The Recession- A Comprehensive Analysis (Part 1)

To truly understand how the country is currently facing the worst economic situation since the Great Depression, we must go back to the late 1990s.  The most recent boom began around 1998, when investors decided that U.S. real estate was a very safe, appreciable investment (as opposed to Europe, where investment was hindered by the Russian debt crisis).  The housing market has still not fully recovered from its dip in the early 1990s, so investors saw the sector was on its way up (and was cheap at the time), and intended to take full advantage.  During this increasing interest in real estate, Wall Street firms were making it easier for homeowners to obtain loans.  Consolidation of banks shifted the mortgage business from a more local environment, to a global one.  Large investment firms and banks could receive funding from anywhere in the world, providing liquidity to a potential debtor.

With the increased cash reserves and investment potential, large banks lowered mortgage interest rates to compete nationally.  The one catch with this new opportunity was that investors demanded high returns, so Wall Street turned to the new structures of subprime mortgages.  These mortgages, since they were issued to people who could not as easily afford a house, came at higher interest rates (even if interest rates were initially lower), and would supply investors with higher returns.  However, this was all based on the assumption that nothing would ever happen to stall or stop housing prices from rising over the term of the mortgage (and that wages would never stop increasing).  Then, to exacerbate the situation, the mortgages were packaged and turned into Mortgage Backed Securities (MBS), Collateralized Mortgage Obligations (CMO), and Collateralized Debt Obligations (CDOs), which could then be sold to different groups of investors.

These securitizations all operated in a similar manner.  Institutions constructed tranched bond offerings, consisting of different maturity dates, interest rates, and asset cash flows; all of which could be purchased by tranche, allowing different levels of risk, and return.  CDOs were a high octane version of a tranched bond, where junior tranches (of MBS and other non-securitized offerings such as mezzanine loans), i.e. the high risk portions of bonds were packaged together and rerated by the rating agencies.  So through the magic of the rating agencies' black boxes within a portfolio of high risk junior tranches of securities you could have investment grade tranches within a CDO.   Of course demand for these CDO's fell rapidly with the onset of the credit crisis and many banks, notably CitiBank were left holding billions of dollars of this paper.  However, until the crisis the use of CDO's increased mortgage market liquidity, giving different levels of investors more options.

These investors were compounding their risk, but magnifying their returns by leveraging their investments.  Any given organization or individual could invest in a CDO with a small percentage of their money.  For example, if an investor buys $100 Million in CDOs with $1 Million of liquidity (the remaining $99 Million provided through debt), if the value of the CDO increase by 1% to $101 Billion, then the investor has doubled their money.  However, the reverse is just as possible (if the CDO depreciates by 1%, the investor has lost their principal investment).  This risky investment trend also fueled the rapid decline in financial firms for as the value of the CDO's decreased the banks providing the debt made margin calls and defaulted many of the CDO investors.  As fears regarding CDOs and MBSs became more prevalent, assumptions began to rule the market.  If consumers perceived an institution did not have the required assets to back up a potential CDO loss, they would not invest.  As a result, financial institutions tightened their spending, significantly reducing market liquidity.  And as the subprime mortgages began to fail, investors began asking for their money back, and lenders refused to offer credit. This initial crunch led to Bear Stearns demise.

Now, before you go blaming Wall Street for all of Americas troubles, its important to remember two mortgage giants who contributed to the situation.  Fannie Mae and Freddie Mac, who combined held $6 trillion in real estate mortgages (about 50% of U.S. mortgages) at their height, were the first organizations to be bailed out.  These were GSEs (Government Sponsored Enterprise), so all the loans they sold were backed by the government, meaning they did not require nearly as much capital as traditional banks.  As a result, Fannie and Freddie knew they wouldn’t suffer any consequences if/when things turned south.  The one guideline these GSEs had to follow however wasn’t heeded.  In 1999, the Clinton administration pushed for increased lending, and the easiest way was through Fannie and Freddie.  Lending restrictions were eased; however investors remained to expect the same returns as they had previously. This credit increase, combined with the call for profits forced the GSEs to significantly increase lending, setting the trend for securitization markets.  Government regulations restricted Fannie Mae and Freddie Mac from investing in mortgages that didn’t meet certain down payment and credit requirements (which essentially takes subprime mortgages off their radar), however as mortgages changed, so did Fannie and Freddie (even though government regulations remained as they were).  Between 2005-2008, of Fannie Mae and Freddie Mac’s acquisitions, 58% and 67%, respectively, were subprime. This caused the two largest financial GSEs to cost the government over $200 Billion in bailout funding by the end of 2010.

Article 2 in this series will cover the trends in mergers and acquisitions leading up to the current crisis, along with credit concerns and leveraging issues.