8
Commercial Banks and Investment Banks
Countrywide, Bank of America, Bear Stearns, Lehman Brothers, Merrill Lynch, and the others weren’t government-sponsored enterprises. They were private firms, commercial and investment banks, that originated subprime mortgages and issued private label mortgage-backed securities. But what the banks and Wall Street were doing was very similar to what Fannie and Freddie were doing—they were borrowing at a relatively low rate and lending at a relatively higher one. If you can manage that, you make money on the spread.
Why could they borrow at such low rates? There were two reasons—they borrowed very short term (sometimes overnight). They also had the implicit guarantee that Fannie and Freddie had, though it was certainly less certain for the investment banks than for Fannie and Freddie. The other difference between the government-sponsored enterprises and Wall Street firms is that Fannie and Freddie were borrowing from people outside the poker game—the Chinese government, individual investors, insurance companies. But in the case of the investment banks, their lenders were often the other gamblers around the table. Lehman Brothers, Merrill Lynch, Bank of America, and Credit Suisse were all major investors in subprime securities. Some were more invested than others. Some were more leveraged than others. But they were all financing others’ seats at the table.
When the price of houses grows by at least 10 percent annually for almost a decade, you can imagine making a loan to someone with a lousy credit history and no money down—a borrower who puts no money down can have substantial equity in the house, greatly reducing the risk of default.
The rising prices of houses created the opportunity for subprime securitization and the financing of riskier mortgages generally. According to Inside Mortgage Finance, the subprime market grew steadily from $100 billion in 2000 to over $600 billion in 2006. Alt-A mortgages went from being insignificant in 2000 to $400 billion in 2006. So by 2006, there was a trillion dollars’ worth of high-risk mortgages (see figure 8).
In 2006, Alt-A and subprime mortgages were one-third of all originations. Some of those risky loans were bought and held or securitized by Fannie and Freddie. But most of those mortgages were bought and held by large financial institutions that had nothing to do with a government housing mandate or US housing policy. US housing policy helped to inflate the housing bubble that made a high-risk loan imaginable. But what were these private investors thinking? Why were they pouring money into risky loans?
Figure 8. Value of Mortgage Originations, 1990–2008 (in billions of dollars)
Source: Author’s calculations based on data from Inside Mortgage Finance.
A lot of people made a lot of money making these loans before the market collapsed in 2007 and 2008. The lenders made money by selling the loans to the GSEs and to Wall Street firms or by holding onto them. The borrowers made money as their houses appreciated and they sold, enjoyed the equity, or took that equity out via a home equity line of credit. The people who bought the securities packaged by the GSEs and Wall Street did well. As long as the prices kept rising, everything was better than fine. And some people got out in time. They sold their houses. They sold their mortgage-backed securities before the default rates rose.
But too many people kept dancing like crazy even when the music began to slow down and then came to a halt. Why did so many people invest so much money in what turned out to be incredibly risky assets?
One answer is that they believed in the risk assessment models that said that mortgage-backed securities and collateralized debt obligations (CDOs) were very safe, even when the mortgages were subprime. The AAA-rated portions were supposed to be as safe as Treasuries. The logic of the tranching system was the logic of the Titanic—damage would be contained and absorbed by the lower tranches. The AAA tranches were unsinkable. That was how risky assets could be turned into AAA assets. But like the Titanic, there is always an iceberg big enough to break enough compartments so that the damage cannot be contained.
For those who accept this narrative, the subprime collapse is a lesson in hubris, greed, and myopia—irrational exuberance run wild. The investment bankers believed their risk models that said that the AAA portions of mortgage-backed securities were safer than safe—and that the risk of bankruptcy was therefore very small.1 This failure of imagination, this failure to appreciate the real odds of a housing collapse, explains part of the enthusiasm investors had for an asset that was appreciating year after year.
One problem with this explanation is that many practitioners were surely aware of the shortcomings of their models. Consider Riccardo Rebonato, the chief risk officer of the Royal Bank of Scotland (RBS). In his thoughtful book The Plight of the Fortune Tellers, written before the crisis, he argued that the standard measures of risk, such as Value at Risk (VaR), were not as reliable as they seemed and that the whole enterprise of risk management is less scientific than it appears.2 I presume that Rebonato knew that RBS was on thin ice as it expanded its purchases of mortgage-backed securities. Shortly after Rebonato’s book was published, the Bank of England took over RBS because of the collapse in the value of RBS’s investments. I suspect Rebonato warned his bosses plenty about the risks they were taking. They either viewed the situation differently or their incentives reduced the appeal of prudence.
Another problem with the irrational exuberance explanation is that it wasn’t really the same asset appreciating year after year. The fundamentals of the asset were steadily deteriorating. The proportion of the mortgage market that was subprime was increasing. The investors were lending money to finance increasingly risky loans. And yet the money kept flowing. Why? Was it simply human frailty or were the natural incentives for restraint distorted by public policy?
In the first part of this book, I argued that an expectation of creditor bailout encouraged lenders to finance much riskier investments than borrowers would have financed had they had more of their own skin in the game. But there is a puzzle. The large financial institutions that were highly leveraged invested mostly in the safest assets, not the riskiest ones. They purchased the most senior tranches of mortgage-backed securities. True, these did not turn out to be as safe as they appeared. But there were much riskier mortgage-backed products—the junior tranches for example—or much riskier assets not related to housing. Why did financial institutions pour money into housing, particularly the safest parts of housing, given my earlier story about the poker game? Why didn’t the investment banks invest in even riskier assets given that they were playing with other people’s money?
NOTES
1. Nassim Nicholas Taleb, in discussion with the author for EconTalk, March 23, 2009, http://www.econtalk.org/archives/2009/03/taleb_on_the_fi.html.
2. Riccardo Rebonato, The Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently (Princeton, NJ: Princeton University Press, 2007).