CLOSING CASE: SUBPRIME MELTDOWN, GLOBAL RECESSION
The recession of 2008–2009 was truly global: World GDP fell from $60.6 trillion in 2008 to $58.2 trillion in 2009, while world merchandise trade plummeted from $16.2 trillion to $12.5 trillion. Unemployment in the United States reached 10.4 percent; the United Kingdom, 8.0 percent; Ireland, 14.8 percent; France, 10.0 percent; and Spain, 20.7 percent. Few countries escaped this economic tsunami: Every EU member save Poland suffered a contraction in its GDP, as did Brazil, Canada, Japan, the United States, and numerous other countries. Among the few countries to be spared were China, India, and South Korea, which nonetheless suffered decreases in their GDP growth rates.
One key cause of the global recession was the globalization of financial markets that allowed bursting real estate bubbles in numerous countries—including Australia, Ireland, Italy, Spain, the United Kingdom, and the United States—to spew their damage well beyond their national borders. Much of the blame can be laid at the feet of the United States, where housing prices boomed as a result of the cheap credit policies of the Federal Reserve Bank, declining lending standards, and regulatory inattention. When the
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American housing bubble finally burst, the ensuing “subprime meltdown” traumatized the global financial services industry, damaging banks, brokerage houses, hedge funds, mortgage brokers, and municipal bond issuers throughout the world.
Over the past 10 years, some $2 trillion worth of securities backed by American home mortgages were sold globally by highly paid investment bankers to customers worldwide. Pension funds and hedge funds around the world were eager to get their piece of the action, secure in the belief that American housing prices would continue to rise and that homeowners would continue to make their house payments. Unfortunately, those beliefs proved to be inaccurate, and the global nature of the capital market ensured that the pain created by the meltdown in the American housing market would cascade throughout the world.
The problem began with the low interest rate policy that the Federal Reserve System adopted in 2001 to combat a developing recession. These low interest rates made it cheaper to purchase homes, and many Americans took advantage of this opportunity. Other homeowners, lured by a barrage of TV advertising, chose to refinance their homes, many taking advantage of rising home prices to extract equity from their homes. In hot markets like Southern California and southern Florida, newspaper articles abounded about real estate speculators who would put a small deposit on a condo unit during the preconstruction phase of a new development and make a quick profit by selling their unit to a new buyer when the condo project was completed. TV shows like Flip This House provided step-by-step instructions for their viewers to get their share of the action.
In this frenzied market—where housing prices were rising and were a “sure thing” to continue to rise—many mortgage lenders relaxed their traditional 20 percent down payment requirement and began to offer no down payment, interest-only, adjustable rate mortgages. These so-called subprime mortgages began to become increasingly common. Of course, the easy lending standards of the subprime market boosted demand for homes, further raising prices. This boom-time mentality encouraged developers to build more inventory; by the third quarter of 2007 there were a record 2.1 million housing units available for sale.
The flow of money into home mortgages was facilitated by innovative investment bankers in money markets like New York and London. Banks pooled the mortgages of thousands of homeowners and packaged them into new financial instruments called collateralized debt obligations (CDOs). A bank might pool a thousand mortgages, for example, worth a total of $300 million, into a CDO. The cash flow rights from these CDOs would be subdivided into different pieces, or tranches. Each tranche would carry a different risk-reward profile. The most senior tranche would enjoy the right to the first cash flows generated by the underlying mortgages. This tranche would be relatively risk free, so it would offer a relatively low rate of return. Conversely, the most junior tranche of the CDO would enjoy the highest rates of return, but would also be highly risky, for it would be the first to be affected if any of the mortgagees defaulted. Nonetheless, the creation of the tranches allowed investors to choose the risk-reward trade-off that best met their needs and preferences.
