More to the financial crisis than just subprime

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

Just as the recession in the early 2000s became linked with the bursting of the tech bubble, for many the financial crisis in 2008 has been synonymous with the blow-up of subprime mortgages.

But there was more to 2008 than that.

Gary Gorton, an economist at Yale, recently published an analysis that shows how well some subprime mortgage-backed securities have performed over the past few years – a very counterintuitive conclusion. Citing one of his graduate students, Gorton explains that AAA/Aaa-rated subprime bonds issued in the peak bubble years (when mortgage underwriting was arguably the weakest in history) were only down 0.17 percent as of 2011. In other words, the highly rated subprime bonds – or toxic assets so associated with the financial crisis – have experienced only minimal losses since the bubble popped.

Of course, that bond statistic ignores the numerous costs borne by the federal government in response to the crisis. For example, the mortgage giants Fannie Mae and Freddie Mac required more than a $150 billion bailout, and the Federal Reserve dropped and held interest rates to historical lows, in part so that millions of homeowners could refinance their mortgages (often into new mortgage products that were also backed by taxpayers through another government program). That is, it’s important to acknowledge that subprime mortgage products have done relatively well partly because of post-crisis government interventions that were costly for taxpayers.

Nevertheless, the subprime bonds’ better-than-expected performance can help us think through the broader role of highly rated securities in the financial crisis. In particular, it helps focus our attention away from the assets themselves (as it now appears that some subprime securities held up surprisingly well) and toward how the assets were financed using leverage and risky holding structures.

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Consider the production process for mortgage securities during the crisis. To convert bundles of poorer-quality mortgages into valuable securities, banks made use of waterfall structures in securitization. Any future losses on subprime mortgages would first go to the lower-rated tranches of the securities. The highest-rated tranches – given AAA status – would only lose money in the event of extraordinary mortgage losses, which effectively wiped out the lower-rated tranches. Generally, lower-rated tranches accounted for 20 to 25 percent of the securitization. This meant that if mortgages defaulted and only 50 percent of the value was recovered through foreclosure, then between 40 percent and 50 percent of the mortgages in a pool would have to default for the AAA noteholder to suffer any losses. While defaults and loss severities on subprime loans have been bad, they have not been this extreme in most cases thus far, which is why the highly rated subprime bonds seem to have escaped serious losses so far – declining in value only a small amount, as Gorton suggests.

If the performance of these mortgage pools remains sustainable in the future, then one surprising conclusion post-crisis may be that the securitization waterfall structure will have actually held up surprisingly well. The construction of mortgage-backed securities in most instances will have sufficiently left enough of a buffer in place to protect the highest-rated tranches from serious losses.

Of course, the much bigger problems lay in the quality of that buffer – the lower-rated pieces of subprime mortgage-backed securities. These were generated in many cases almost as a waste by-product of the securitization process. As the housing bubble burst, it was the holders of these assets that suffered massive losses, since they were in the first loss position.

While it was originally difficult to find willing buyers of the lower-rated pieces of subprime mortgage-backed securities, issuers eventually combined and repackaged them into derivative products called collateralized debt obligations. It was these products – including the so-called synthetic variety, which relied on credit default swaps – that proved to be the real problem products. Many of them were held by structured investment vehicles (often sponsored by banks) and constitute one of the reasons financial institutions faced insolvency during the crisis.

Underlying the demand for CDO products was the phenomenon previously discussed. the universal hunger for highly rated financial products. Overwhelming demand for AAA-rated securities induced banks to create new financial instruments that effectively stretched the definitional bounds of what was truly a quality or safe asset. These structured products wound up constituting a large fraction of the losses borne by subprime mortgages.

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The problem with securities during the financial crisis wasnt just how they impacted the asset side of the balance sheet. Rather, the greatest fallout appears to be the result of how these (and other similar) securities were funded through short-term loans on the wholesale market.

Prior to the financial crisis, in the so-called shadow banking system, banks came to use securities – highly rated MBS and asset-backed commercial paper – for the purposes of short-term borrowing and lending. The higher the security was rated, the greater its collateral value, which allowed the bank to secure more funding on better terms.

The onset of the financial crisis led to large-scale downgrades of many of the securities that were used as collateral. Even though a lot of these securities did not end up experiencing large credit losses over time (per Gorton), they did suffer huge declines in market value (at least initially).

Many mortgage securities were used in relationships of overnight lending referred to as repo – between banks and other financial institutions. The downgrading of mortgage-backed securities led to greater margin calls, leading to trading losses and finally some fire-asset sales. In short, these assets could no longer support the loans secured against them; their collateral value fell and, effectively, there was a run on major aspects of the financial system as lenders demanded their money back. The resulting losses – from the collapse of trading arrangements, not of the underlying securities – wound up bankrupting major financial participants like Bear Sterns and Lehman Brothers.

Recent research by Northwestern economist Arvind Krishnamurthy and colleagues has found that similar problems with asset-backed commercial paper were actually far greater in scope. The resulting collapse of credit in other areas of the financial sector, such as money market mutual funds, subsequently fueled the recession.

The lesson is that it wasn’t just the product that was the issue – fragile financing mechanisms were really the key driver in the financial crisis. If financial intermediaries had held their asset positions with less leverage or with longer-duration borrowings, they would have been able to ride out market gyrations. Instead, reliance on debt and short-term holdings forced banks into costly sales and drove widespread insolvency.

The mix of leverage and the shared interdependence on extremely short-term wholesale funding markets (comprising both repos and commercial paper) turned what were initially relatively small losses into tens of trillions in lost output globally.

In many respects, the pre-crisis shadow banking system resembled the pre-Depression-era banking system, which was also prone to fragility and frequent crises. The problem back in the 1930s was partially addressed through the use of deposit insurance, which limited the potential for bank runs (though with the cost of boosting moral hazard).

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Regulators today face two options in dealing with this complex financial system. One option would be to further encourage financial complexity but offer sufficient insurance (along the lines of the FDIC deposit guarantee) to financial institutions. However, this would expose taxpayers to future losses that could rise into the trillions, meaning the guarantee itself might not be sufficient to prevent a crisis to begin with. Additionally, it would further fuel moral hazard.

Another option would be to recognize the systemic fragility and work to combat the underlying sources. The first of these is the widespread reliance on safe assets, which itself is partially a regulator-driven phenomenon. As weve seen, regulators’ preferences for seemingly safe assets incentivizes market participants to create and transform risky assets into new products that can be passed off as safe. Additionally, no asset is truly safe from losses to begin with, and doubling down on that fiction simply raises the stakes when default finally happens.

The second core reform should be to restructure the liability system of systemically important financial institutions. Maturity mismatch, to the extent it happens, should take place in traditionally regulated commercial banking institutions. Firms should be free to pursue real financial innovation, so long as their actions do not result in demands for bailouts or contagious financial losses for others.

A review of this narrative suggests a rather stark picture of the reality of the modern financial system. Rather than the financial crisis being a one-off result of a historically anomalous housing boom, it increasingly appears that the central problem was a financial system so levered and dependent on near-term financing that relatively small losses could spark big problems. Absent reform, look for this pattern to return.