This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.
THE DAY CAME when the house of cards collapsed upon itself. The rapidity of destruction was astonishing:
• First half of 2007. The financial system started to come unglued during the fourth quarter of 2006 as delinquency rates on subprime mortgages rose, leading to a wave of bankruptcies among subprime lenders. On February 8, 2007, HSBC Holdings, the multinational bank headquartered in London, said it would have to add to loan loss reserves to cover bad debts in the subprime lending portfolio. On June 20, a couple of hedge funds at Bear Stearns announced major losses resulting from bad bets on securities backed by subprime loans.
• Second half of 2007. On July 30, German bank IKB announced losses linked to US subprime securities. On October 24, Merrill Lynch reported huge losses in its credit derivatives portfolio. The firm’s CEO, Stanley O’Neal, left at the end of the month. MBIA announced a significant exposure to credit derivatives, which threatened its AAA rating as well as the value of its insurance on many municipal bonds.
• First half of 2008. On March 16, JP Morgan agreed to buy Bear Stearns, with the Fed agreeing to acquire up to $30 billion of Bear’s distressed assets. On March 19, the government lowered capital requirements on Fannie Mae and Freddie Mac to provide liquidity to the mortgage market.
• Second half of 2008. On July 11, the FDIC assumed control of IndyMac, a California bank that had been one of the leading lenders making home loans to borrowers without proof of income. On July 13, the Fed authorized the GSEs to borrow from the discount window for emergency funding. On September 7, Fannie Mae and Freddie Mac were placed in conservatorship, with life support provided by the US Treasury.[1] On Monday, September 15, Bank of America agreed to acquire Merrill Lynch. The very same day, Lehman Brothers filed for bankruptcy due to losses resulting from holding onto large positions in subprime and other lower-rated tranches of securitized mortgages.
On Thursday, September 16, AIG imploded following the failure of its Financial Products unit. This division was overseen by OTS, the thrift regulator, which The New York Times in a May 20, 2009 article called “arguably . . . the weakest of all the federal bank regulators.”[2] Thanks to the Financial Services Modernization Act of 1999, AIG had been allowed to choose OTS as its noninsurance overseer in 1999, the article explained, after buying a small S&L. The FCIC concluded in January 2011 that “AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure.”
On Sunday, September 21, the Fed announced that Goldman Sachs and Morgan Stanley, the last two independent investment banks, would become bank holding companies, subjecting them to new regulation and supervision. The move also signaled that the Fed wouldn’t let them fail, because it gave them access to the Fed’s borrowing window. Why the same courtesy wasn’t extended to Bear Stearns, Merrill Lynch, and Lehman Brothers remains a mystery. (See Appendix 8.3 in my book, Bernanke’s Fed and the Lehman Bankruptcy.)
Here in brief is the credit history of the housing crisis:
• Home prices, owners’ equity, and mortgage debt. On a 12-month average basis, the median existing single-family home price doubled from the fall of 1994 to peak at $224,283 during July 2006. Not surprisingly, this series is highly correlated with the value of real estate held by households—a data series, compiled quarterly in the Fed’s Financial Accounts of the United States, that doubled from the second quarter of 2000 to peak at $22.7 trillion during the second quarter of 2006.
The Fed also tabulates quarterly data on “owners’ equity in household real estate.” That doubled from the second quarter of 2000 to peak at $13.4 trillion during the first quarter of 2006. Over the same period, home mortgage debt also doubled.
Home prices proceeded to drop 27% from July 2006 through February 2012. That doesn’t seem like a big correction given the steep ascent of home prices since the early 1980s. However, mortgage leverage converted that into a 56% drop in owners’ equity from the first quarter of 2006 through the first quarter of 2009. The aggregate value of owners’ equity fell below the amount of mortgage debt outstanding, which was reflected in lots of “underwater” homeowners who owed more than their houses were worth.