The growth of the subprime CDO market, which ultimately reached $400 billion, was stimulated by another financial innovation, specialized investment vehicles (SIVs), which were created by investment bankers and hedge funds to invest in CDOs. The banks and hedge funds collected lucrative fees to create, market, and operate the SIVs on the behalf of the investors to whom they were sold. And SIVs had a particular advantage to banks: Because the banks were not owners of the SIVs, the SIVs were not on the banks’ balance sheets. Citigroup, for example, created seven separate SIVs, with combined assets of $80 billion, specializing in subprime CDOs. Of course, foreign banks were eager to crash the lucrative subprime SIV market. Switzerland’s UBS invested more than $40 billion in SIVs, CDOs, and other subprime holdings. SIVs were also created by the Bank of Montreal, Germany’s Dresdner Kleinwort, the Netherlands’ Rabobank, and HSBC and Standard Chartered of the United Kingdom. One German state-owned bank, Sachsen LB, established an office in Dublin, Ireland, to trade and market CDOs, while the Bank of China purchased $9.7 billion of CDOs backed by U.S. subprime mortgages. Even smaller banks got involved, such as IKB Deutsche Industriebank, whose primary business was lending money to small German companies. In 2002, it established a subsidiary, Rhineland Funding Capital Corporation, to invest in high yielding bonds. Most of Rhineland’s investments were in CDOs backed by American subprime mortgages.
Unfortunately, Rhineland and other purveyors of SIVs fell into the classic trap of borrowing short and lending long. Most SIVs were financed by issuing commercial paper, a form of short-term financing that typically carries low interest rates. They then invested in high-yielding CDOs backed by subprime mortgages. In normal times, the SIVs benefited from the spread between the two interest rates. But a perfect storm soon hit the U.S. mortgage market. The Federal Reserve Bank began to worry more about inflation than recession. In June 2004, it raised the federal funds rate, then 1.00 percent, a quarter of a point. This modest increase was a harbinger of future rate hikes. In the ensuing two years, the Federal Reserve Bank increased the federal funds rate 16 times, reaching a peak of 5.25 percent in June 2006. As the federal funds rate rose, so too did other short-term interest rates, raising the borrowing costs of many SIVs. These higher short-term interest rates also elevated the borrowing costs of homeowners who had utilized an adjustable rate mortgage to finance their home purchases. Higher borrowing costs caused housing prices to begin to fall in many markets—particularly ones that had enjoyed the greatest increases in prices, such as in Florida or Southern California—leaving some borrowers who put little or no money down for the homes in the unhappy position of owing more on their mortgage loan than their home was worth. Homeowners increasingly choose to—or were forced to—default on their mortgages. A vicious cycle developed: As defaults increased, the inventory of unsold housing rose, which intensified the downward pressure on housing prices, which then caused more homeowners to default.
Rising default rates triggered a decline in the value of CDOs backed by subprime loans. Soon SIVs found it more difficult and more expensive—sometimes even impossible—to issue new commercial paper to replace their short-term loans as they matured. Unable to secure short-term financing, the SIVs were forced to dump their CDOs on the market at distressed prices.
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The result was a flood of red ink, massive loan write-offs, and concerns that the world economy might plunge into recession. UBS alone lost $37 billion on loans associated with CDOs and SIVs backed by subprime mortgages. To restore its shattered balance sheet, it sold a 12.4 percent share of the company to the Singapore Investment Corporation, a sovereign wealth fund, and an unidentified investor from the Middle East for $11.5 billion. Morgan Stanley wrote off $13.1 billion of bad subprime loans. It too was forced to restore its balance sheet by selling a 10 percent ownership share of the firm to the China Investment Corporation for $5 billion. Citigroup’s potential exposure was over $21 billion, forcing it to seek new capital as well—$7.5 billion from the Abu Dhabi Investment Authority, in return for a 4.9 percent ownership share. And the list of losses goes on: Merrill Lynch, $25.1 billion; HSBC, $7.5 billion; IKB Deutsche Industriebank, €3.5 billion; Deutsche Bank, $7.4 billion; Société Général, $4.8 billion; Royal Bank of Scotland, $6.0 billion; Barclays, $4.5 billion; Swiss Reinsurance, $875 million—a Who’s Who of the international financial world. And a host of smaller investors, such as the city governments of Manley, Australia, and Narvik, Norway, got clobbered as well. Manley’s losses were relatively mild, for its council had invested only A$3 million in CDOs. But Narvik invested $44 million in CDOs and related products—an amount equal to a quarter of the town’s annual budget. Its employees went without paychecks in the weeks before Christmas as a result.
