The Bank Bailout, Subprime Mortgages, Bank Failures, and Financial Crisis
At the foundation of the financial crisis of 2008, with its bank failures and bank bailouts, are many things gone wrong. The financial crisis was a result of subprime mortgage foreclosures, bank failures and risk gone wrong. When this house of cards collapsed, banks in danger of failure were bailed out because they were too big to fail. In summary, the financial crisis was created on Wall Street, but it affected everyone.
Lenders offered subprime mortgages that exploited borrowers.
- New risky financial instruments based on mortgages were designed like a house of cards.
- They became worthless as subprime home mortgages were in default.
- Bank and hedge funds invested in subprime mortgage securities.
- Their investments were over-leveraged with borrowed money.
- Banks failed after they took unusual risks and conducted offshore, off-balance-sheet activities.
- Wall Street turned a blind eye to risks, assuming that the future would be just like the present.
- Government banking regulations grew lax.
- The real scandal of the financial crisis that triggered bank failures, the subprime mortgage crisis and bank bailouts is that the hedge funds were able to borrow hundreds of billions of dollars from banks.
- Banks, and bank regulators had no idea how much hedge funds had borrowed or what they were doing with it.
- Banks too big to fail were bailed out with government intervention.
- The scandal of the financial crisis of 2008 is that banks jeopardized the international monetary system with unregulated risk taking.
- We will be paying a long time for the financial crisis, the bank bailout and subprime mortgage crisis of 2008.
The New Financial World of Subprime Mortgages
The financial crisis has its roots in the mortgage markets. Traditionally, when you applied for a mortgage, your bank handled all stages of the transaction. The bank checked your credit, lent you money to buy a house, held the mortgage in its vault, collected your monthly payments and foreclosed on any bad loans. In the 1990s, things changed. A different specialist handled each stage of the mortgage. Mortgage brokers drummed up applicants for mortgages. Mortgage banks lent the money and held the mortgage note. They quickly resold these mortgage notes to investment banks. Mortgage servicing companies collected your monthly payment, and remitted the money to the owner of your mortgage.
Creative Finance with Mortgages
Meanwhile, investment banks put the mortgages into a trust, sorted the mortgages by risk and designed a new financial instrument, called a CMO, collateralized mortgage obligation. Basically CMOs were fancy debt instruments, IOUs with a fixed rate of return, based on bundles of home mortgages. The CMOs were supposed to work just like corporate bonds. Some CMOs, the toxic ones, were based on high risk mortgages, and some CMOs were based on high-quality, lower-interest mortgages. CMOs were rated for quality just like corporate bonds. Everyone in the financial world wanted to own them.
The CMO market collapsed in 1994 because the bundling structure wasn’t financially sound. So Wall Street created another financial instrument called RMBS, residential mortgage-backed securities, bundles of mortgages with more conservative payouts to investors. Some RMBS were created as high-risk, high-return. Some were created as low-risk, low return. They negotiated with rating agencies to get good ratings for these bonds. Because these securities had good ratings, pension funds, mutual funds, life insurance companies, banks and corporations bought them.
The Federal Reserve kept interest rates down so that money was cheap for banks. Cheap money encouraged more borrowing and higher home prices. What happened in this decade was an asset bubble. The prices of assets like houses rose. Buyers assumed that home prices would continue to rise indefinitely. Homeowners could get a second mortgage on their homes, because they were worth more. Homebuilding also soared.
roots of the Financial Crisis ~ Subprime Mortgage Crisis
In many financial centers, lending practices quickly became predatory. Caution was thrown to the wind. Telemarketers in boiler rooms at mortgage brokers cold-called homeowners to drum up more mortgage business. Subprime mortgage loans with higher rates and higher fees were made to people who had no means to repay them. Often no one made credit checks or confirmed the income of the borrowers. Sometimes borrowers were encouraged to overstate their income on the mortgage application.
Instead of conservative fixed-rate mortgages, adjustable rate mortgages called ARMs were offered to the unsuspecting homebuyer. Interest-only mortgages were offered. With a new scheme, negative-amortization loans, the homeowner’s monthly payments did not cover even the interest on the loan. The unpaid portion of the interest was added to the outstanding balance of the loan. Homebuyers who could have qualified for a low interest rate were sold loans with a higher-interest rate. Speculators got easy mortgage money and started flipping homes. These mortgage scams were encouraged by big national lenders, who knew what was going on.
When you create a financial instrument like a RMBS, you estimate the rate of mortgage defaults. But there were more subprime mortgages in the bundles than anyone realized. When mortgage interest rates were reset and payments escalated, owners had to walk away from their homes. As home values fell, and a home was worth less than the mortgage on it, more owners walked away. Their mortgages were in default and were foreclosed. The housing market was flooded with unsold homes, and home values declined more.