• Ratios of owners’ equity to income. The ratio of aggregate home values to disposable personal income soared from 1.4 at the start of 1998 to peak at a record high of 2.3 during the final quarter of 2005. The comparable ratio for owners’ equity in their homes rose from 0.8 to 1.4 over this same period. That was a heady time to own a home. Almost no one seemed to recognize the bubble, inflated by the flood of mortgage credit, for what it was. The ratio of home mortgage debt to disposable income rose from 0.6 at the start of 1998 to a record high of 1.0 during the last half of 2007.
Owners’ equity as a percentage of the value of household real estate was 84% when the data started in 1945. It fell to a range of 60%–70% from the mid-1960s through the mid-2000s. It then fell from 60% during the last quarter of 2005 to a record low of 36% during the first quarter of 2009. The flip side of that story, of course, is that the amount of leverage—i.e., the percentage of mortgage debt on the underlying value of residential real estate—rose to a record high of 64% during the first quarter of 2009.
• Borrowing binge. During the 1990s, the annual pace of home mortgage borrowing was fairly steady around $200 billion. It then went parabolic during the first six years of the 2000s, peaking at $1.3 trillion over the four quarters through the second quarter of 2006. Home equity loans also became a popular way to extract some of the real estate gains on home sweet home. The outstanding amount of such loans soared from $334 billion at the end of 1999 to peak at a record high of $1.1 trillion during the last quarter of 2007.
Mortgage borrowing collapsed during the financial crisis and remained weak for years, with loan repayments exceeding loan extensions from 2010 through 2013 before recovering from 2014 through 2016. Home equity loans dropped back down to $585 billion by mid-2017, the lowest since the third quarter of 2003.
• ABS issuers. In the private sector, the issuers of asset-backed securities (ABS) mimicked the GSEs and created credit derivatives but with mortgages that didn’t conform to the lending standards of the GSEs. From the first quarter of 2000, the debt of ABS issuers soared 391% from $815 billion to a record high of $4.0 trillion during the first quarter of 2008. It then plunged, returning to $1.2 trillion by the end of 2016, while the amount of home mortgages held by the ABS issuers fell from a peak of $2.4 trillion during the second quarter of 2007 to $521 billion by the end of 2016.
• Commercial paper. The commercial paper of ABS issuers turned toxic, peaking at a record $1.2 trillion during the week of August 8, 2007. It sank to $708 billion during the week of October 8, 2008, when the Fed set up an emergency facility to provide liquidity to the commercial paper market.
• Depository institutions. Among FDIC-insured depository institutions, provisions for loan losses soared along with delinquency rates. It didn’t take long for spiraling delinquencies to turn into foreclosures, resulting in net charge-offs for bad loans. Cumulative net charge-offs soared $693 billion from the fourth quarter of 2007 through the fourth quarter of 2012. The Fed’s Financial Accounts of the United States shows that financial institutions were forced to shore up their badly depleted capital by issuing $720 billion in equities from the fourth quarter of 2007 through the fourth quarter of 2009.
The global economy sank into a severe synchronized recession as business activity fell off a cliff everywhere. Global industrial production dropped 12.8% from February 2008 through February 2009. The volume of world exports plunged 20.0% from January 2008 through January 2009. In the United States, real GDP declined by 4.2% from the last quarter of 2007 through mid-2009. It was the deepest recession since the Great Depression. However, it lasted only 18 months. So why has it been dubbed the “Great Recession,” even by Fed officials who had touted the Great Moderation only a few years earlier? The answer is that the recovery was the weakest on record.
Contributing to the weak recovery was housing starts, which plummeted from a high of 2.27 million units during January 2006, at a seasonally adjusted annual rate, to 478,000 units during April 2009, a record low since the start of the data in 1959. By the end of 2016, housing starts had recovered to 1.27 million units, a pace comparable to previous cyclical lows rather than cyclical highs.
This is in line with the history of bubbles: when a bubble in an asset or an industry bursts, it can take a painfully long time for the ensuing recovery in related prices and activity to unfold. That’s because the flood of capital that had poured into the asset or industry dries up while investors, lenders, and speculators lick their wounds.