The worst was yet to come. In September 2008, new crises erupted. The U.S. government effectively took over control of the Federal National Mortgage Association (often referred to as Fannie Mae) and the Federal Home Loan Mortgage Corporation (known as Freddie Mac), two huge players in the U.S. mortgage market, and granted a $85 billion bridge loan to American International Group, an insurance conglomerate. The venerable investment house Lehman Brothers slipped into bankruptcy; to avoid a similar fate, Merrill Lynch arranged to sell itself to Bank of America.
Unfortunately, the United States was not the only country to suffer from a real estate bubble. The construction and housing markets in Ireland and Spain, for example, boomed as a result of the low-interest rate policies of the European Central Bank, which were designed to stimulate the then stagnating economies of the majority of the eurozone members. Other EU members, including France, Italy, and the United Kingdom, also experienced housing bubbles, as did dozens of other countries in Asia, Europe, and Latin America. As their bubbles burst, governments were forced to bail out their crippled financial services industries. The United Kingdom’s bank bailout bore a price tag of more than £500 billion. Ireland was forced to nationalize or recapitalize the country’s three largest banks, as did Iceland.
1. The case refers to the “classic trap of borrowing short and lending long.” Explain what this means. What are the advantages of borrowing short and lending long? What are the disadvantages?
2. Why did the sovereign wealth funds of Singapore, Abu Dhabi, and China choose to invest in UBS, Citigroup, and Morgan Stanley at a time when they were performing so poorly? Do these investments create any public policy issues? If so, what are they?
3. What happens to an economy when a housing bubble bursts?
4. The change in mortgage lending standards in the United States created a global financial crisis. Do you think an international financial regulatory agency should be created to reduce the likelihood that such crises will arise in the future? Why or why not?
Sources: “Bank bail-out adds £1.5 trillion to debt,” The Telegraph, January 16, 2011 (online); “Mounting fears pummel world markets as banking giants rush to find buyers,” Wall Street Journal, September 18, 2008, p. A1; “Stocks surge as 2 major banks advance turnaround plans,” Wall Street Journal, April 2, 2008, p. A1; “S&P lowers rating on Alabama County,” Wall Street Journal, April 1, 2008 (online); “Crunch, from Alabama to stocks,” Wall Street Journal, March 7, 2008, p. C1; “France presses bank to dump besieged chief over trading,” Wall Street Journal, January 30, 2008, p. A1; “UBS takes a $14 billion write-off,” New York Times, January 30, 2008 (online); “Credit scare spreads in U.S., abroad,” Wall Street Journal, January 22, 2008, p. A1; “Loss pressures Morgan Stanley CEO,” Wall Street Journal, December 20, 2007, p. A1; “$9.4 billion write-down at Morgan Stanley,” New York Times, December 20, 2007 (online); “U.S. mortgage crisis rivals S&L meltdown,” Wall Street Journal, December 10, 2007, p. A1; “Societe General to bail out SIV,” New York Times, December 10, 2007 (online); “U.S. credit crisis adds to gloom in Arctic Norway,” New York Times, December 2, 2007 (online); “Abu Dhabi to bolster Citigroup with $7.5 billion capital infusion,” Wall Street Journal, November 27, 2007, p. A3; “$75 billion fund is seen as stopgap,” New York Times, November 1, 2007 (online); “How London created a snarl in global markets,” Wall Street Journal, October 18, 2007, p. A1; “How subprime mess ensnared German bank; IKB gets a bailout,” Wall Street Journal, August 10, 2007, p. A1.
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