An American Financial Collapse: What Happened on Wall Street?

For an overview of the bailout and stimulus acts passed in response to the financial crisis of 2007-2009, please read The Bailout and Stimulus of the American Economy

Economists have called it the worst financial crisis since the Great Depression. Unemployment is at its highest rate in nearly three decades. Companies are declaring bankruptcy right and left, and those that aren’t are slashing discretionary spending to meet their shrinking budgets. All this comes after years of some of the greatest economic prosperity this nation has ever seen. In a matter of days, without warning, we went from triumph to turmoil. Well, not with no warning. The Credit Crisis of 2007-2009 by no means happened overnight. We’ve gotten ourselves to our current state through Wall Street gambles gone bad aided by the complicity of the American people. But to understand where we are now, you must first understand: what happened on Wall Street?

How Did It Start?

The American government began to set the stage for collapse as early as 1982, when President Reagan signed a bill beginning the deregulation of banking. In 1999, President Clinton approved the Gramm-Leach-Bliley Act which repealed the Glass-Steagall Act of 1933 which had been introduced to reform banking and curtail speculation. This reduced the separation between the more risky investment banks and the traditionally conservative commercial banks, allowing for the creation of the financial behemoths we have today like Bank of America and Citigroup. These regulations allowed banking to become an extremely lucrative industry. Everyone wanted in.

As the financial industry expanded, it needed credit. And with the lowering of the federal reserve rate to 1% and an influx of trillions of dollars from China, Japan, and the Middle East (specifically Saudi Arabia), we got all the credit we wanted. In fact, Wall Street had so much credit, it was running out of investments to make. The supply of safe and profitable investments had not grown in proportion with investors’ wealth. Wall Street has never been content with making with making a lot of money. It’s the Wall Street culture that if you have a lot of money, you make more of it. And so they found a way do it: mortgage-backed securities.

And it worked brilliantly. Mortgage brokers used to receive a nice commission for the mortgages they sold for their lender. The lender would collect the mortgage payments, and he would have a good profit as well. But now, the lender sold their mortgages to investment bankers on Wall Street, who used their abundance of credit to purchase thousands and thousands of mortgages. Now the investment banker was the final recipient of the homeowner’s mortgage payment. The lender’s profit skyrocketed, so he was happy. And now Wall Street had a new investment to buy and sell, so it was happy.

Wall Street took these mortgages and bundled them together (called Collateralized Debt Obligations, or CDOs). Because the investment banks were now receiving the mortgage payment, an element of risk was involved. So banks split the CDOs into levels, which were assigned ratings by ratings agency, AAA for safest, BBB for moderately safe, and Unrated for risky investments, with other gradations in between. Each rating level was then packaged again and sold to investors. If fewer people paid their mortgages, there might not be enough money to give those who bought the Unrated investments their return, so the Unrated investments had a much higher rate of return to compensate for the increased risk. AAA investments, in turn, had much lower risk, and therefore a lower, but still respectable return.

And this should have worked perfectly, right? Well, it did. For many years, this system made Wall Street even richer than it had been and it seemed to have an unlimited supply of money to generate. But soon, almost everyone who could afford one had a mortgage. With the threat of a smaller stream of money coming from the mortgage lenders, Wall Street devised a plan. And with this plan, Wall Street unwittingly brought the United States economy to the brink of collapse.

Collapse of Mortgage-Backed Securities

Sub-prime Mortgages

Mortgages had been always been highly regulated financial instruments. Potential homeowners were carefully reviewed to ensure that they could pay back their mortgages, since lenders couldn’t afford to have too many defaulted mortgages or they would collapse. These qualified mortgage holders have what are known as prime mortgages . Investment banks, on the other hand, had orders of magnitude more capital than the lenders, and could afford to have mortgages default. If a homeowner defaulted, the bank would seize their house, and since home prices were always rising and the investment banks had a financial cushion to absorb the losses, it was a very good deal for Wall Street. In an effort to expand the market of potential mortgage buyers, Wall Street began selling sub-prime mortgages.

