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 â€˜redliningâ€™.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 worldâ€™s financial
The nozzle through which much of the air inflating the
housing bubble passed was the asset backed collateralized debt obligation (CDO)
fashioned by Wall Streetâ€™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 firmâ€™s solvency which in turn demanded more capital
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
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.
Chief Market Analyst
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Tue 17 July 2018 AA 08:30 GB- Employment A 13:15 US- Industrial Production AA 14:00 US-Powell Testimony Wed 18 July 2018 AA 08:30 GB- CPI A 12:30 US- Housing Starts/Permits AA 14:00 US-Powell Testimony Thu 19 July 2018 AA 1:30 AU- Employment AA 08:30 GB- Retail Sales A 14:30 US- EIA Crude A 12:30 US- Weekly Jobless Fri 20 Jun 2018 A 12:30 CA- CPI/Retail Sales
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