Thursday, May 28, 2009

Part II: the Hangover.

So why did the party end? There is no single reason. The first hints that things were amiss occurred in 2007 as housing markets became saturated. The economic run-up throughout the ‘90s was driven by homebuilding, and the consumer spending financed by rising home values and home equity lending. As both the housing and consumer credit sectors became stagnant, consumer spending began to dry up, indicating the approach of a recession. At the same time, the huge growth in subprime sales to finance the appetite of the secondary MBS market had created a critical mass of mortgages that began to default. The folks who bought houses they couldn’t afford simply quit paying. Again, the idea behind mortgage backed securities was to dilute the risk of default by selling shares of hundreds/thousands of mortgages the vast majority of which are paid on time. This only works when the slice of mortgages is representative of the entire market. When you buy a percentage of 1000 subprime, non-performing mortgages, you don’t dilute risk – you just mask it.

The rise in defaults fed a vicious cycle, as saturation in the housing market flattened prices at the very time where the majority of growth was occurring in subprime markets – which relied on continued rapid appreciation to keep new buyers above water. A surge of homeowners were forced to sell to avoid foreclosure, even as new home inventories peaked (homebuilding is a long lead industry that chases a rising market.) A surge in the pool of used homes competing with the now heavily discounted glut of new homes created a rapid drop in house values, particularly in the more volatile markets of California, Florida, and Nevada. The large number of recent homebuyers with no equity (their subprime loans requiring almost no down payments) found themselves underwater, and began walking away in droves.

It is easy to understand the housing sector bust – but its relationship with the broader financial crisis is more complex. As home prices declined precipitously in 2008, and foreclosures reached record numbers, it became apparent that the financial risk in MBSs was much higher than the AAA rating granted by S&P and the other agencies, and these MBSs began to quickly lose value. The downturn became a crisis when the market could no longer accurately assess the value of the underlying mortgages. Why? Because every mortgage is unique, and every security contains a huge mix of unique assets that have individual non-zero values: even a defaulted mortgage is still backed by the inherent value in the house. A bank owning a single mortgage can repossess the house and auction it for a sum that is relatively easy to value, even if it is only 80 cents on the dollar. But the holder of a mortgage backed security doesn’t own the rights to a single loan – he holds a percentage of thousands. The bondholder cannot recoup his loss through repossession, he can only sell the bond. And the market for mortgage backed securities quickly froze. Holders valued the bonds at a much higher price than any buyer was willing to purchase them. When no one is willing to buy an asset at a price anyone is willing to sell it, the asset becomes “toxic.”

And why the reticence to bite the bullet and sell the MBS at a huge loss? Part of the answer is “Mark to Market” accounting rules. In the early ‘90s, the government changed accounting rules to force banks to value assets at current traded market rates, rather than projected or modeled values. Without getting into the merit of MtM, suffice it to say that they are difficult to apply accurately to MBSs that are heterogeneous assets. When MBS of all varieties became toxic, brokers and banks were forced by MtM to dramatically downgrade the value of these assets. While holders of the assets valued them around 80% of their face value due to the underlying value of the property, the actual market value was dramatically less. And market sales set the value of under MtM rules. Since many of these securities were being used as collateral and reserves for other investments -- often on margins as high as 60-1, the entire investment banking industry found itself undercapitalized. While credit default swaps – the insurance on bond defaults – should have theoretically come to the rescue, the CDS issuers (like AIG) themselves were insolvent due to the markdown of the ubiquitous MBS in their portfolios. They were using toxic assets to underwrite insurance on other toxic assets.

To cut it short, investment firms found themselves without adequate reserves to cover their margin calls, banks found themselves without adequate capital to loan, and the Fed had to step in as the lender of last resort. Investment banks like Bear Stearns went under. Nearly every company offering any consumer credit suffered huge losses in the MBS market, and due to the increase in non-performing consumer loans. Mortgage lending tightened dramatically, reducing the pool of prospective homebuyers, and further reduced prices. Consumer confidence and spending dropped, and a broad based recession ensued.

As the Titanic took on water, the Bush and Obama administrations struggled to understand the fundamental problem and have pursued policy that has generally been ineffective, and possibly delayed the bottom. It is not clear that the US government can do much to stop the pop of the bubble – the best policy may very well be to let the chips fall where they may. But government is not paid to just stand there: we expect them to do something. There may even be a placebo effect of government action, provided the proposed cure is not worse than the disease. One can only hope.