The Anatomy of a Financial Crisis

6o Minutes and Half the Truth

When I watched the 60 Minutes piece on television the other night, I was impressed at how they were able to boil down a very complicated, global financial meltdown and break it into two easy-to-understand pieces. According to 60 minutes, it was a case of greed and planned ignorance among the Wall Street crowd.

Our investment banks up risky mortgages, packaged them without regulation and sold them (using huge offering memorandums detailing mathematical models designed by physics experts and cosmologists) to an unwary public as investment-grade debt. Then they “insured” the payment of these securities (CDOs) through something called “Credit Swaps.” Of course, it wasn’t called insurance. That would have meant regulation, and the setting aside of reserves to meet this liability. Ultimately, (according to the show) it was the credit swaps that caused many large financial institutions (Lehman, Bear Stearns, AIG, etc.) to teeter on (or over) the edge of bankruptcy.

I give CBS credit for explaining the nub of the issue in a way that hockey moms and Joe six-pack can understand. Unfortunately, CBS only addressed half of the cause. They were correct in describing Wall Street execs as greedy, amoral souls (my words) intent on reaping huge profits, regardless of risk, at any cost. But CBS completely ignored the role that Congress should (could) have played in preventing this global crisis.

According to CBS, Congress allowed $50,000,000,000,000-$60,000,000,000,000 ($50-$60 trillion for those of you who get a brain freeze with so many zeros.) to go unregulated. This is as much as the total U.S. net worth, of $55 trillion.

Much of the money used to purchase these securities has been borrowed, perhaps 90% or more. To put this in perspective, debt currently held by the U.S. public is about $5 trillion. Total U.S. government debt is about $10 trillion. The U.S. Treasury puts this at $4.2 trillion. But they have not added the $700 billion bailout or the $ 5 trillion of debt assumed in the takeover of Fannie Mae and Freddie Mac.

So, somewhere out there in the ether, financial institutions have borrowed three times as much as every American and the U.S. government combined. And these are the people that are lending money to us?

How did this happen? I have explained the mechanisms in prior blogs, so I won’t go into that here in detail. Simply put: Financial institutions (for themselves and for their clients) purchased these things (CDOs, mortgage-backed securities, toxic debt) with the expectation that there were assets backing them.

The rating agencies relied upon a twenty-year bull market in real estate (brought on by duel working families, the lowering interest rates enhanced by a generous Fed policy), complex algorithms developed by geeks trained at Harvard, Stanford, Cal Tech and MIT who had chased the big bucks on Wall Street. They also relied upon the word (and the historical practices) of Fannie Mae and Freddie Mac.

In the 60 Minutes piece, one of the “experts” stated (I am paraphrasing) that math cannot predict human behavior. That is not a correct statement. Math can predict human behavior, but not with certainty. With investments, math can predict behavior (of which a large part is irrational emotion), but only to a point within ranges and probabilities. For example, math can predict that a certain investment’s return will fall between a range of returns with a given probability. Below I give a simple illustration.

Example: A basket of stocks might be expected to return 10% per year over time. There will be a “standard deviation” or volatility to this return. Let’s say that the standard deviation is 10. Our math tells us that two thirds of the time, in a one year span of time, our return will fall within our expected return (10%), plus or minus one standard deviation (10%). This means that our investment return will fall between zero (10% minus 10%) and 20% (10% plus 10%). Ninety-five percent of the time, our return will land within our expected return plus or minus two standard deviations. This gives us a range of -10% to 30% return, 95% of the time. If we go to three standard deviations, our expected return is predicted to fall within our expected return plus or minus three standard deviations. (-20% and 40%)

In summary, our math tells us that we can determine the probability of a range of returns given our expected return, plus or minus our standard deviations.

Percentage Probability Range of Return
1 Year Low High
67% 0% +20%
95% -10% +30%
99% -30% +40%

The expected return range expands as our certainty increases. In other words, most of the time, the return will fall somewhat close to what we suspect. However, some of the time, unusual things will happen (war, terrorism, financial collapse) that will cause an unexpected return. The greater the certainty, the greater the range of returns.

The longer the time frame grows, the smaller our range becomes. Over time, investments tend to repeat the returns of the past. For example, when our time frame moves to ten years, our standard deviation may narrow to 5%. In this case, our ranges would be as follows:

Percentage Probability Range of Return
10 Year Low High
67% 5% +15%
95% 0% +20%
99% -5% +25%

The Wall Street firms all had mathematical models that predicted the performance of mortgage securities, depending upon quality, initial equity, time duration, property location, etc. These models took such statistics as a borrower’s credit ratings, their occupation, their documentation, length of employment and used them to come up with the probabilities of ongoing payments the probabilities of complete repayment in any given time frame, the probabilities of interest rate resets and what they might be. There were hundreds of variables that went into these calculations.

