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Monday September 22, 2008 - 13:22:54 GMT
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A Brief History of the Financial Crisis

The outlines of the financial and credit crisis are clear though the blame will be argued and discussed far into the future.  Three primary causes played out over the past decade culminating in the tumultuous events of the past two weeks with the American Federal Government on Friday putting forth a plan to buy the housing based bad debt of the entire United States financial system. 

 

In the early part of this decade the Federal Reserve held interest rates at historically low levels for three years. In the mortgage industry increasingly lax credit standards were encouraged by government pressure to lend to marginal customers. Finally Wall Street firms became enamored of the profitability and supposed safety of their securitized credit derivative instruments, not only originating many products but also stocking their balance sheets with them. 

 

In the aftermath of the 9/11 attacks in 2001 the Federal Reserve cut the Fed Funds rate in half, to 1.75%.  The rate would stay below 2.0% for almost three years.  Those low nominal rates, negative in real inflation adjusted terms, stoked a building and buying boom in housing that developed into a huge speculative bubble. 

 

When the Fed brought rates back to 5.25% at the end of June 2006, the bubble began to deflate; the housing based credit crisis began a little more than a year later. Market bubbles always burst. Perhaps the fall of the housing market now seems preordained. But at the time the risk of the dicey mortgages spread throughout the financial system was disguised by the financially engineered instruments that had repackaged the questionable bits with higher quality debt, supposedly insuring the whole against default.

 

Starting in the closing years of the Clinton Administration the Community Redevelopment Act, a Carter Era program, was used to force banks to lend to mortgage customers formerly considered ineligible for loans. In pursuit of a social goal, universal home ownership, banks either lowered credit standards and granted mortgages or faced fines and business penalties for ‘redlining’.  Banks by and large complied with government dictates.

 

Two of the government sponsored enterprises (GSEs) in the mortgage field, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) bought much of the bank mortgage debt and sold it back to the market with their implied government guarantee behind it.  The banks and loan companies used the cash obtained to sponsor more loans and keep the housing bubble inflating.  As with the banks, the GSEs also brought some of this debt onto their balance sheets.  All in all these two GSEs held title to or guaranteed upwards of 70% of residential mortgages in the United States. Their mortgage paper is endemic on the balance sheets of the world’s financial institutions.

 

The nozzle through which much of the air inflating the housing bubble passed was the asset backed collateralized debt obligation (CDO) fashioned by Wall Street’s leading investment houses and banks.  Combining different types and grades of debt in one instrument these complex securities were supposed to reduce risk of the whole below the level of the individual pieces.  Their complexity often rendered them opaque to the rating agencies whose rankings customers buying the securities relied on for risk measurement. Usually sold with default insurance these securities had one major flaw, their balance sheet value was assessed not by the value of the underlying income streams but by their sale price in the secondary market. If there were no market, if no one were willing to buy these securities, the theoretical book value fell to zero.

 

As the housing market stagnated and then fell, the value of those securities with housing components dropped as default rates on mortgages rose. But housing prices in the US have only declined on average about 20%. How could such a large but not catastrophic decline threaten the very foundations of the financial system?  The crux is the mark to market nature of the security. As the financial markets progressively lost faith in asset backed securities and as housing prices continued to fall bids for these securities became scarce.  The lower the prices for the securities the more capital the firm had to set aside to meet regulatory limits.  The firms that owned large amounts of these securities were caught in a downward spiral of devalued securities requiring ever large amounts of the firms capital for support which progressively undermined the worth of the firms stock and market confidence in the firm’s solvency which in turn demanded more capital support.

 

The United States has had market bubbles before, but none shook the financial system to its core and threatened the financial system. What has been different this time? The factor that levered a serious housing market bubble and collapse into a threat to the entire US and indeed world financial system was the asset-backed derivative.  These new and poorly understood instruments were embraced by the financial world for their touted safety and for their high return.  Yet their safety, the quality of their financial analysis and most importantly the underlying assumptions were completely untested.

 

Chief among the assumptions underpinning these derivative securities was the mark to market rule for valuation. Imposed by regulators in the aftermath of the failure of Enron it posits, natural enough in normal times, a functioning secondary market. Its purpose was to insure realistic pricing for securities.  All is fine with the rule unless there is no market.  As with the failure of Long Term Credit, it was the assumption that there will always be a functioning orderly market that was at fault.  Markets are not always rational, they are voluntary and they are psychological. People and firms do not have to participate. When enough market participants choose abstinence the market collapses and all calculations that depend on market pricing are void.

 

Markets are reflections of the faith and credit of their participants.  When that is lost no amount of financial engineering can make up for the loss of liquidity.  In a panic the market vanishes.  The asset backed derivative made the stability of the entire financial system beholden to its least stable component, the psychology of the market.  

 


Joseph Trevisani

Chief Market Analyst

FX Solutions

Joe@fxsol.com



 

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