The catastrophic collapse in our financial system was a morality play in three acts. It reminds us why the Bible begins with the story of Adam and Eve.
Act I: In order to buy a home, most American families require a mortgage. For years, mortgages were issued by a local bank and held until they were repaid. Then banks found investors wanted to buy mortgages because “securitization” and mortgage-based “derivatives” made them attractive financial products. Soon, banks were originating mortgages, not to hold, but to sell to others.
Wall Street investment bankers bought and resold the mortgages. Selling one mortgage at a time is inefficient, because each transfer requires paperwork. So the bankers collected a large number of mortgages in a basket and sold investors notes secured by that basket. Notes secured in this way had two advantages. First, the mortgages stayed in the basket held by a custodian, while the notes moved freely. Second, while some of the mortgages might default, it was unlikely that all would default, so the aggregate package was less risky than an individual mortgage. The notes were known as “mortgage-backed securities,” and the whole process was called “securitization.”
The fact that mortgage-backed securities were readily transferable was important because many institutional investors, such as retirement plans, can only invest in readily marketable securities. Securitizing increased the number of potential investors, gave borrowers access to more funds, and brought down costs.
Bankers took securitization one step further. The monthly payments of principal and interest by homeowners went, in the case of mortgage-backed securities, to the custodian of the mortgages. The custodian used those funds to pay the note holders. In a large pool of mortgages, some defaults are likely, but receiving less than 100 percent was not acceptable to many security holders. So investment bankers created two levels of mortgage-backed securities: a senior class and a junior one. The custodian paid the senior class first and then paid the junior class from whatever was left. The senior class was very attractive, since it would take a large number of defaults to bring the funds received to less than what was needed to pay that class. The senior class was thus rated AAA, the highest possible rating given by rating agencies. Those agencies assess risk of default, and their ratings are relied on by many investors.
The higher risk of default for the junior class brought a lower rating, balanced by a higher interest rate. The investment bankers often created many more than two classes. This “slicing and dicing” was a creative way to distribute risk to buyers with different appetites for it.
Another technique—“swaps”—also increased available funds. A bank holding a note with a fixed rate of interest might contact a bank that held a floating-rate note, one whose interest rate was reset periodically to the current market rate. The banks might agree to exchange, or “swap,” a portion of their respective notes. That way they could hedge their risks, the holder of the fixed-rate note hedging the risk that interest rates would rise, and the holder of the floating-rate note reducing the risk that interest rates would fall. No exchange of notes was involved; the banks simply agreed on the terms of their deal. In the next step, one bank, for a fee, simply insured the other against the risk of a rate change. Swap transactions then evolved to “credit default swaps,” where one bank insured another against payment default by the borrower. Swaps increased the banks’ capacity to lend. Because banks are regulated on the amount of risk they can carry, transferring some risk to another institution gave them room for new transactions. Alan Greenspan, chairman of the Federal Reserve Bank, testified that derivatives “have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and capable of doing so.”
Act II: House prices began to rise. In the fifteen years before 2000, prices had increased about 3.5 percent a year. Now they began to appreciate at an annual rate of more than 12 percent, a rate that means a house price doubles in six years. The Federal Reserve Bank, in an effort to help the general economy after the collapse of the dot.com stocks and the shock of 9/11, had decided to hold down interest rates. Low interest rates stimulate borrowing. People recognized that borrowing at a low rate to buy a house that was appreciating rapidly was a smart economic decision. Builders obliged by building houses as quickly as they could. Homeowners looked at their rapidly appreciating home and saw it as a source of cash, using their home as an ATM, as one observer put it. Homeowners expected the house to continue appreciating and felt comfortable spending what they had borrowed. So did those who used their credit cards as a source of cash. The low interest rates sparked a flood of borrowing. As a nation, we were spending far more than we were producing.
