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The Financial Crisis Revealed

In this article you will learn:

  • What makes a bank fail
  • How mortgage-backed securities work
  • The role of Freddie Mac and Fannie Mae
  • The difference between prime and subprime mortgages
  • Events that led to today’s financial crisis
  • Who is to blame

It All Started With the Savings and Loan Crisis

The current crisis started in the 1980s when savings and loans (S&Ls) took the cash they had on hand and structured them into loans and mortgages for home buyers. These transactions affected the S&Ls’ balance sheets (balance sheets can be thought of as a list of what firms “own” and what they “owe”). For the S&Ls, the balance sheet consisted of the following:

  • On the “own” side—loans to home buyers locked into 30-year terms, at 3 to 5% interest
  • On the “owe” side—deposits from bank customers, along with loans from other banks
Balance Sheet

During the early 1980s, inflation was over 10%. So, deposits and borrowings (what the savings and loans “owed”) required a 10% return. What the S&Ls “owned,” however, were locked into 3 to 5% returns for 30 years. The result was a negative “worth” on the S&Ls’ balance sheets (what they owned was earning a lower interest rate than what they owed to their depositors).

Negative Worth

This problem was resolved in the 1980s by government intervention that was similar to the current bailout.

Freddie and Fannie Seemed to Address the Problem, But…

One of the ways the government resolved the S&L financial crisis in the 1980s was through two government-sponsored entities, Freddie Mac and Fannie Mae.

The two agencies were commissioned to purchase the mortgages bearing a 3 to 5% interest rate, with 30-year terms from the S&Ls.

The result was a conversion, in effect, of those mortgages into cash for the S&Ls. The S&Ls got existing mortgages “off their books,” and in return, Freddie and Fannie paid them cash. The S&Ls then loaned the cash back out by way of more mortgages with higher and more competitive rates that reflected the day’s market rates and would help keep the S&Ls solvent.

The banks were back in business. But a larger problem remained: Freddie and Fannie were holding billions of dollars’ worth of 30-year, low-interest mortgages. Freddie and Fannie also needed to be “liquid,” or have more cash on hand to buy more mortgages from the S&Ls.

The Solution: Mortgage-Backed Securities

The solution arrived in the form of a new investment created by Freddie and Fannie, called a “Mortgage-Backed Security” (MBS).

MBSs pool together several thousand, or sometimes several hundred thousand, mortgages and are sold on Wall Street in the form of an investment or a bond. Investors pay to buy the rights to a certain portion of the returns on the pooled mortgages.

Selling MBSs to Wall Street allowed Freddie and Fannie to convert the mortgages they bought from the S&Ls into cash, which they could then use to purchase even more mortgages.

The process created liquidity in the system by allowing the MBSs to flow through Wall Street to the investors, whose cash would then eventually make it back to the S&Ls. This liquidity currently keeps our banking system running.

Liquidity

Another Problem: Prime Versus Subprime Mortgages

The federal government commissioned Freddie and Fannie to buy a certain kind of mortgage called a “prime” mortgage. A prime mortgage had a fixed interest rate and a 30-year term, was no larger than a certain amount, and was limited to borrowers with excellent credit.

Anything else was considered a “subprime” mortgage, including large mortgages, ones with variable interest rates or ones whose borrowers had a less than perfect credit rating.

Freddie and Fannie were only allowed to purchase prime mortgages from the S&Ls, which meant that there was no market for subprime mortgages, which, in turn, made those mortgages more difficult for borrowers to get.

This Was the Beginning of the Current Crisis

In the 1990s, when other private financial institutions noticed that Freddie and Fannie were making money packaging and selling MBSs, they began buying sub-prime mortgages from the S&Ls and packaging them and selling them to Wall Street. Consequently, a market was created for purchasing subprime mortgages.