Obviously, some of the important factors were not included in the calculations, or they were minimized.

Here’s what happened:

When determining their capital base, financial institutions are required to “mark to the market” with securities they hold. They are not allowed to say that investments in their portfolio are worth their purchase price, which may have been far in the past. They are required to assess the current value of the securities on their balance sheets.

For years, there was no actual “market” for these securities. They were not traded on exchanges, they were simply held. Investment banking firms simply assigned values to these securities, since there was no market. Many firms chose to value these securities higher than initial cost. This allowed them to book higher profits (which triggered lucrative stock options) and increase their capital base so they could buy more.

When Countrywide failed, the world (or at least regulators) suddenly realized that these CDOs were worth far less than expected. This forced financial institutions to revalue portfolio securities, dramatically reducing their capital.

Capital is needed by banks before they can issue loans. They must maintain certain capital to loan ratios. So, when capital decreases, loans to business and individuals must also decrease. This causes business to slow, jobs to be lost, etc.

While balance sheets were being redrafted to reflect the current (and rapidly falling) value of mortgage backed securities, another nasty thing was happening to the investment banks. They were being asked to make good on their credit swaps (unregulated insurance).

Companies like Bear Stearns, AIG, Lehman Brothers and Citi had profited greatly by selling “guarantees” on mortgage backed securities they thought would never lose value. They were forced to pay the interest (and principal) on mortgages when homeowners began defaulting. This hampered cash flow. It also dramatically increased liabilities as it decreased capital. This is the equivalent of bank hari kari.

Do not underestimate the function of these credit swaps. This “insurance” was purchased by investors, because they often borrowed the money to buy these investments in the first place. These securities were purchased with enormous leverage, so even a small drop in value would be devastating to a bank’s (investor’s or pension’s) capital base.

Enter the Perfect Financial Storm

As it became apparent that these CDOs were worth nowhere near the values on bank balance sheets, banks (I use this term broadly) were forced to readjust their capital base. Many of the investment banks (Lehman, Bear Stearns, Citi) also faced mounting liabilities from their credit swaps. Within a few short months, enormously profitable, asset rich companies became completely insolvent. If allowed to continue, this insolvency would have blown through our society like a hurricane. In fact, this has already started, nearly pulling the world beyond a global recession into a depression.

Banks cannot lend money when they have no capital. This is a simple fact, but an awesome, bitter truth.

Wall Street firms must take much of the blame for this problem. Their mathematical algorithms predicted this. Nothing is certain. But the probability of this happening was slight, and considered an “acceptable risk” of business. Big mistake.

One of the main problems for this statistical breakdown was that Fannie Mae and Freddie Mac dramatically relaxed their underwriting standards, without really telling anyone. These two organizations purchase about half of all mortgage loans in the country. Their purchase is generally considered to be a kind of “seal of approval” with regard to quality.

These two organizations allowed mortgage companies to send increasingly inferior loans, purchased them and sold them off for profit. Appraisal standards deteriorated. Documentation standards grew lax. Borrowers became a commodity, not a banking decision.

This strategy allowed men like Fannie CEO, Franklin Raines, to make hundreds of millions of dollars while they cooked the books and destabilized our economy. Wall Street banks, hedge funds and pension plans were willing buyers. But Fannie and Freddie flat out lied about what they were selling.

What Was The Government’s Contribution?

Our government must shoulder a good portion of the blame for this. This crisis was caused by too little regulation and too much regulation. It was caused by corporate greed, but also by political ambition and greed. This helped cause and then magnify the problem.


It began in 1992 when Clinton vowed to end “corporate greed.” He demanded, and got, legislation that limited the tax deduction on corporate salaries to $1 million. Congress didn’t realize that corporate executives are like highly paid athletes (except that many of them actually produce something). They are free agents, able to go to the team that will pay them the most.

These executives are worth far more to companies than $1 million. However, it is not good business practice to pay taxes on compensation, since it leaves less for shareholders. Corporations used the complex tax laws to find a way around the 1992 law limiting corporate deductions. They replaced large corporate salaries with smaller salaries combined with incentives. Many of these incentives were based upon stock performance. This caused executives (including those at Fannie Mae and Freddie Mac) to drive stock performance, even if it meant breaking the law and committing fraud.

This is a classic case of unintended consequences. The president and Congress thought they were addressing corporate “greed.” Instead, they created a way to make it worse.

This law change was one of the main culprits in the “tech bubble” of the 1990s. Company executives forced their stock prices upward in order to trigger stock options. This caused businesses to lose much of their long-term focus, in favor of questionable accounting practices and short-term thinking.

The ensuing stock market collapse (of 2000) helped create a ready market for mortgage backed securities. Pension plans grew underfunded, and they needed securities with low risk and high returns. Wall Street filled the enormous demand with mortgage backed securities. A crisis was incubated.

