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Meltdown 101

Subprime mortgages and the road to financial ruin

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Just how did we get into this economic mess? The answers are both complex and troubling. Blame greed, irresponsibility, lax government oversight, conflicts of interest and especially blind faith in a housing boom that seemingly had no end. But end it did, setting off a chain reaction that has left the economy in tatters and stuck the American people with the tab.

Thus far, the government has committed $1.75 trillion to buying or propping up a portfolio dominated by devalued real estate assets — and this may be just a down payment. The Obama administration has a new plan that will commit more government cash to rid the financial system of the toxic assets that have wrecked the economy.

Roots in an Earlier Collapse

The origins of the current crisis can be found in an earlier calamity — the collapse of the technology industry in 2000. The Federal Reserve responded to that downturn by lowering interest rates. Ideally, lower rates trigger more borrowing and spending, which in turn lead to economic growth.

In May 2000, the Federal Reserve’s federal funds rate — the rate banks charge one another for overnight loans — was 6.5 percent. By August of 2001, it was 3.5 percent. The Fed further lowered rates after the attacks of September 11, to 1.75 percent by December. By June 2003, the rate had been cut to 1 percent and the average monthly rate on a 30-year, fixed mortgage, according to a Federal Home Mortgage Corp. (Freddie Mac) survey, dropped to 5.23 percent, the lowest level since the mortgage buyer started tracking rates in 1971. And so everyone, it seemed, was looking to buy a home.

At the same time, investments known as “mortgage-backed securities,” were becoming increasingly popular. Created in the 1980s, the securities work like this: Let’s say Jack takes out a mortgage loan on a home. His lender sells the loan to an investment bank that combines it with a thousand other loans into a pool. The pool is cut into pieces and sold to investors as mortgage-backed securities, or bonds, with varying degrees of risk. The interest Jack pays on the loan, rather than going to his bank, now goes to the owners of the securities.

The bottom line? Investors have bought the right to receive Jack’s interest payments.

Not all securities in a particular pool are rated the same. Some segments of the pool (known as tranches) contain riskier loans than others. Securities from risky tranches pay higher interest to investors but lose their value first if the underlying mortgages go bust. Securities from safer tranches don’t pay as high a return.

Initially, it seemed like a pretty good system. The mortgage-backed securities were considered secure and brought solid returns — better than U.S. treasuries. The bonds created from the pools were blessed as safe by ratings firms like S&P and Moody’s. Those ratings firms were later criticized for being too lenient because their fees come from the same institutions that sell the bonds. But at the time, their seal of approval created investor faith in the bonds.

Last October, the House Oversight and Government Reform Committee released an instant message exchange between two S&P employees who were criticizing the model being used to evaluate one particular security offering, noting that it shouldn’t be rated.

“It could be structured by cows and we would rate it,” wrote one employee. Since then, S&P executives have been instituting safeguards against conflicts of interest, S&P president Deven Sharma said in hearing testimony.

Exacerbating the mortgage problem was a form of insurance known as a “credit default swap.” Swaps work like this: Remember Jack’s mortgage? Maybe Jack’s credit rating isn’t so great. The buyer of the mortgage-backed security is concerned — if enough people default on their mortgages, the investment becomes worthless.

So the investor buys a swap from a company like American International Group Inc. to protect against losses. AIG is a giant insurance company. But these contracts are not insurance, not exactly, because there are no requirements that the sellers maintain reserves to guard against unforeseen losses — losses that did indeed come back to haunt AIG. And the swaps business itself is largely unregulated — the contracts do not trade on any public exchange the way stocks do.

The swaps helped fuel the demand for the mortgage-backed bonds. Conservative institutional investors like pension funds and insurance companies lined up to buy the seemingly safe securities, while yield-hungry hedge funds bought securities from the riskier tranches. The Wall Street sellers of the securities had ready buyers thanks to a global savings glut. China and oil-producing nations, flush with cash, were looking for places to invest it.