Around the same time, the U.S. Senate and the House of Representatives passed laws requiring S&Ls and banks to offer mortgages to subprime borrowers, which increased the number of subprime loans in the market. Freddie and Fannie were then also allowed to offer MBSs packaged from subprime loans, which expanded the market for selling subprime mortgages even more.

So, while a few years earlier, financing (or cash) was available only for prime mortgages, the regulatory changes enacted by Congress and the actions of financial institutions helped create a market for selling subprime mortgages. As a result, S&Ls, small banks, and mortgage brokers were now able to write a variety of loans and quickly sell them in the market.

In fact, they could “flip” the loans, by writing them and almost immediately turning around and selling them to Freddie or Fannie or to the other institutions, who could convert them into MBSs sold on Wall Street, and thus quickly and easily converting them into cash available to loan out yet again.

And as long as interest rates stayed low and housing prices increased, the cash could keep flowing.

Inflation of Home Prices and Other Signs of Trouble

The result of all this activity was the creation of millions of new homebuyers in the market, which in turn drove up the housing market. Mortgage brokers continued to flip more and more mortgages by offering loans to new buyers who, until then, weren’t in the market to buy homes. The greater availability of loans and easy qualification continued to push the housing market even higher.

The result of all this activity was a “no-lose” situation for everyone in the system. As long as the housing market was robust and housing prices were increasing, there were no problems. When someone defaulted on a sub-prime loan, the underlying asset, the house, was worth substantially more than the loan balance, which meant that the risk of loss—and in most cases, the actual loss—to investors was, in effect, nearly zero.

But Changes in the Market Were Coming

So far, everyone in the system was making money. But in 2006, the housing market went flat. And as subprime borrowers started to default and interest rates started to adjust upward on Adjustable-Rate Mortgages (ARMs), home values could no longer support the mortgage balances owed on them.

And as homes became available on the market as a result of increasing defaults, they began to sell at prices below prevailing market rates, which pushed housing prices down further. The holders of MBSs on Wall Street now began sustaining losses on their investments, and, almost overnight, MBSs became far less favorable investments.

What made matters even worse was the widespread use of MBSs. Many investment banks, such as Lehman Brothers and Merrill Lynch, held billions of dollars in these high-risk, high-return investments, and very little equity, in the form of actual cash from investors. Most of their assets, in fact, were in these investments. And when the MBS market foundered, so did many of these banks, as the majority of their assets quickly became nearly worthless.

Negative Worth 2

This scenario helps explain why so many investment banks have gone under in recent months.

The Result: A Liquidity Crunch

As the MBS market soured, Freddie, Fannie and the other sellers of MBSs found it more difficult to package and sell their mortgages on Wall Street. And the small banks and S&Ls, in turn, found that the mortgages that they originated, including subprimes, could no longer be sold in the marketplace.

The net result was a significant reduction in liquidity (or, cash in the system), which further lowered the prices of homes, as fewer borrowers were able to obtain mortgages to buy homes in a tightened credit system.

From Bad to Worse: The Financial Markets Today

As we discussed earlier, in the 1980s some banks and S&Ls had a negative worth, because they paid out more on short-term deposits and loans from other banks (what they owed) than they got in return for the loans they had made (what they owned).

This scenario was what precipitated the government’s initial attempt to “bail out” these institutions in the 1980s by creating Freddie and Fannie to buy the low-rate, 30-year loans from these institutions.

What exacerbated the problem for these banks is an accounting rule (mentioned quite often in the media) referred to as “mark to market.” The rule required institutions that had on their books any assets that had a ready market—such as bond or stocks—to “mark them to market,” which means setting or pegging their prices to current market rates.

Since many of these institutions owned mortgages and there was still a market (if not an attractive one) for them, they had to peg them to the market price. And since the value of those assets was rapidly declining, many financial institutions found themselves having to reduce the value of their assets. Since what they owed was more or less fixed, their total worth continued to decline, pushing some into bankruptcy.

Negative Worth 3

This is where we are today.

