- The Perfect Storm - The various factors that led to the collapse
- Victims of the Carnage
- Who's To Blame
- Where We Are We Go From Here
The Perfect Storm - The various factors that led to the collapse
In my last post, I gave you what I think is the root cause of the collapse of the mortgage industry. If I had to say it in one oversimplified sentence, it would come down to this: The mortgage crisis stemmed from a breakdown in discipline by mortgage originators and investors due their inability to adequately model and track risks associated with relatively new mortgage investment vehicles. Yeah, it's high level and not a complete picture, but it give you the essence of what started this mess. But the important part of this sentence is how it identifies the root cause of where the breaking point originated - specifically "mortgage originators and investors". That is where the mess began, and they are the ones who paid very heavily in the debacle. Let's see how and why...
The 2 "L's" - Liquidity and Leverage
Ahhh, the banks. Mammoth institutions that form the backbone of capitalism and give the world what it needs to do business. They provide the economy with the means and opportunity to become financially successful through a myriad of services and products that range from interest bearing savings accounts, to complex financial restructurings that allow companies to transform themselves. But in all that fancy jargon and hooplah, banks essentially work off of two basic concepts, Liquidity and Leverage. And understanding these two concepts will help you understand they suffered so greatly in the financial crisis.
Liquidity is simple - it's the the ability to access money easily (at least in my non-professional terms). The more cash you have on hand, the more liquid you are considered. For banks, liquidity is very important in that it's what allows them to do their day-to-day operations. They take their sources of liquidity - money invested in them by clients (through mutual funds, pension funds, bank deposits, etc.) - and invest that money into the market in the hope of making a return. They then come back and, depending on the source of that liquidity, pay their clients back. They can also use various other sources of liquidity like issuing credit.
Leverage - A little more subtle, but still not difficult to understand, leverage is how banks multiply their returns without needing as much liquidity. In other words, the bank will take $1 of cash it has on hand and use it as collateral to borrow more money - usually from other banks or the government. It then takes that increase in liquidity and goes and invests that money. The bank can essentially make the returns of more than $1 without needing to have more than $1 on hand. BUT, it also opens itself to the risk of losing more than $1 when it originally only had $1 to invest - I'm sure you can see the problem there.
Sorry to sound like a textbook, but those two concepts are important (I promise, no more for the rest of this post). Going back to our train-wreck analogy, during the peak of the mortgage bubble, banks were able to access a lot of liquidity and gain a HUGE amount of leverage. Why? Without going into too many details, basically the previous few years (some say from 2002 onwards), money was cheap to borrow for the banks. They were able to access huge amounts of capital. They then used that capital and leveraged it to obtain even more capital. By market peak, both liquidity and leverage ratios were at historical highs for banks - all because things were going so well, that the more leverage they had, the more money they were making. This is analogous to attaching rockets onto our train. It was going very very fast. Things were good...too good.
Well, then it happened. The mortgage market started turning sour around mid-2007. Why then? I'm really not that sure. If I had to guess, I would say that it was a natural tipping point for the American consumer - they just couldn't afford to take on anymore debt. This over-extension had to snap back at some point, and this seemed to be it. It looked like an economic downturn was on its way, but, unfortunately, this one was going to be a lot worse than previous ones. The reason for this was because the banks were over-leveraged in the mortgage market, and when the market collapsed, they were unable to pull out in time to recoup their losses. In fact, some banks were leveraged well beyond historical norms to about 30:1. This means that they were borrwing $30 to every $1 they had in hand. They then took that $30 and invested in the MBS's we had discussed earlier. Now, if the mortgage payor is the over-extended consumer, then they will likely not be able to pay that mortgage and default. This caused the prices of the MBS's to plummet, and the banks that were deeply involved in the MBS market were unable to sell the MBS's since they were now considered 'toxic' assets.
The Ensuing Panic
Remember when I mentioned that there was no market for MBS's and, thus, no direct way of determining exactly what the value of the MBS is? Well, here's when it caused real problems. Because of this lack of transparency, nobody wanted to trade the MBS's...essentially making the worthless. Because the banks had so many of these assets on their books, their was a general loss in confidence in the viability of those banks. Think about it, if you're a banker, and another bank you're dealing with had what at one time was $100 billion worth of MBS's on their books, you would likely think that they were $100 billion in the hole. Consequently, you'd like be worried that this bank wouldn't be able to pay you back and you wouldn't do business with them. Well by the beginning of 2008, when it became apparent how bad the mortgage market was going to get and how deep some banks were involved in it, this started happening all over the place. Banks stopped doing business with each other, causing a huge shutdown in the markets.
Now, you're probably wondering why this became such a huge issue outside of the banks. Why were so many people and businesses outside of the financial industry impacted so heavily by this shutdown in the banking system? In fact, a 'investingdecoded' reader commented that there were a lot of other things that caused this downturn to occur other than just the housing market. While that is true, I do argue that the collapse of the housing market, which in turn caused the collapse of the banking industry, caused many of the economic woes people are experiencing today. This is because, in the panic that ensued with the mortgage crisis, many banks stopped lending money all together for fear that they needed that money to cover current obligations. A massive de-leveraging began occuring so the financial system could backtrack into it's original state. Unfortunately, this had a wide-spread impact on all businesses. Most businesses, especially major corporations, need credit lines in order to do day-to-day business. Whether it's a loan to build a new factory, or a line of credit to acquire raw materials with which to produce goods, in some form or another, these businesses interacted with banks to get the capital needed to build new businesses. Well, as these banks were de-leveraging, this capital became either prohibitively expensive, or impossible to find all together. This phenomenon known as the 'freezing' of the credit markets had the cascading effect of a larger economic slowdown. At the same time, the consumer, which accounts for about 70% of the American economy, drastically cut back on spending as part of its own de-leveraging process, further adding to the woes of the economy and putting us in the place we are today.
