When we say “investors” we naturally think of Thurston Howell III from “Gilligan’s Island.” Nothing could be further from the truth in contemporary America. Now “investors” means banks, insurance companies, hedge funds, and pension funds. Many of these investors are, in turn, owned by mutual funds. These investors had a lot of money to throw around and they wanted safe investments.[1] The banks addressed this dual problem by creating Collateralized Debt Obligations (CDO). Essentially, a CDO is a super-bond that groups together many smaller loans. So, a CDO is a big financial instrument appropriate for a big investor. At the same time, the CDO addressed the safety problem by bundling the few loans anticipated to default with the many that were expected to not default. These CDOs proved to be wildly popular with investors: $550 billion worth of CDOs were issued in 2006 alone.
For a combination of reasons, the risky, or “sub-prime,” share of mortgages greatly expanded. Rather than trying to rein-in the “sub-prime” risk, lenders relied on safety features of the CDO (many presumably sound mortgages bundled together with a handful of presumably bad mortgages). Furthermore, other companies sold insurance for the derivatives, so they seemed very safe. The market in these “financial derivatives” just exploded. Less noticed, many of the loans were also adjustable rate mortgages (ARMs) which allowed the lender to increase the interest rate charged the borrower if interest rates in general began to rise.
Then, in the second half of the 2000s the whole process went into reverse.[2] The Federal Reserve Bank raised the Federal Funds Rate from 1 percent in Summer 2004 to 5.25 percent in 2006, then left it there until Summer 2007.[3] Interest rates began to rise and housing prices began to drop. The adjustable rate mortgages followed the track of interest rates in general, squeezing many marginal home owners to the point where they could not service the mortgage at all. Defaults suddenly began to mount, leading to foreclosures, leading to a glut of homes on an already falling market, leading to a further decline in the value of all homes.
The trouble here finally appeared in the opacity of the CDOs. Once the defaults started to mount, it proved impossible to tell with any certainty how solid any one CDO was. It might be made up of mostly good loans with a few dogs mixed in. It might be a veritable animal rescue society with a few good loans mixed in. As Peter Peterson put it, “you’ve got ten bottles of water and one of them is poisoned; which one do you drink?” There was no way to tell, so people did the safe thing by distrusting all of them.
As the number of worthless mortgages inside the “bundles” of mortgages bought by investors rose sharply, the value of the securities plunged. Banks that had bought these securities as part of their capital, suddenly found their balance sheets showing huge losses. Worse still, the companies which had sold insurance on the derivatives found that they had misunderstood the degree of risk of default and did not have the resources necessary to cover their own losses. Banks started refusing to lend to other banks out of a fear that the loans would not be repaid. Suddenly, the whole financial system seemed to be on the verge of collapse.
The United States had been through this once before, in the early stages of the Great Depression of the Thirties. Inadequate government action then had led to more than a decade of hardship, misery, and political upheaval. This time would be different. Sort of.
[1] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.
[2] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.
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