterns of internal migration (away from the north of England, and towards London) to the housing shortage, it is easy to see why the following rates of inflation (2014) are so high:

Regional-house-price-inflation-Annual-change_chartbuilder

In a historical perspective, the average house in 1979 was around £20,000, which in todays money is about £102,000. As it is, the average house today costs £195,000, just shy of twice the growth of inflation.

For interest, it is also worth noting that a housing shortage also drives up rents, and has lead to the UK having by far the highest average rent in Europe:

RentSource: http://www.numbeo.com/cost-of-living/rankings_by_country.jsp

Now it is important to be aware that a shortage of supply is not the only thing that can cause a bubble, and the US housing bubble prior to the crash was actually caused by a variety of other factors, such as ease of attaining mortgages (if it’s easy for people to get $120,000 in a mortgage, why only charge $110,000?). However, in understanding what caused the crash, it is only necessary to understand what a bubble is, and to know that there was a very large housing bubble, as can be seen here:

Real-US-home-prices-1890-20142

With the housing bubble (hopefully) clear, Part 2 explores financial derivatives and financial deregulation.