Foundation for the Bank Failure
Subprime mortgages are about 15 to 20% of all outstanding mortgages. By themselves, defaults on subprime mortgages could not rock the world’s entire financial system.
CDOs, or collateralized debt obligations, is the general name for all the various types of financial “bundles” of debt, called securitized assets. The finance industry created numerous CDO products to resell to investors. They bundled and sliced corporate bonds to create collateralized bond obligations, CBOs, which they sold. Bank loans were bundled into CLOs, collateralized loan obligations, and resold. Companies that owed a lot of debt were especially eager to convert it and sell it as CDOs.
But the bank crisis doesn’t stop with CDOs. Financial engineers were just hitting their stride. They created a new instrument, called the credit default swap. When Bank A feels its loan portfolio is too risky, it can use a credit default swap to buy insurance for its loan portfolio. Bank B in another part of the world will guarantee against losses on the portfolio of Bank A, for a fee. So we have banks legally obligating themselves to help bail out other banks around the world. The banks felt that the credit default swap would diversify their geographical risk. But it didn’t stop there. The Credit Default Swaps were bundled up and remarketed as a kind of bond.
And it doesn’t stop there. New synthetic bonds, without any underlying assets, were designed to perform just like CDOs. You could create as many synthetic CDOs as the market would bear, without regard to how much debt and mortgages existed in the real world.
Defaults were low on all types of loans during the brief period of Greenspan easy money, 2003-2006. So CDO bonds received high ratings from the rating services. And it was easy to sell these instruments. Buyers often did not understand the underlying risk of the instruments they bought, but they relied on the bond rating. Hedge funds, investment banks and banks invested in CDOs with borrowed money. The fat cats of Wall Street purred, while the financial crisis loomed.
Mortgage Collapse Shakes the Banks
Highly-leveraged hedge funds were the weakest chain in the link. Hedge funds are unregulated investment groups that invest money for institutions and wealthy individuals with the promise of exceptional earnings. Hedge funds often borrowed money to buy those CDOs with the highest risk and highest return. As the market value of the CDOs fell, brokers requested more collateral from the hedge funds. And this is how some hedge funds were forced into bankruptcy.
The Mortgage Crisis Grows Into the Financial Crisis
Suddenly the financial crisis loomed. It became apparent that the emperor had no clothes. As the default rate on subprime mortgages grew, the market for CDOs dried up. There simply were no more buyers. Banks, hedge funds and investment banks were holding these CDO investments that could not be sold at any price. Banks were required to show the loss on their income statements. Some banks did not have enough capital to continue operating.
But the financial crisis doesn’t stop there. All the major banks also own limited partnerships called SIV, Structured Investment Vehicles, often set up offshore on the Cayman Islands. Bank SIVs apparently hold a lot of risky CDOs that don’t appear on the bank financial statements. It is said that Citigroup lent its own SIV partnerships three times as much money as it lent to new borrowers around the world. Banks borrowed, by using short-term commercial paper, to pay for these CDO investments. When the subprime meltdown became public knowledge, the interest rate on commercial paper jumped, making it more costly for banks to finance their rollover SIV debt. It also became more expensive to make legitimate business loans. It is expected that most bank SIV partnerships are bankrupt and will be liquidated.
Consequently, credit markets were frozen. No one knew which banks were on shaky ground. Lenders did not trust each other. Stock markets around the world went into a tailspin. Fears of a global recession took hold. Because of the capital crunch some banks had to merge. We saw the demise of investment banking as a business model. The federal government stepped in to ameliorate the financial crisis.
How to Recover from the Financial Crisis
The federal plan to solve the financial crisis and the bank and mortgage crisis involved a major bailout, or rescue.
- As part of the federal bailout, the government plans to purchase toxic CDO and subprime mortgage debt from banks.
- Strong banks were enlisted to take over failing banks.
- The FDIC, Federal Deposit Insurance Corporation, raised its guarantee on bank deposits from $100,000 to $250,000 to calm worried depositors.
- The government plans to encourage lenders to lower the interest rates on outstanding mortgages, so that homeowners can avoid foreclosure.
- The government also plans a large infusion of capital into the individual banks in exchange for partial national ownership of the banks.
- The government proposes to guarantee inter-bank loans.
- The Federal Reserve is lowering interest rates, so that banks will resume lending to businesses.
- Finally, bank CEOs who undermined the system with bad decisions have been dismissed. Sometimes, CEOs were stripped of their golden parachutes and exorbitant retirement packages.
- The world leaders met in a show of strength and international cooperation and simultaneously announced plans to strengthen banks.
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