At the same time, we had entered one of those periodic moments when euphoria grips the whole market, clear thinking becomes fogged, and we come to believe that the price of some asset class, in this case homes, can only go up. It was a classic bubble. One banker said, “The whole world was at the party, high on leverage-and enjoying it while it lasted.” The low interest rates put pressure on professional investors, whose job it is to find good rates of return on the portfolios they are managing. Home mortgages were attractive because they traditionally pay a higher interest rate than many other financial obligations.
The belief that house prices could only go up made mortgages seem even more attractive. Buyers of mortgage-backed securities wanted more. Mortgage originators, anxious to meet demand, moved to subprime mortgages—that is, mortgages that did not meet traditional standards. Then they began to lower standards even for those mortgages. First, the income requirements for home buyers were reduced; then the margin of security in home value was reduced. Next lenders eliminated verification of the buyer’s income. In time, the buyer did not even have to state his or her income. Finally, no supporting documentation was required from the borrower. (These were known as “liar mortgages”; some spoke of “ninja” mortgages—“no income, no job or assets.”) Adjustable-rate mortgages were devised, with “teaser rates”—that is, very low payments at the front end, to be made up with large payments some years later. Less scrupulous originators pushed those on people not able to make normal payments.
When experienced mortgage brokers questioned the process, they were told that other firms were doing it and that if they did not want to participate, other employees would take their place. Employees who refused to approve substandard mortgages were shown the door.
The brokers passed on the less-qualified mortgages and the higher risk of default to others. So did the investment bankers who packaged and resold those mortgages. Rating agencies seemed to bless almost everything submitted to them.
John Q. Public also participated. He took mortgages that he, and presumably the brokers, knew he could not pay. In San Francisco, a bus driver earning $46,000 a year was granted a mortgage that required annual payments in excess of his salary. A poverty-level window washer in Southern California got a mortgage for $535,000. Twenty-three dead people got mortgages in Ohio. Stories abound.
It’s easy to blame John Q. Public for greed or naiveté. But distinguished economists haved argued that those who took such mortgages were acting sensibly from an economic point of view. They were, as the economists saw it, taking an option. If the house price increased, they would stay and refinance. If prices dropped, they would consider themselves renters and walk away. The fact that they had signed a contract seemed irrelevant.
At the same time, credit default swaps, the insurance against default in mortgages, were also booming. There were few limits to the growth of swaps, because, as in a horse race, you did not have to own the horse to bet on it; many people could bet on the outcome. It was just a question of “the odds”—the fees someone would charge for selling you insurance. If you believed that there might be defaults and someone was willing to insure your risk for a reasonable fee, you bought it. The seller presumably saw little risk of default in traditional mortgages and was willing to take a fee for that minimal risk.
The ballooning in swaps was fed by three factors. First, they were not regulated. Traditional insurance companies are required to maintain specified ratios between the amount of insurance they write and the amount of capital they have to back up their promises. There were no such limits in the swap market. Second, new unregulated players, such as hedge funds with large bank accounts and an appetite for risk, entered the market. Finally, regulated banks and insurance companies, anxious to do more business, found techniques for doing swaps outside their regulatory constraints. The swap market was soon in the trillions of dollars.
In 1994, the Government Accountability Office issued a report indicating potential risk in the market for derivatives, such as swaps, and at least one government agency wanted to regulate them. The proposed regulations were successfully opposed by Alan Greenspan and others who believed markets best regulate themselves.
Act III: In 2007, house prices stopped rising; they began to soften and then to come down. As house prices continued their decline, it became clear that many mortgage holders would default. One of the few clear-headed people around, Warren Buffett, summed it up: “Just about all Americans came to believe that house prices would forever rise. That made borrowers’ income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA—house price appreciation—would cure all problems.... As house prices fall, a huge amount of financial folly is being exposed.”