Chain Reaction

The prime lending rate is what banks charge their best customers. Subprime does not mean “less than the prime rate.” In this case “sub” actually means “worse” — higher interest rates, not lower. Such loans generally start out with a low interest “teaser rate” that remains in place for a couple of years and increases — sometimes by a lot. Ultimately, those types of loans and others like them proved to be ticking time bombs.

But no one worried about that at the outset. Wall Street’s insatiable appetite for mortgages to “securitize” was satisfied largely by subprime lenders that specialized in volume, earning their money off fees and commissions. Many of the originators — most based in California, now out of business — used a computerized process that sped the approval process dramatically. Lender profits increasingly became dependent on quantity, not on quality. Pretty soon, those in the business were joking about “NINJA” loans — as in loans made to borrowers with “no income, no job and no assets.”

As demand increased for the bonds, so too did demand for large numbers of mortgages. As a result, “subprime” loans became much more popular. The Federal Reserve reported subprime loans accounted for about 19 percent of all home loan originations in 2004, up from less than 5 percent in 1994.

Lenders were often unconcerned about the creditworthiness of the borrowers because they planned on selling the mortgages to Wall Street. And Wall Street wasn’t worried because the housing market was booming and credit default swaps had been purchased to protect against losses. And so even though risky subprime mortgages were becoming an increasingly larger component of these loan pools, there were still plenty of buyers for the securities created from them. Probably the two most influential were Freddie Mac and the Federal National Mortgage Corporation (Fannie Mae).

Fannie and Freddie were created by the government to basically do the same thing Wall Street was doing, just years earlier, and more safely: Buy loans (not subprime), convert them to securities, and sell them to investors. The goal was to make more money available for lending and thus spur the American dream of home ownership. These securities were desirable investments because Fannie and Freddie guaranteed the underlying loans against losses. There was also the presumption that if they ever got into trouble, the government would bail them out. (That presumption was in fact correct.)

By 2004, Fannie and Freddie had begun buying billions of dollars worth of “private label” mortgage-backed securities created by investment banks as a means to further affordable housing goals. Fannie and Freddie’s participation gave the whole business an air of legitimacy and safety.

With interest rates so low and so much money available for lending, home prices soared. Real estate speculators had a field day. Increasing property values led to a surge in refinancing. Homeowners converted equity in their homes to cash, bought more homes and “flipped” them for a profit. It all seemed too good to be true. And indeed, it was.

Just as lower interest rates marked the start of the boom, rising interest rates signaled the beginning of its end. In June 2004, the Federal Reserve, fearing an increase in the rate of inflation, made the first of 17 consecutive quarter-point interest rate increases. The federal funds rate topped out at 5.25 percent by the summer of 2006. The monthly average fixed rate on a 30-year mortgage had risen to 6.76 percent by July.

Those higher rates led to a cooling housing market. Property values leveled off and eventually began to drop. Around the same time, millions of subprime mortgages with those low, two-year teaser rates were resetting upward, causing what federal regulators call “payment shock.”

Borrowers who rode the wave up and took out loans they couldn’t afford — especially those who relied on selling their homes at a profit, or refinancing them to make future house payments — were in trouble. Foreclosures for the second quarter of 2007 hit a record, with residential delinquency rates encompassing 5 percent of all loans, according to the Mortgage Bankers Association.

Between 2000 and 2007, underwriters of mortgage-backed securities — primarily Wall Street and European investment banks — poured $2.1 trillion into underwriting subprime mortgage backed securities, according to Inside Mortgage Finance, and the loans had spread far and wide — to bank portfolios, hedge funds, pension plans, and more. Alarmed by the corresponding drop in the value of their portfolios, the big firms cut off credit to subprime lenders and forced some of them to buy back mortgages that were immediately going into default. By the summer of 2007, the subprime industry, starved for cash, had all but disappeared.

The real estate crash was followed — inevitably — by the banking crash. Bear Stearns was the first U.S. bank to fall. In March of 2008, JPMorgan Chase & Co., agreed to buy Bear thanks to a financing arrangement created by the Federal Reserve Bank of New York. The bank basically bought $29 billion of bad Bear assets and moved the portfolio to a newly formed corporation, clearing the way for the sale.

