Local postmortem on the financial crisis

Monthly sat down with local finance minds to discuss the core causes, impacts and aftermath of the recent financial crisis. Here’s what we learned. 

• $13 trillion evaporation of subprime market 
• $13.5 trillion total U.S. government bailout
• Wall Street lost $7 trillion (48 percent) of value in 2008
• U.S. housing prices dropped $7.5 trillion (40-50 percent)
• U.S. unemployment rate reached 12 percent (20 million)
• Global unemployment rate reached 25 percent
• $23 trillion in global wealth lost

It took a $23 trillion financial crisis for the world to understand just how interconnected the global financial system is.

Narcissism, greed and ignorance are a few of the fatal factors that led to the crisis and ensuing economic fallout.

The housing bubble — increasingly lax lending standards, growth of overleveraged subprime mortgages and easy money for the bankers writing the loans — played a role. 

Core catalysts include the sharp rise of unregulated “shadow banks” from fly-by-night mortgage brokers to powerful investment firms like Lehman Brothers who lent vast amounts of money to non-creditworthy borrowers.

Because they do not take deposits, shadow banks are subject to fewer regulatory safeguards and can increase return on investments by leveraging up much more debt in comparison to traditional bankers.
Under pressure to compete with their unregulated rivals during the housing bubble, banks such as Bank of America and Citibank began offering subprime mortgages with low upfront costs but skyrocketing rates.    

Bankers started bundling subprime mortgages and creditworthy loans into mortgage-backed securities and then sold them to thousands of investors and institutions around the world, spreading the risks of default throughout the global financial system.

“Low-quality securities backed by subprime mortgages were the No. 1 U.S. export between1990 and 2008,” noted retired professor of finance William MacPhee, the author of “Structured to Fail: Implosion of the Global Economy.” “It’s important to realize that mortgages are a commodity, just like soybeans. When subprime tanked, so did all mortgages.”

With mortgage-back securities, lenders no longer assume the risk of a loan default. They issue the loan and sell it to others who ultimately take the risk if payments stop.

To produce more mortgages and more securities during the boom, bankers loosed loan qualification guidelines. Some brokers earned kickbacks for guiding borrowers to loans with higher interest rates but lower up-front costs.

“Another key driver was Wall Street. Major money-center banks like Bank of America are traded on the New York Stock Exchange. The new fees collected from selling mortgage-back securities with subprime mortgages increased bank income without increasing assets, making their balance sheets more attractive to investors,” said MacPhee. 

The complex securities could not have been sold without ratings by the "Big Three" financial credit rating agencies: Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. This year, Standard & Poor’s agreed to pay almost $1.4 billion to settle allegations that it inflated ratings on the mortgage-backed securities.

In the end, the mortgage-bond business inflated Wall Street. Ordinary investors bet their life savings on the little-understood securities. Investment firms placed even bigger bets on them. Hedge-fund managers were more than willing to swallow the risk in exchange for the promise of fat returns.

Meanwhile a new crop of amateur investors grew using low down payments and subprime credit to flip real estate — they’d purchase multiple properties then resell them at higher prices. The speculative practice contributed to inflated home prices and record foreclosures, according to the Federal Reserve.

“Classic supply and demand,” said Jim MacLeod, president and COO of Coastal States Bank. “As the housing bubble grew and appreciation rates started going up and up, more and more people entered the market. Supply and demand continued to push prices up.”

The subprime mortgage market exploded from 5 percent of all mortgages in 1994 to half of all mortgages by 2007. And the government did little to stem the tide.

A type of mortgage made out to borrowers with lower credit ratings and a larger risk of loan default. Lending institutions often charge higher interest rates on subprime mortgages. Many subprime loans ultimately defaulted, contributing to the financial crisis.

Boom Gone Bust

Large numbers of early subprime defaults helped catalyze the financial crisis. Securitization of subprime mortgages all but dried up by 2007.

Before the mania, most financial institutions exercised caution when lending to riskier applicants. 

“In the old days, there was a way for a borrower with financial problems to get a loan. It required a 35 percent down payment and 4 percent higher interest rate up front,” said MacLeod. “In 2004, a smart 35-year-old kid at Lehman Brothers told me that I could be very comfortable insuring a pool of their mortgage-backed securities because ‘real estate prices never go down.’ He said we could risk not asking what the borrowers made, not even asking if they, in fact, had a job … I said, ‘You’re nuts!’ ”

When subprime borrowers started missing payments, the mortgage market stalled. Credit dried up. Housing prices dropped. Bond prices collapsed. Investment banks, overexposed to the toxic assets, closed their doors. Investors lost fortunes.

“Any time you employ leverage to acquire assets, you’re going to drive up prices for those assets. Ultimately, that leverage has another side to it,” said MacLeod. “Overleverage creates asset bubbles; asset bubbles eventually bust.”  

What role did the government play?

Low interest rates helped promote an unsustainable credit and housing boom. And regulators could have done more. Outright mortgage fraud flourished in an environment of lax lending standards and regulation. Some argue that the government’s push for affordable housing set the stage for irresponsible practices. 

“The Clinton administration said, ‘We want to increase the home ownership rate to over 70 percent as a social policy.’ Their rationale? Homeowners are able to accumulate greater wealth than non-homeowners. They also wanted to overcome the racial disparity that exists in homeownership. So, working with Congress, working with Fannie Mae and Freddie Mac, they put together a program designed to increase the rate of homeownership in the country.”