Buffet had an equally clear view of swaps. He warned repeatedly against them for two reasons: counterparty risk, and lack of transparency. In 2002, he called them “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Counterparty risk means the ability of the party who sold the insurance to pay when and if that becomes necessary. Institutions were writing a high volume of swaps to earn fees, but unfortunately their managements were not requiring a reasonable relationship between the amount of derivatives written and the capital available to meet the risks assumed. Second, there was no transparency because there was no central clearing exchange for swaps. Swap transactions were private. There was simply no way to tell who had written what and how much was outstanding.
Then it happened. Three large players—Bear Stearns, Lehman Brothers, and AIG—indicated that they would not be able to honor their swaps contracts. The firms were central figures in the wide web of derivatives, with hundreds of billions of dollars worth of outstanding contracts; their failure to perform would have cascaded through the financial system with devastating consequences. The government concluded that it had to step in. It forced Bear Stearns into other hands and provided massive support for AIG. The cost to the taxpayer was hundreds of billions of dollars.
Lehman Brothers was allowed to go bankrupt. That decision proved disastrous, as the bankruptcy immediately undermined a money-market fund that held substantial amounts of Lehman paper. That panicked the short-term money market, including the commercial paper market. Short-term markets provide the lubricant for the wheels of everyday commerce and are essential to the functioning of business. The government rushed to the rescue by having the Fed backstop money-market funds and agreeing to buy commercial paper from nonfinancial institutions (something the Fed had never done before).
The subprime mortgage market was also collapsing. In September 2008, the federal government had to take over Fannie Mae and its sibling, Freddie Mac, and to provide them with credit of $200 billion.
The situation was aggravated by an accounting rule that made banks write down the value of securities they held to current market prices. The rule, sensible in an active market, is problematic in the absence of one. Without real transactions, banks must estimate value; if someone, honestly or mischievously, makes a lower estimate, the bank has to use that lower price, and so they chase each other down a spiral.
The crises in subprime mortgages and in the swaps market led to a liquidity crisis. Banks froze; they refused to lend to other banks or other financial institutions. As one expert put it, “Sophisticated institutions are afraid to trade with each other, because they don’t believe each other’s balance sheets.” Those balance sheets included subprime mortgages and swap exposures, neither of which could be reliably assessed. The banks hesitated to lend, each fearing that the other might turn out to be the next Lehman Brothers.
Banks, rating agencies, and Fannie Mae had all relied on sophisticated computer programs to monitor their investments. “It was,” someone noted, “the triumph of data over common sense.” Those relying on their expensive computers were victims of the old rule: “garbage in/garbage out.” The most sophisticated programs give results that are no better than the quality of the data fed into the computer. Here, computer models continued to assume that the mortgages received met traditional standards and that housing prices were following normal patterns. The models had not been updated to reflect the flood of substandard, subprime mortgages now in the system, or the rapid escalation in house prices. People knew that “liar mortgages” were proliferating, but Wall Street was chasing profits; it did not want to hear about the growing risks.
To summarize, imaginative arrangements provided new tools for wealth creation. Interest rates were kept low and housing prices rose rapidly. Excesses appeared and proliferated. Predatory brokers foisted mortgages on naive borrowers. Bankers passed toxic mortgages along to investors. Many in the chain had little concern for what they were selling. Big bonuses were paid for volume, without regard to the long-term outcome. Rating agencies skimped on their responsibility. The excesses were unsustainable and catastrophe ensued. The largest mutual funds, all of which had invested in major financial institutions, lost more than 40 percent in value, putting millions of retirees and other investors in a perilous situation.
What moral are we to draw from all this? Some are always ready to blame government. “What started in August 2007 was not the failure of free markets but the outcome of bad government actions” (Steve Forbes of Forbes magazine). Others suggest that the participants were predictably (innocently?) following the incentives placed before them. Both approaches seem to me to give the participants, in particular top management, a pass.
