Dummies guide to crisis 2007-09 (Part 3 of 4)

In this posting and the next, we will take a look at how real estate securitization contributed to the financial crisis. The thing that governments and bankers fear the most a a bank-run. When all depositors demand their deposits back, it wont be available because the money has been loaned for thirty years on a mortgage or three years on a car loan. It can be made available only if the bank can turn its long-term loans into cash. It can be prevented only if someone quickly loans the bank cash on its assets -- or buys the assets quickly.

The problem of toxic assets is not that banks loaned too much money. In fact, the system for making loans made perfect sense. People were loaned money from depositors, but then the loans were packaged and sold to investors. The result was to return the cash to the bank that made the mortgage. Depositors were not at risk (beyond the usual risk due to fractional reserve banking).

The problem occurred at the other end. Banks thought these securitized mortgage packages were safer than the actual mortgages that they might have just held on to. Mortgages are usually excellent investments, paid without fail in about 99% of the cases and the underlying collateral -- housing -- regularly increases in price (mainly due to the steady inflation of currencies). Furthermore, risks were reduced by packaging mortgages from a variety of locations (protecting against a decline in any one city or region), organized by level of risk (riskier mortgages were packaged separately from less risky mortgages), and insured by a large international insurance company. What could be safer?

However, after 9/11, the US Federal Reserve lowered interest rates substantially to prevent the economy from freezing up or spiraling into a recession. The low interest rates caused housing prices to rise at an unusually high rate for several years. Then, perhaps in part because housing prices were rising so rapidly, suggesting inflation that was not being observed in the US Consumer Price Index, which does not include housing to any appreciable degree in its calculations, the Fed reversed course. This began a collapse in housing prices as the higher mortgage rates sharply reduced demand.

So these securities, presumably safe packages of insured loans, suddenly were hit from all sides. First, interest rates were rising, which made the old mortgages (and the related securities) decline in value since investors preferred the higher rates now available. Second, because housing prices were now declining, the value of the underlying collateral was declining as well, making the securities less secure. Third, because some buyers had bought property with adjustable rate mortgages, the rising rates and lower housing prices caught them in a trap; they could not refinance, and there was a steady increase in foreclosures. Fourth, a recession in the US was beginning, threatening loss of jobs and more foreclosures.

Now, what seemed an advantage -- securitization and insurance -- was reversed. Prior to securitization, the value of the mortgages on a bank's books was fairly clear. If it was being paid, it was valued at face value. If not, it was in foreclosure and had a reduced value based on the costs of foreclosure and resale. Typically this might mean the bank's mortgages were valued at 99.5% of their original value. In a crisis, with many foreclosures, this might drop to 97%, but that would be unlikely. In the case of a run on the bank, it could get cash for its fully valued mortgages.

However, with securitization, there was a market for the securities. Because there were a great many securities each with thousands of different loans, after the first sale was made to an investor, usually to an institution, not many actual resales occurred. Now, however, because it was unclear which securities included mortgages in the greatest danger and which did not, the very small number of sales saw prices that were extremely low -- less than 50% of the face value of the securities.

Now, the banks had a new problem. They had bought these securities themselves (not the smartest move, but it seemed safe), and the securities had to be valued, not on the grab-bag of underlying assets, but on the recent sales of such securities at fire-sale prices, an accounting rule called "marked to market".

Although foreclosures represented only a few percent of the mortgages, the practice of marking to market and the limited number of buyers for the securities dropped the value of these bank assets by 30-70%. The banks were suddenly insolvent -- as were all those who had insured them and other financial institutions against losses -- including all the investment banks.

So, in this situation, what should be done? If the banks failed, the depositors were secured by the FDIC, in theory. However the FDIC, despite its name (Federal Deposit Insurance Corporation) was a private corporation funded by a small insurance fee paid by banks. It's assets would be exhausted by the first few banks that failed. It could not pay more than a tiny fraction of depositors if there were a run on the banks.

Thus, to avoid a collapse of the banking system, the US Treasury and Federal Reserve began sticking fingers in the dike. It pressured the accounting body to eliminate mark-to-market, and at the same time, cut deals to give money to the insurance companies and banks.

The hasty effort to stop the panic may have prevented a collapse, but it did not slow the overall decline. People now became more afraid, worsening the housing price decline and the recession. Furthermore, since little or nothing has been done to preserve the value of the underlying mortgages (something that could have been done with a government guarantee of the principle and interest), the value of the assets continues to decline, requiring further bailouts.