With the benefit of hindsight, there was plenty of anecdotal evidence showing that mortgage originators had lowered lending standards significantly before the crisis. They were offering loans with all sorts of gimmicks, including no down payments, home equity loans equivalent to the down payment, below-market teaser rates for a year on variable-rate loans, balloon loans that were interest-only for several years before any principal was due, and heavily discounted closing costs. NINJA loans proliferated—i.e., mortgages extended to a borrower with “no income, no job, and no assets.”
Nouriel Roubini, a professor at New York University’s Stern School of Business and chairman of Roubini Global Economics, had been vocally pessimistic since 2005. Roubini was right. The financial press dubbed him “Dr. Doom.” David Rosenberg also correctly predicted the severity of the financial calamity. He was the chief North American economist at Bank of America Merrill Lynch in New York for seven years, prior to joining Gluskin Sheff in the spring of 2009. Ironically, while he was issuing his dire warnings, his firm was one of the leading manufacturers of CDOs.
A handful of investors who did their homework and positioned for the calamity made fortunes, as chronicled by Michael Lewis in The Big Short: Inside the Doomsday Machine (2010). Prior to the crisis, Fed Chairman Ben Bernanke offered a relatively sanguine assessment, which he presented in a May 17, 2007 speech in Chicago titled “The Subprime Mortgage Market.”[3] He certainly must regret coming to the following conclusion:
“The rise in subprime mortgage lending likely boosted home sales somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. Moreover, we are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets. All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.”
Following the financial crisis, the most prominent bears were joined by lots of other tardy doomsayers who warned that financial calamity might soon return. Then years later, US real GDP and the Dow Jones Industrial Average climbed well into record-high territory.
__________
[1] For more on the housing GSEs’ conservatorship, see the Federal Housing Finance Agency’s “FHFA as Conservator of Fannie Mae and Freddie Mac.”
[2] “Regulator Shopping,” editorial in The New York Times, May 20, 2009.
[3] “The Subprime Mortgage Market,” Bernanke’s May 17, 2007 speech.
THE DAY CAME when the house of cards collapsed upon itself. The rapidity of destruction was astonishing:
• First half of 2007. The financial system started to come unglued during the fourth quarter of 2006 as delinquency rates on subprime mortgages rose, leading to a wave of bankruptcies among subprime lenders. On February 8, 2007, HSBC Holdings, the multinational bank headquartered in London, said it would have to add to loan loss reserves to cover bad debts in the subprime lending portfolio. On June 20, a couple of hedge funds at Bear Stearns announced major losses resulting from bad bets on securities backed by subprime loans.
• Second half of 2007. On July 30, German bank IKB announced losses linked to US subprime securities. On October 24, Merrill Lynch reported huge losses in its credit derivatives portfolio. The firm’s CEO, Stanley O’Neal, left at the end of the month. MBIA announced a significant exposure to credit derivatives, which threatened its AAA rating as well as the value of its insurance on many municipal bonds.
• First half of 2008. On March 16, JP Morgan agreed to buy Bear Stearns, with the Fed agreeing to acquire up to $30 billion of Bear’s distressed assets. On March 19, the government lowered capital requirements on Fannie Mae and Freddie Mac to provide liquidity to the mortgage market.
• Second half of 2008. On July 11, the FDIC assumed control of IndyMac, a California bank that had been one of the leading lenders making home loans to borrowers without proof of income. On July 13, the Fed authorized the GSEs to borrow from the discount window for emergency funding. On September 7, Fannie Mae and Freddie Mac were placed in conservatorship, with life support provided by the US Treasury.[1] On Monday, September 15, Bank of America agreed to acquire Merrill Lynch. The very same day, Lehman Brothers filed for bankruptcy due to losses resulting from holding onto large positions in subprime and other lower-rated tranches of securitized mortgages.