The better conclusion, I think, is suggested by Paul Volcker. In mid-2008, he referred to the erosion of “the mutual trust among respected market participants upon which any strong and efficient market system must rest.” Alan Greenspan, whose doctrinaire espousal of unfettered free markets has been chastened by the collapse of the economy, also concluded that the participants in the market had failed. The market system, he said, is “based on trust,” and, as he saw it, many participants had not acted with integrity, which led to the crisis.
The fundamental building block in the market system is a transaction between a willing buyer and a willing seller, both acting in their self-interest. As Peter Drucker once observed, “The business of a company is to create a customer.” The company does not find a customer, it creates one. A customer is not just an individual, but a person who stands in a relationship with the company; the enterprise must work to build that relationship. Business rests on relationships among people, relationships based on meeting expectations and dealing fairly. Indra Nooyi, CEO of Pepsico, put it this way: “Companies rely on a daily exchange of trust with customers, consumers, and numerous other stakeholders.”
To the Canadian novelist Margaret Atwood, the financial crisis represented a failure to see debt as “a simple personal relationship” between borrower and lender. It seems quaint to speak of a “personal relationship” in our computerized, fast-moving world of large institutions. Yet stripped to its fundamentals, that is the reality. We find it hard to see beyond the impersonal façade of large institutions, but those façades are simply the collective names of groups of individuals. Companies are legal creations, animated by individuals like you and me. Within each company, it is people who are making the buy-and-sell decisions, and people who are creating relationships with those on the other side of their transactions.
But as we learn from the story of Adam and Eve, people—including those who are the flesh and blood of a corporation—are prey to temptation. In the current crisis, too many individuals in too many institutions focused on their personal income and allowed themselves to be distracted from the impact of their actions on their customers (and ultimately on their institution and fellow employees). They sought instant gratification and did not look beyond themselves or the morrow. In the words of Bill George, former CEO of Medtronic, “They let self-interest trump their responsibility to create lasting value.” I also agree with George that “the root cause of this crisis is failed management.” Boards of directors and top managers are a step removed from the fray. Their job is to look at the larger picture and to set the tone for the enterprise. One gets the sense that they never looked beyond the quarterly statements to examine how the money was actually being earned.
More regulation could have made a difference. Swaps should be regulated, traded openly on exchanges, and collateralized. (The Obama administration proposed rules to that effect on May 13.) Collateralizing limits leverage. Regulators should not have allowed investment banking leverage to balloon, from ten-to-one to thirty-to-one. They should not allow banks to push off obligations to unregulated special-purpose vehicles, even when the banks backstop them. We need a comprehensive system that covers such attempts to skirt the system and oversees the larger “shadow banking” system.
There are two larger answers. First, many of the failures involved deception in the sale of securities. We already have laws to deal with such matters. Other failures were breaches of management’s fiduciary duty to shareholders: to build a sustainable, valuable enterprise. How could a prudent management allow essentially unlimited swap exposure, as at AIG, or the destruction of customer relationships by the sale of toxic products? These are failures for which boards must examine themselves, and for which investors should demand accountability.
Second, the fact that a particular transaction is not specifically regulated does not mean that companies are operating in a moral vacuum. Just because something is not specifically prohibited by a regulation does not mean it’s OK to do it. There are fundamental precepts of human behavior. They are simple, even if not easy. Thinkers from different wisdom traditions have long reflected on what constitutes right behavior. Some twenty-five-hundred years ago, some came to the same general conclusion. The Jewish sage Hillel summarized it: “What you would not have done to you, do not do to others.” The wisdom traditions concluded that relationships among people work best when each person recognizes the other as another human being and treats the other as he or she wants to be treated.
Business is just another aspect of our life in the larger community. It should not be a surprise that the fundamental principles of human relationships are also central to the system we have developed to exchange goods and services. A healthy market system is based on trust. In the depths of the Depression, FDR put it well: “We have always known that heedless self-interest was bad morals; we know now that it is bad economics.”
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Mark A. Sargent, "Greed 101"