Many of the institutional investors, banks, and pension funds have conservative investment policies that limit the types of investments they can make. These investors rely on bond rating agencies like Moody’s and Standard & Poor’s to determine the overall level of risk of an investment. Many can only invest in AAA or AA+ rated bonds. These are the highest ratings and typically indicate that the investment is extremely safe. Many of the CDOs that investors bought had these high ratings.
The underlying problem was that the rating agencies were only rating the top layer of the CDO. The CDOs are divided into tranches, or parts, with secure, high-quality loans in the top tranche, and lesser-quality loans in the lower tranches. The CDOs were packaged this way so that they would yield higher returns to the investors. The lower, riskier tranches paid higher interest rates, which made the entire CDO have a higher yield than a CDO made up of only high-quality mortgages.
Once again, a principal-agent problem was at work. The rating agencies earn fees from those marketing the CDOs, so they have an incentive to award high ratings to their customers’ products. The institutional investors are investing other people’s money, so as long as they are following the protocol and buying the highly rated investment, they have little incentive to do anything other than maximize the return to their paying customers.
To sweeten the deal, some investment banks that marketed CDOs to investors sold a type of insurance called a credit default swap (CDS) that would pay the investor if the CDO went into default. For the investor, this was enough to make CDOs the perfect investment. For the investment banks, they were making money hand over fist selling the CDOs and then again charging for the CDSs. Profits went through the roof, as did the incentive for managers and chief executive officers to market these products to their customers. There was only one small problem. The CDOs were much less secure than people believed and the CDSs were not adequately funded. If the CDOs were to default en masse, the investment banks that sold the CDSs would be liable for hundreds of billions of dollars. That is exactly what happened.
Bear Stearns was the first Wall Street victim of the mortgage crisis. When the housing bubble burst, the value of the CDOs came into question. Bear had heavily marketed the CDOs and also invested in them. In the face of heavy financial losses, Bear Stearns’s balance sheet became toxic. If they sold their assets, the value of the firm would plummet. Soon other investment banks refused to lend to Bear, and the company faced insolvency. The New York Federal Reserve president, Tim Geithner, orchestrated a bailout of Bear Stearns by lending money to banking giant JPMorgan Chase with the understanding that JPMorgan would use the funds to purchase Bear Stearns at a deep discount. It was hoped that this would prevent a widespread panic, but exactly the opposite happened. Soon Lehman Brothers was on the ropes, but this time no one came to the rescue of the firm. The panic had spread.
A moral hazard is created when insurance or expectation of a government bailout encourages risk-taking behavior. Economists and policymakers must address moral hazard when making decisions. Failure to do so encourages more risk taking. Ignoring moral hazard is a moral hazard.
As CDOs defaulted, investors exercised their CDSs, which insurance giant AIG had marketed. AIG faced losses of hundreds of billions of dollars. AIG is a key player in America’s financial system, and many on Wall Street and in Washington DC believed that AIG was “too big to fail.” If AIG failed, the entire financial system could have possibly collapsed. The U.S. government and the Federal Reserve took the unprecedented action of bailing out AIG in order to prevent further catastrophe.
As the mortgage crisis spread, the value of CDOs, in which financial institutions had invested heavily, collapsed. With the high-profile failure of two of America’s largest investment banks and the bailout of AIG, financial institutions stopped lending to each other. Banks were fearful of each other’s balance sheets. When the banks stop lending to each other, banks stop lending altogether. Soon businesses not tied to housing or banking were unable to borrow, and the commercial paper market froze. Business ground to a halt. The Great Recession had begun.