Victims of the Carnage
In all this mess, there were a few names that really stand out as 'victims' of the downturn. Most of these names are associated with the financial services industry and were either bought out by healthier competition for pennies on the dollar or went outright bankrupt. Even a whole industry as we night it may be considered 'dead'. Here's my list of the victims:
Countrywide Financial - The first and most spectular collapse, Countrywide played a key role in the rise of the MBS market and the creative new mortgages that allowed all types of people buy all types of homes. Even as the crisis began, the CEO of Countrywide, Anthony Mozillo, adamantly stated that the market was solid and healthy. Not too long after, the company was bought out by Bank of America for literally pennies on the dollar...they still may have paid too much.
Lehman Brothers - A highly reputable name who's collapse really led to the freezing of the credit markets. This company was over 150 years old and survived 2 World Wars, a Great Depression, and even the Civil War. Unfortunately, as a big holder of MBS's and a key player in the credit markets, it found it difficult to find other banks to do business with due to sheer fear. On the other side, its clients were pulling money out at an alarming rate, basically causing a run on the bank. By the fall of 2008, Lehman Brothers would no longer exist.
Citibank - The largest financial institution in the world was having trouble long before the crisis even began. People said its sheer size and complexity resulted in an overly bloated structure that couldn't react well to changing market conditions. Well, it wasn't able to react quickly enough to this massive change in conditions and has been hit hard as a result. Last I checked, they were well on their way to firing upwards of 50,000 of their employees, but at least they're still in business!
AIG - Banks weren't completely dumb in recklessly buying MBS's without mitigating their risks. Many bought insurance policies on those securities in case they did lose value as a hedging strategy. Well, AIG, the largest insurance name in the world, was a big originator of these policies better known as Collateralized Debt Obligations (CDO's). But when the MBS's became worthless, the banks went to cash in their policies, putting an immense strain on AIG which, eventually required government help to stay afloat to the tune of $100+ Billion (last I checked).
Investment Banks - The term investment banks refers to banks that did not take regular deposits from consumers and, therefore, are less heavily regulated than commercial banks. These guys (names like Goldman Sachs, Merrill Lynch, Lehman Brothers, etc.) were able to take more risks and, for a while, gain huge rewards for their clients and themselves. As the market went bad, so did their businesses. In fact, their business went so bad that they needed government help to stay afloat. To get that help (by way of the $700 Billion TARP program), however, they needed to be commercial banks (like Citi, JP Morgan, Bank of America etc.). Therefore, most of the major investment banks either changed to commercial banks or went belly up, or were acquired by other names, thereby ending the concept of the investment bank altogether.
Financially Responsible People - Yes, you guys that didn't get crazy mortgages and didn't over-extend your finances are paying for the mistakes of others. It's unfortunate, but it's what the reality is. Makes me almost wish I bought a Ferrari by re-financing a house that I never planned to pay the mortgage for or something...
Who's To Blame
Now that we have an understanding of what happened, the natural question becomes who's responsible for it. Like any problem of this magnitude, I think it's safe to say there are many culprits. The banks are an easy one. The greed and manipulation that overtook Wall Street for many years resulted in banks taking way too many risks with their client's money. The models they were using were broken, and they didn't see it. Whether that was intentional or not, I'm not sure - but if it was truly uncontrollable, than banks like Wells Fargo and US Bank, who were able to stay healthy through all this carnage must be really really really lucky.
Blame can also be placed on the government. Why were financial institutions allowed to over-extend themselves to such a great degree? Why didn't someone (SEC?) say something to regulate how the mortgage industry could be traded. Furthermore, the Federal Reserve played a large role in giving banks the cheap capital it used to fire up the MBS market. Where was the intervention there through tools like interest rates?
Finally, one that I particularly want to point out is people's common sense. If you make $50,000 a year, you shouldn't be able to afford a $750,000 house, I don't care what your monthly payments are. If it's too good to be true, it probably is. And I don't care what that mortgage broker told you, you are over-extending yourself beyond your means. Common sense took a back seat in many people's minds. Hopefully it's coming back now.
Where We Are We Go From Here
So here we are, a year and a half into this whole fiasco. The credit markets are slowly un-freezing and companies are finding ways to do business again. The US Government has stepped in and pledged trillions of dollars to support the economy and world governments have followed suit. However, the damage has been done. Literally trillions of dollars of wealth has been wiped out of the market. You can't have something like that happen and just bounce back from it. That's why I feel that it'll take at least through the rest of 2009 before we seen some real growth in the economy again. Furthermore, there will be major changes in the financial industry to try to ensure something like this doesn't occur again. You'll probably see some more banking names disappear as well.
There are some bright points, however. I really believe that, unlike the 2000 recession, the market has been much more drastic in the realization of the downturn. By that I mean that this downturn was so sudden and dramatic, companies also reacted with similar intensity. As a result, I think a great deal of the layoffs and cutting of business capacity is in place. Although I do think more will still be happning, the worst is behind us. Now I expect an era of rebuilding the foundations of the market for the rest of 2009 and a return to growth sometime in 2010. If you're a long term investor, it isn't a bad time to start nibbling again. We just have to hang on a little longer, but we'll get there.
Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!
The Standard Disclaimer:
The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.
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