Hedge funds caught on to this game. They used a common exclusion (Regulation D) to the Securities Act of 1933 to create large pools of investments outside the regulation of the SEC. They raised billions of dollars, borrowed trillions and invested in mortgage backed securities. If they could borrow at 3% and earn 6%, they profited greatly from the spread. Big time.

Investment banks used the liberal Fed window to borrow funds to purchase (hedge) mortgage backed securities. This was almost a license to print money and profits skyrocketed.

Fannie and Freddie were seen as golden boys, manufacturing the geese that laid these golden eggs.

No Regulation

Republican leaders pushed for fewer regulations of the securities markets. Their mantra was that regulation inhibits productivity. But both parties stood by and allowed a shadow market to grow far too large with little regulation.

Mortgage Fairness

For years, Fannie Mae was not buying loans issued to low income, low credit borrowers. Democratic leaders called this discriminatory and pushed for mortgage “fairness.” This caused Fannie to buy mortgages they would not normally even consider. With little government oversight, they were able to almost do this at will.

Poor loans received the Fannie “stamp of approval” and sold along with the rest, as quasi-investment grade.

The Fed

The tech bubble (partly caused by tax legislation) caused our stock markets to become highly overvalued. P/E ratios were twice their traditional multiples. At the end of the boom, business had to digest a spending binge, so it was up to the American consumer to pull our economy along and prevent a big recession. Enter the Fed.

Alan Greenspan quietly engineered a housing boom to create equity and consumer spending. He did this by consistently lowering interest rates (among other things). As home equity rose, consumers refinanced their homes. They used refinancing proceeds to purchase goods and services and drive the economy.

Political Games

As early as 2002, Congressmen began calling for an investigation into the practices of Fannie Mae and Freddie Mac. Fannie and Freddie were quasi-government organizations. They were independent, publicly traded companies, but their debt was guaranteed by the Federal Government. As a result of this crisis, they are now, technically, owned by Uncle Sam. So is their debt.

Fannie was being run by Clinton appointee and adviser, Franklin Raines. When it became apparent that Fannie was abusing the system, Republicans began calling for an investigation. (Raines has since been assessed a fine of more than $23 million) The Democrats saw this as a political problem, not an economic one, so they blocked meaningful oversight.

Democrats control Congress, so they chair the banking committees of the Senate and the House. Christopher Dodd and Barney Frank simply refused to investigate any wrongdoings by Fannie and Freddie. So, the problem grew greater, until everything collapsed.

The Fed Bailout

Enter the Fed rescue plan, or “bailout.” This will help stabilize markets and keep some liquidity in our banking system. But it will not replace the trillions in capital that have been lost by the world’s financial system, and by investors. It will not make this problem go away; it just softens the blow. We will face lower stock market returns for a good decade because of this. Inflation will be greater because of the massive infusion of money by the Fed. Our children and grandchildren will pay the ultimate price, because they will have to pay on this debt for decades.

The Final Result – A Perfect Financial Storm

As you can see, this problem was caused by a confluence of seemingly unrelated factors, all converging to create the perfect financial storm. We had the law change that helped create the tech bubble. The stock market collapse caused Greenspan to help create the housing boom. Pension plans cried for higher yielding, low risk securities. Wall Street built computer models that convinced the rating agencies to consider mortgage backed securities as investment grade debt. Low interest rates allowed unregulated hedge funds to join the investment banks and pension plans. Together, they bought as much as could be created. Congress forced a lowering of underwriting standards. Fannie Mae (and Freddie Mac) executives cooked the books and lowered quality to drive their stock prices higher to trigger stock options. Democratic leaders refused to investigate. Republican leaders pushed for deregulation and allowed a huge piece of the financial world to go unregulated. Insurance companies and investment banks borrowed huge sums of money to purchase these securities. Then they “insured” them to add to their profits. Wall Street ignored the bottom end of the mathematical return range, seeing it as acceptable risk. When mortgage holders began defaulting, investment banks were forced to “mark to the market.” This caused a dramatic fall in capital, and instant insolvency. The credit markets seized and the world economy ground to a halt. Investment banks and insurance companies were asked to make good on their guarantees and couldn’t deliver. World stock market values plummet and the capital base grew even weaker. The U.S. Government more than doubled our national debt (when we add the assumption of Fannie Mae and Freddie Mac debt).

This reminds me of hurricane Katrina and New Orleans. It has been three years, and New Orleans is still not the same. Areas of the city remain blighted. The local economy still suffers. And the danger still remains.

The same thing goes for our nation and the world. The United States will feel the effects of this for years. We will have lower corporate earnings than we might have enjoyed. Inflation will be greater than it would have been. We will create new regulations. Those regulations will have their own unintended consequences. And someday, hopefully not too soon, we will probably do it all over again.

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