On Thursday, September 16, AIG imploded following the failure of its Financial Products unit. This division was overseen by OTS, the thrift regulator, which The New York Times in a May 20, 2009 article called “arguably . . . the weakest of all the federal bank regulators.”[2] Thanks to the Financial Services Modernization Act of 1999, AIG had been allowed to choose OTS as its noninsurance overseer in 1999, the article explained, after buying a small S&L. The FCIC concluded in January 2011 that “AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure.”
On Sunday, September 21, the Fed announced that Goldman Sachs and Morgan Stanley, the last two independent investment banks, would become bank holding companies, subjecting them to new regulation and supervision. The move also signaled that the Fed wouldn’t let them fail, because it gave them access to the Fed’s borrowing window. Why the same courtesy wasn’t extended to Bear Stearns, Merrill Lynch, and Lehman Brothers remains a mystery. (See Appendix 8.3 in my book, Bernanke’s Fed and the Lehman Bankruptcy.)
Here in brief is the credit history of the housing crisis:
• Home prices, owners’ equity, and mortgage debt. On a 12-month average basis, the median existing single-family home price doubled from the fall of 1994 to peak at $224,283 during July 2006. Not surprisingly, this series is highly correlated with the value of real estate held by households—a data series, compiled quarterly in the Fed’s Financial Accounts of the United States, that doubled from the second quarter of 2000 to peak at $22.7 trillion during the second quarter of 2006.
The Fed also tabulates quarterly data on “owners’ equity in household real estate.” That doubled from the second quarter of 2000 to peak at $13.4 trillion during the first quarter of 2006. Over the same period, home mortgage debt also doubled.
Home prices proceeded to drop 27% from July 2006 through February 2012. That doesn’t seem like a big correction given the steep ascent of home prices since the early 1980s. However, mortgage leverage converted that into a 56% drop in owners’ equity from the first quarter of 2006 through the first quarter of 2009. The aggregate value of owners’ equity fell below the amount of mortgage debt outstanding, which was reflected in lots of “underwater” homeowners who owed more than their houses were worth.
• Ratios of owners’ equity to income. The ratio of aggregate home values to disposable personal income soared from 1.4 at the start of 1998 to peak at a record high of 2.3 during the final quarter of 2005. The comparable ratio for owners’ equity in their homes rose from 0.8 to 1.4 over this same period. That was a heady time to own a home. Almost no one seemed to recognize the bubble, inflated by the flood of mortgage credit, for what it was. The ratio of home mortgage debt to disposable income rose from 0.6 at the start of 1998 to a record high of 1.0 during the last half of 2007.
Owners’ equity as a percentage of the value of household real estate was 84% when the data started in 1945. It fell to a range of 60%–70% from the mid-1960s through the mid-2000s. It then fell from 60% during the last quarter of 2005 to a record low of 36% during the first quarter of 2009. The flip side of that story, of course, is that the amount of leverage—i.e., the percentage of mortgage debt on the underlying value of residential real estate—rose to a record high of 64% during the first quarter of 2009.
• Borrowing binge. During the 1990s, the annual pace of home mortgage borrowing was fairly steady around $200 billion. It then went parabolic during the first six years of the 2000s, peaking at $1.3 trillion over the four quarters through the second quarter of 2006. Home equity loans also became a popular way to extract some of the real estate gains on home sweet home. The outstanding amount of such loans soared from $334 billion at the end of 1999 to peak at a record high of $1.1 trillion during the last quarter of 2007.
Mortgage borrowing collapsed during the financial crisis and remained weak for years, with loan repayments exceeding loan extensions from 2010 through 2013 before recovering from 2014 through 2016. Home equity loans dropped back down to $585 billion by mid-2017, the lowest since the third quarter of 2003.
• ABS issuers. In the private sector, the issuers of asset-backed securities (ABS) mimicked the GSEs and created credit derivatives but with mortgages that didn’t conform to the lending standards of the GSEs. From the first quarter of 2000, the debt of ABS issuers soared 391% from $815 billion to a record high of $4.0 trillion during the first quarter of 2008. It then plunged, returning to $1.2 trillion by the end of 2016, while the amount of home mortgages held by the ABS issuers fell from a peak of $2.4 trillion during the second quarter of 2007 to $521 billion by the end of 2016.