These sub-prime mortgages were sold to people with a host of financial issues, most prominently insufficient income (i.e. those with $40,000/yr in income buying a $700,000 house). Sub-prime lending was a component of the predatory lending market. Firms such as Countrywide were famous for providing loans to lower and middle class people that had no or little down payment and an affordable payment schedule in the first year, but then jumped in rate, causing buyers to default and go bankrupt trying to afford payments greater than their salaries. This is what happened with homes. Americans took out mortgages that promised low rates, but quickly became unaffordable. Still, no problem.

The bank seized the defaulters’ homes, but housing prices were always on the rise, so the bank still had a valuable asset. But as more and more homeowners defaulted on their mortgages and the housing market was flooded, the deal turned sour. Simple supply and demand kicked in. If there is greater supply than there is demand for a commodity, a surplus will occur. And surpluses lead to lower prices, which is exactly what resulted. Home prices dropped precipitously, snowballing into the credit collapse which began the crisis. Many homeowners now owned houses for which the mortgage value was multiple times greater than the actual property value. They decided that it was ridiculous to pay mortgages worth $300,000 when their homes’ values had fallen to $100,000, stopped paying their mortgages, and left their houses. This meant that there was a significant pool of mortgage payments which stopped flowing in. For the hedge funds and other high-risk investors who had purchased very risky mortgage-backed securities, their money was gone. Those who bought AAA investments, the safest there are, should have been OK.

Credit Ratings and Accounting Practices

Independent ratings agencies are supposed to assign ratings based on risk of an investment. But for reasons still not determined, the risks of CDO investments were not accurately portrayed. As the overall quality of CDOs fell, ratings agencies began to give the best of the sub-prime their AAA rating, despite the fact that the CDOs were far more risky. Average returns on “high quality” CDOs has been approximately 30¢ on the dollar, a risk level that was masked by inflated ratings. While buyers of riskier mortgage-backed securities came out with nothing, even those who had bought allegedly safe investments lost much of their investment.

Accounting practices also played a role in hiding the collapse until it had occurred. Deregulation of accounting allowed banks to shift assets and liabilities of their balance-sheets, allowing them to hide some of their losses. This played a part in the severity of the panic; when people finally realized what had happened, they all realized at once. It seemed like it had come from nowhere, since the banks had hidden the failing assets until the collapse was already well underway.

The Fall of the Banks

Banks had bought thousands of sub-prime mortgages, which were now worthless. But the woes of the investment banks, especially AIG, were exacerbated by three more irresponsible trading practices: Derivatives, Credit Default Swaps, and lack of Capital.

Derivatives

Derivatives are basically investments that derive their value from the value of another asset or investment. An example would be a futures contract in which one company agreed to buy a certain amount of a product from another for a set amount at a set date in the future. Properly used, derivatives diffuse risk for firms and ensure a steady and predictable cashflow. However, problems arise when the chain of derivatives becomes so long that no one knows what the original investment was. Those at the end of the chain had little to no idea of what the original investment was, and therefore had no idea their investment was about to be worthless. AIG was responsible for the most derivative securities of any of the American investment banks. And when companies began to go bankrupt, AIG was responsible for paying the holders of one controversial type of credit derivative, the Credit default swap.

Credit Default Swaps

Credit default swaps are almost like an insurance policy for investments. A CDS basically states that, for a fee, if an investment made by the investor defaults, the seller of the CDS will pay the investor the full value of the investment. So you buy a $100 bond from a construction company. The housing market is near non-existent, so the firm is unable to pay back your $30 in interest or your $100 original investment. Never fear, you’ve purchased a CDS for $25 from a small bank, which pays you your $100, leaving you with $25 less dollars then you started with instead of $100. If the company was successful and had paid your $30 in interest, you would have earned $5 even with the CDS, still a 5% net return. Had this been all that credit default swaps were, the system would have run smoothly. But in reality, that bank was worried about the risk, so it purchased a CDS from a larger investment bank for $20. That investment bank wanted to eliminate its risk, so it bought a 3rd CDS from AIG for $15.

S&P 500 Index, 2008

How can you do this with an insurance policy? Because CDSs are insurance on anything whether you own it or not. Kind of like taking out a homeowner’s insurance policy on your neighbor’s house. If his house burns down, you get a payoff. AIG sold huge amounts of CDS protection with no regard to what might happen if the assets they represented declined in value. Investment banks even sold CDSs on other banks, such as Bear Stearns and Lehman Brothers. And as companies investment in mortgage-backed CDOs failed, the CDS paymens owed to investors grew. And none of the banks had the money to pay the credit default swaps they owed. Just like sub-prime mortgages, when too many default, the whole system collapses.