On September 7, the government seized control of Fannie and Freddie, pledging $200 billion in support from the Treasury. A little over a week later, Merrill Lynch, staggered by $45 billion in losses on mortgage investments, agreed to be sold to Bank of America. In the same week, investment banking icon Lehman Brothers filed for bankruptcy protection and the government agreed to an $85 billion bailout of AIG.

Banks, concerned about the financial health and unseen liabilities of other financial institutions, stopped lending. It was time for the government to do something drastic.

The Bailout Bill

On October 3, 2008, then-President Bush signed the $700 billion Emergency Economic Stabilization Act into law. The legislation was presented to the public as a way to use taxpayer money to buy so-called “toxic” mortgage assets from banks so they could start lending again. It was hoped the government could use the “Troubled Asset Relief Program” — or TARP, as it is known — to buy the mortgage-backed securities, and auction them off when they recovered some of their value.

But instead, the Bush administration changed course when it decided not to buy those toxic assets, but to buy shares of preferred stock in banks themselves. The toxic asset problem was in some ways taken on by the Federal Reserve, whose financial commitment has far exceeded the $700 billion TARP program.

In addition to the $29 billion committed to smooth the sale of Bear Stearns by the Federal Reserve Bank of New York, the government has guaranteed against losses of $118 billion in real estate and other assets held by Bank of America and $306 billion in similarly described assets held by Citigroup. The New York Fed has also financed the purchase of $52.5 billion in mortgage securities and credit default swaps from AIG.

In addition, the Federal Reserve has committed to buy up to $1.25 trillion-worth of Fannie, Freddie, and Ginnie Mae mortgage-backed securities. All told, since the real estate crash, the government — including the Treasury Department, the Fed, and the Federal Deposit Insurance Corporation — has committed to purchase or guarantee against losses a total of $1.75 trillion in poorly performing assets — and that doesn’t include the TARP or a host of Fed programs created to jumpstart lending.

And there’s more to come. On March 23, new Treasury Secretary Timothy Geithner unveiled a plan to convince private investors to buy “legacy” assets, a more agreeable description than “toxic.” Geithner wants to lure private investors into buying the assets by providing matching funds and government financing. So how much will this cost? Initially, it will require somewhere between $75 billion and $100 billion in TARP money, according to Geithner. The plan is complex, and so it will be awhile before it’s clear whether it helps the economy. Wall Street, however, was impressed. The Dow Jones Industrial Average — led by financial stocks — jumped nearly 500 points — almost 7 percent — on the day details of the program were released.

Meanwhile, the government is trying to figure out what went wrong. Federal Reserve Chairman Ben Bernanke in April of this year in a speech argued for greater government oversight of financial institutions, “especially large and interconnected ones like AIG.” Bernanke said oversight of the insurance company’s activities was limited, which allowed it to take “dangerous risks largely out of sight of federal regulators.”

Such oversight was clearly not a top priority when Congress passed a law “modernizing” the financial services industry in 1999. Many believe the deregulatory Financial Services Modernization Act set the stage for the current financial meltdown. The legislation knocked down the Depression-era barriers between insurance, investment banking, and commercial banking. It allowed financial service companies to expand into other lines of business, but failed to create a sufficient guardian to oversee systemic risk to the economy. The bill passed Congress overwhelmingly, and was signed into law by former President Clinton.

Not everyone was in favor.

Michigan Democratic Rep. John Dingell, in a speech on the floor of the House, warned that his colleagues were passing a bill “written in the dark of night, without any real awareness on the part of most of what it contains.” Dingell said the law was creating a group of institutions which will not just be “big banks” but “big everything.”

“And under this legislation, the whole of the regulatory structure is so obfuscated and so confused that liability in one area is going to fall over into liability in the next,” he continued. “You are going to find that they [financial institutions] are too big to fail, so the Fed is going to be in and other federal agencies are going to be in to bail them out. Just expect that.”