A debate over the extent of the government’s blame flourishes.

“The banking industry tends to distract attention from itself from subprime by blaming Freddie Mac, Fannie Mae, and government housing reforms,” said MacPhee. “But there is little empirical evidence — including discussions with the U.S. Treasury, the Federal Reserve and the Government Accounting Office, plus review of congressional investigations — that support these charges.”

Private lending institutions and firms issued about 85 percent of subprime mortgages in 2006, according to Federal Reserve data. And delinquency rates for loans purchased or securitized by Fannie and Freddie were dramatically lower than for mortgages securitized by Wall Street. 

“It was all incentive and no effective regulation. But in terms of who is to blame for the financial crisis, I’d say 10 percent the industry, 30 percent the government, and then 60 percent Wall Street,” estimated Bill Snider, a retired domestic and international banking executive.

Irresponsible consumer behavior drove the crisis, too.

“People took out home equity loans like crazy to sustain their level of consumption, buy a vacation home or another car,” said Snider. “A narcissistic societal trend of thinking about the ‘here and now’ versus the long-term encouraged risky behaviors.”

After reaching the highest average debt-to-income ratio since 1929, families have been “deleveraging” ever since.

Economic Fallout 

Between 2007 and 2009, the typical American household lost a fifth of its wealth. The GDP shrank at a level indicating the worst slump since the Great Depression.

“Statistically, I believe we experienced a depression, and I’m not alone on that,” said MacPhee. “A number of economists like Paul Krugman believe the same. The difference between a recession and depression is severity. If you just look at the impact of subprime — $23 trillion worldwide — the impact of the crisis far exceeds the Great Depression, which was  $4 trillion, adjusted for inflation.”

Unemployment in America rose to 10 percent to 12 percent in 2009. In some South Carolina counties, it rose over 20 percent.  

“Locally, we had a depression,” said MacLeod. “There’s no question that we had a depression. The values of local real estate, whether commercial or residential, dropped 50 percent to 60 percent. Vacant land sales dropped 90 percent, and in some cases, went from an excess of half-a-million dollars to negative.”

Hilton Head got the double-whammy: real estate and tourism declined. Tourism generates about $1 billion annually.

“But it also creates employment, sales, and taxes — another half a billion dollars in local revenue,” said MacPhee. “When looking at the town’s tourism revenue and the annual rate of change, tourism begins to show a recession early on and lags behind the nation’s recovery. While we see a dip in 2007 of -1 percent in Hilton Head tourism, the real hit occurs in 2009 (-7 percent) and 2010 (-6 percent) with a total decline of 13 percent.”

Local tourism has risen sharply in recent years. Still, real estate prices haven’t recovered from pre-crisis values.

“They’re down 20 percent,” said MacLeod.

Are We Still at Risk?

Since the financial crisis, about 80 percent to 90 percent of mortgages have had some form of taxpayer guarantee. Banks generate mortgages, but they still turn around and sell most of them to bond investors with a government backstop attached. Most of that backstop comes from Fannie Mae and Freddie Mac.

“If you want to buy a home today in Hilton Head, you’ll need two years proof of regular distribution of income, making it tougher for retirees to purchase a home,” said Snider.

Dodd-Frank, the financial-reform bill that Obama signed into law in 2010, probably won’t prevent another financial crisis.

“Keep in mind that very few senators on the finance committees have finance or economics experience; the majority of members are attorneys with little or no exposure to the dynamics,” said MacPhee.

But the new law does a few important things.

Systemically important financial institutions, those that could create a crisis if they were to fail, are under extra scrutiny to maintain enough capital to cover possible losses. As a result, banking institutions that are “too big to fail” have a much higher capital ratio today than pre-crisis.

“Today, Bank of America has over $2.10 trillion in total assets, making them larger than the GDP of most countries,” said MacPhee.

If another crisis hits, the U.S. Treasury now has the legal right to seize banks that are too big to fail. In the past, the government could only seize smaller banks threatening default.

Another important outcome of Dodd-Frank is that a new standalone agency, the Consumer Financial Protection Bureau, now cracks down on predatory lending — a range of practices epitomized by the sale of the exploding subprime mortgages.

The regulator scrutinizes the safety of financial products, as the federal government does with toys, cars, appliances, airlines, food, drugs, and most everything else that’s for sale in our capitalist economy.

The Ripple Effect Continues 

When the recent housing bubble burst, the $13 trillion U.S. bailout halted the total implosion of the housing, mortgage, lending and finance markets. But no one, including the U.S. government, could stop the economic fallout. The reverberations continue today and will do so into the foreseeable future.

“Given the ripple effect,” according to MacPhee and a group of economists that he consulted, “the bailout equates to a global loss of $23 trillion, an amount that won’t be absorbed easily. We predict that it will be between 2030 and 2038 before it is. The money will never be recouped — it evaporated. This explains the wild economic gyrations in nations like China, Japan, and Greece.” 

Our local finance gurus warn that cycles of boom and bust are here to stay in 21st century global capitalism — a key fact to keep in mind during the next asset bubble.

BOOK SIGNING0515-Business-BookCoverMeet William MacPhee, author of “Structured to Fail: Implosion of the Global Economy” and purchase a signed copy of his book at 1 p.m. May 19 at the Hilton Head public library on 11 Beach City Road.