Capital

Some of the investor losses could have been prevented had banks had a greater amount of cash-on-hand. As a result of deregulation, banks were allowed to take on more debt in proportion to the cash they had. This meant that when CDOs and CDSs and all the other three letter acronym-ed securities went bad, there was literally no money to pay the investors. Because of a lack of capital, investments in failed assets were worth virtually nothing.

From Wall Street to Main Street

“Main Street”, or the American people, were hit just as hard as the investment banks of Wall Street. In our complex modern economy, all financial assets are traded. Gone are the days where pensions sit in a locked vault; pension funds are traded aggressively to increase pension values and to make a tidy profit for the fund. College funds, mutual funds, stocks, and other common investments held by average Americans dropped significantly in value as the chain of assets and investments they represented fell in value. Corporations trying to stave off insolvency laid off workers by the thousands, and the unemployment rate climbed rapidly. But despite how hard America was hit was the economic collapse, we barely avoided the most serious consequences.

Few Americans realize how close we truly came to a Great Depression-like banking catastrophe. The lack of separation between investment and savings banks meant that as investment banks tanked, the savings banks teetered on the edge of failure. In the 10 days between September 7th and 17th, our nation’s economy nearly crumbled. Fannie Mae and Freddie Mac were taken over by the federal government, Merrill Lynch was sold to Bank of America, Lehman Brother filed for bankruptcy, and AIG received $85 billion from the Fed. The $85 billion to keep AIG from bankruptcy just might have saved us from visiting the ATM and being told that our money was gone.

The FDIC can only do so much. In 2008 and the first nine months of 2009, the FDIC had taken over a total of 126 failed banks, for a total sum of nearly $40 billion. By comparison, the FDIC only closed 3 failed banks in 2007, and none in 2005 and 2006. Had Citi or Bank of America or Chase or any of the other major U.S. banks failed, the FDIC would not have been able to handle it. Yes, the FDIC insures all bank accounts in the U.S. up to $100,000 and is back by the full faith and credit of the U.S. government. But if even one major bank collapsed and 5% of Americans’ savings were lost, how long would it take for the FDIC to return the depositors’ money? That’s 15 million people with an empty bank account until the FDIC can cut them their checks. The economic collapse that ensued when the bets Wall Street fell through was a crisis. But that crisis pales in comparison to a financial catastrophe that would have been the worst in American history. And what prevented that catastrophe? The bailout. And what worsened it? The bailout. Confused? You’ll just have to read my next article in my two part series on the financial crisis of 2007-2009.

A Summary:

• Wall Street has credit, wealth, and needs new investments.
• Investment banks begin investing heavily in securities (investments) backed by Americans’ mortgages.
• No one is left to sell mortgages to.
• Sub-prime mortgages with no down payments, no proof of income requirement, or other normal requirements allow Wall Street to sell to a bigger market of potential homeowners.
• Many default on their mortgages, driving housing prices down. Some of those who can still pay their mortgages leave their houses, not wanting to pay off a mortgage worth far more than their house.
• Those invested in mortgage-backed securities (virtually everyone) lose nearly everything
• Failure of housing market and irresponsible derivatives and credit default swaps bring down banks
• Federal government bails out some banks, allows others to fall
• American enters severe recession, unemployment skyrockets, all economic indicators point down

If you didn’t understand one word of this article, I don’t blame you. It’s such a complicated subject that even the top economists in the world have yet to decipher it. Watch the video below. It’s the best and simplest explanation out there. I hope you learn something from my article. Comment below ↓: ask questions, tell me I’m wrong, agree with me; whatever it is, we want you to contribute to the conversation.

Image Credits:
http://www.flickr.com/photos/stuckincustoms/ / CC BY-NC-SA 2.0
http://www.flickr.com/photos/washuugenius/ / CC BY-NC 2.0
http://www.flickr.com/photos/respres/ / CC BY 2.0

S&P 500 graph via Bloomberg

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