In the last post, I talked about the consumer side of the 2008 housing bubble. Today I wanted to talk a bit about the investment house side of things and how what should have just affected the housing markets almost brought down many large players on Wall Street.
While consumers were happily snapping up larger and larger mortgages and using the equity freed up as they refinanced to pay down credit card debt and take vacations, investors were looking for ways to earn more interest on their money. The Federal Reserve had set rates as historically low levels. This was also part of the cause of the housing boom – since mortgage rates were also historically low because Fed Fund rates were very low.
At the same time, banks and other lenders had found a new way to expand their ability to give loans and, they believed at the time, a way to reduce the risk they were taking on by making risky loans. They would take groups of loans and create what were called Mortgage Backed Securities or, more generally, Collateralized Debt Obligations (CDOs). These were financial instruments where the buyer would buy the loans from the banks, thereby removing the loans and the inherent risk from the books of the banks. The buyers would then receive interest payments generated by the interest the homeowners were paying on their mortgages. After a certain period of time the principle would be paid back – when the loans were retired by the home buyers. In this way these new instruments seemed like corporate bonds in that the buyer would be repaid his principle at a fixed date in the future assuming there were not too many defaults on the loans in the package.
The banks were happy because they could quickly resell the risky loans they were making and reduce their risk while making a nice profit on fees and closing costs. The investors in these mortgage-backed securities were happy because they were getting a better interest rate than they could get from corporate bonds. They did not take muct heed in all the warning signs such as the huge amount of debt consumers were taking on, the fact that wages were not high enough for the consumers to pay the payments once the interest rates reset, or the fact that home prices had doubled or tripled within the last few years. They figured that while there might be a few defaults, home prices were normally fairly stable and that because they have thousands of loans contained in the mortgage-backed securities the gains on the majority of the loans would offset the losses from defaults on others.
The rating agencies declared that many of these securities were AAA – the best rating they could have – despite the fact that the loans contained in the CDOs were of low quality. Somehow if you took a lot of risky investments and packaged them together they became a very safe investment in their eyes. The buyers of the CDOs probably wanted to believe they really were very safe and that somehow they were able to get much better interest rates than they could get from AAA rated corporate bonds. There was definitely a bit of greed clouding their judgement. One must realize that greater returns always come with greater risk.
This would have been bad enough, but then the derivative makers got involved. Derivatives tend to start out as insurance contracts which, if used for their intended purpose, actually reduce risk. Derivatives create leverage, however, which usually causes them to be used in extremely risky ways. These new derivatives on CDOs were insurance policies in which the seller agreed to pay the buyer of the policy if the value of their CDOs dropped below a certain value. Like insurance on your house, this limited the losses the buyers of the CDOs – or so they thought – and therefore they thought they knew what their risk was since they could only lose so much before the insurance policy kicked in.
So, some banks and investors were buying CDOs, buying policies to limit their possible losses on the CDOs, and were collecting a large enough interest rate from the CDOs to cover the cost of the insurance policies and still make a nice profit. The trouble was that their “insurance companies” were not as secure as they thought.
Rather than just buying CDOs, investment houses and others like AIG saw the potential to make a lot of money creating these insurance policies. Because they thought the housing market could not possibly suffer a large loss, they felt confident simply creating these policies virtually out of thin air and collecting the premiums. This would be like people writing fire policies for entire neighborhoods with very little money to back them up. As long as only a few fires occurred, they would be able to cover the claims. If the entire neighborhood caught fire, however, there would not be enough money to pay for all of the claims.
The creators of these policies did realize there was a risk to what they were doing. To counter this risk, they started buying these policies themselves, but with a different expiration date. They were therefore selling a policy with a longer term and using some of the proceeds to buy policies with shorter terms. Because the longer term policies had larger premiums, they were able to make a profit. They figured that if there were an issue their risk would be limited because they could just collect on the policies they bought to pay for the claims on the policies they issued. The trouble is that when the collapse did occur, the people whom they bought their policies from could not cover the losses and pay the claims.
In the next post I’ll talk about the collapse and what happened to homeowners and the investment banks.
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