Effects of the Crisis: Liquidity Issues and Bankruptcies

The current financial crisis seemed to happen quickly. As Wall Street lost trust in MBSs, Freddie, Fannie, commercial banks and Wall Street investment banks quickly found that they could no longer sell the securities. And as they, too, adjusted their assets by marking them to market, their net worth also fell into the red. And banks with negative net worth are not allowed to trade or to do business, which made them, in effect, insolvent (or bankrupt).

As the decline in the housing market and the ensuing crisis have revealed the true risk of MBSs to lenders, the remaining banks and financial institutions have, in turn, been less willing to lend out money, which has deepened the liquidity crunch and led directly to the crisis we face today.

Who’s to Blame?

It’s hard not to point fingers and blame someone for this mess. But really, it’s everyone. The list includes:

  • Congress: The U.S. Senate and House of Representatives precipitated the financial crisis through their inability to control and regulate, and possibly understand, the financial markets.
  • The President: The U.S. President also did not properly understand or regulate the financial markets.
  • Wall Street: As the housing market climbed rapidly, rating agencies on Wall Street continued rating MBSs similar to high-rated bonds, which grossly under-estimated their true risk, a fact highlighted by how quickly the market collapsed.
  • Banks: Banks continued to “flip” loans quickly, without having to deal with the ramifications of defaults, a fact that can be laid at the feet of the banks as well as the loose policy and regulatory environment in which they operated.
  • Freddie and Fannie: Both Freddie and Fannie had accounting irregularities as early as 2001 and 2002, when the scandals of WorldCom and Enron broke. But due to lax regulation, the agencies escaped unscathed.
  • Irresponsible Borrowers: Borrowers who bought homes they clearly could not afford are also to blame. Borrowers’ inability to pay became especially clear as rates on adjustable mortgages were ratcheted up.
  • Greed: Just about everyone in the system was motivated by greed. The fact that the greed did not entail consequences or responsibility for what followed is itself an important, underlying cause of the crisis.
  • Regulations/Lack of Regulations: The decision on the part of Congress to compel Freddie, Fannie and other financial institutions to offer more subprime mortgages to borrowers than was prudent added unnecessary risk into a financial system already rife with risk. The fact that the MBS sellers were then only loosely regulated and allowed to sell risky assets as high-grade ones only made matters worse.
  • The Media: The media, finally, has sent mixed signals to the public and confused the issues with “us vs. them” talk of “Main Street” and “Wall Street.” In reality, responsibility for the financial crisis lies with all of us, and we need to fix the system as a team.

Coming Full Circle: Will the Bailout Succeed?

The federal government passed a bailout package that will dedicate $700 billion to buying the troubled mortgages. There is also talk of the federal government infusing capital (or, cash) directly into troubled financial institutions.

The idea is to pump more liquidity into the system. The increased capital should (as in the 1980s) help increase banks’ liquidity by converting both their prime and subprime mortgages into cash, which will in turn allow them to lend more and get the financial system moving again.

In turn, Freddie, Fannie and mortgage brokers will be able to package the mortgages and sell them to Wall Street, as they had done earlier. That will allow cash to flow back into the system, easing the crisis.

But the question remains: What can we do about the lenders and brokers who were “flipping” loans without bearing ultimate responsibility for them, including possible defaults?

The problem has to be corrected, if we’re to avoid yet another crisis. In addition to the bailout itself, tighter and more effective regulation is necessary to resolve the crisis effectively. There is no doubt that those who sell and profit from loans have to be made responsible for the consequences of their decisions and actions, including having the loans go bad.

The financial system is fundamentally sound. We just have to make sure we do everything we can to keep it that way.

Financial Crisis History

©2008 Business Literacy Institute. All Rights Reserved.


Author Bios:

Karen Berman and Joe Knight are coauthors of the book Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean (Harvard Business School Press, January 2006) and co-owners of the Business Literacy Institute, a consulting and training firm dedicated to ensuring that employees, managers, and leaders understand how financial success is measured and how they make an impact.

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