• Commercial paper. The commercial paper of ABS issuers turned toxic, peaking at a record $1.2 trillion during the week of August 8, 2007. It sank to $708 billion during the week of October 8, 2008, when the Fed set up an emergency facility to provide liquidity to the commercial paper market.
• Depository institutions. Among FDIC-insured depository institutions, provisions for loan losses soared along with delinquency rates. It didn’t take long for spiraling delinquencies to turn into foreclosures, resulting in net charge-offs for bad loans. Cumulative net charge-offs soared $693 billion from the fourth quarter of 2007 through the fourth quarter of 2012. The Fed’s Financial Accounts of the United States shows that financial institutions were forced to shore up their badly depleted capital by issuing $720 billion in equities from the fourth quarter of 2007 through the fourth quarter of 2009.
The global economy sank into a severe synchronized recession as business activity fell off a cliff everywhere. Global industrial production dropped 12.8% from February 2008 through February 2009. The volume of world exports plunged 20.0% from January 2008 through January 2009. In the United States, real GDP declined by 4.2% from the last quarter of 2007 through mid-2009. It was the deepest recession since the Great Depression. However, it lasted only 18 months. So why has it been dubbed the “Great Recession,” even by Fed officials who had touted the Great Moderation only a few years earlier? The answer is that the recovery was the weakest on record.
Contributing to the weak recovery was housing starts, which plummeted from a high of 2.27 million units during January 2006, at a seasonally adjusted annual rate, to 478,000 units during April 2009, a record low since the start of the data in 1959. By the end of 2016, housing starts had recovered to 1.27 million units, a pace comparable to previous cyclical lows rather than cyclical highs.
This is in line with the history of bubbles: when a bubble in an asset or an industry bursts, it can take a painfully long time for the ensuing recovery in related prices and activity to unfold. That’s because the flood of capital that had poured into the asset or industry dries up while investors, lenders, and speculators lick their wounds.
With the benefit of hindsight, there was plenty of anecdotal evidence showing that mortgage originators had lowered lending standards significantly before the crisis. They were offering loans with all sorts of gimmicks, including no down payments, home equity loans equivalent to the down payment, below-market teaser rates for a year on variable-rate loans, balloon loans that were interest-only for several years before any principal was due, and heavily discounted closing costs. NINJA loans proliferated—i.e., mortgages extended to a borrower with “no income, no job, and no assets.”
Nouriel Roubini, a professor at New York University’s Stern School of Business and chairman of Roubini Global Economics, had been vocally pessimistic since 2005. Roubini was right. The financial press dubbed him “Dr. Doom.” David Rosenberg also correctly predicted the severity of the financial calamity. He was the chief North American economist at Bank of America Merrill Lynch in New York for seven years, prior to joining Gluskin Sheff in the spring of 2009. Ironically, while he was issuing his dire warnings, his firm was one of the leading manufacturers of CDOs.
A handful of investors who did their homework and positioned for the calamity made fortunes, as chronicled by Michael Lewis in The Big Short: Inside the Doomsday Machine (2010). Prior to the crisis, Fed Chairman Ben Bernanke offered a relatively sanguine assessment, which he presented in a May 17, 2007 speech in Chicago titled “The Subprime Mortgage Market.”[3] He certainly must regret coming to the following conclusion:
“The rise in subprime mortgage lending likely boosted home sales somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. Moreover, we are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets. All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.”
Following the financial crisis, the most prominent bears were joined by lots of other tardy doomsayers who warned that financial calamity might soon return. Then years later, US real GDP and the Dow Jones Industrial Average climbed well into record-high territory.
__________
[1] For more on the housing GSEs’ conservatorship, see the Federal Housing Finance Agency’s “FHFA as Conservator of Fannie Mae and Freddie Mac.”
[2] “Regulator Shopping,” editorial in The New York Times, May 20, 2009.
[3] “The Subprime Mortgage Market,” Bernanke’s May 17, 2007 speech.
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