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The Financial Crisis Explained: Why Complexity Wasn’t the Problem

Wednesday, August 14, 2013

The mortgage market is far from the most complex sector in our economy, so why do so many people believe complexity caused the financial crisis?

We are nearing the fifth anniversary of the 2008 financial crisis, and despite an abundance of evidence, the media and the general public still seem largely misinformed about the hand of government in planting the seeds for the meltdown. The twitchy finger of that hand was the federal government’s aggressive affordable housing policies.

Most folks, however, still believe that the cause of the crisis was some combination of Wall Street greed and government deregulation of financial markets. There also exists the impression that the housing finance market, and especially securitization, had just gotten too darned complex, and that that complexity caused the crisis.

I confess that until I studied the details carefully, I held the same impression. To the uninitiated, understanding this part of the economy requires swimming through a sea filled with esoteric concepts such as tranches and acronyms such as CDO (collateralized debt obligation), synthetic CDO, MBS (mortgage-backed security), and CDS (credit default swap), which crowd the space like so many giant jellyfish.

The Financial Crisis Inquiry Commission — which should have played a very important part in identifying the roots of the crisis — was, in my view, stacked to reach a predetermined conclusion. The majority report of the Commission pointed its finger in many directions (though rarely in the direction of Washington, except when Republicans could be implicated), so not surprisingly, it claimed that overly complex and opaque financial assets and instruments were a major culprit.

The Commission’s majority report was correct to call the rating agencies “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.” However, the report fails to note that government regulation heavily influenced how these agencies operated and that their actions can be largely explained by ignorance, bad incentives, and one big false assumption, without reference to undue complexity.

Here’s how the story goes: banks found it hard to sell the influx of lower-rated tranches (I’ll explain this term below) of mortgage-backed securities; to fix this problem, they bundled tranches of many different low-rated securities (a BBB rating or lower) based on home mortgages in many different places. In this way, they were able to get some 75 percent of the resulting collateralized debt obligations rated as AAA. It might not sound like much, but this sterling designation made all the difference in the securities’ attractiveness to large investors, since many pension funds and institutional investors are required to invest only in the highest-rated bonds, which rarely default. By elevating bonds based on the riskier mezzanine-level tranches to a AAA rating, banks could offer higher-yielding assets to major investors. And since the agencies rated them as safe, investors around the world bought them — big time.

The problem was that the three big ratings agencies were paid by the banks selling the bonds. This defies common sense. Agencies should be rewarded for being accurate, not for giving good grades to those being rated.

The problem was that the three big ratings agencies were paid by the banks selling the bonds. This defies common sense.

Guess how this arrangement came about? Government regulation. In an earlier time, a ratings agency such as Moody’s charged the buyers — that is, the bond investors — for its research and ratings. In the 1970s, however, the SEC changed that arrangement under pressure from unions and public pension plans that didn’t like paying the ratings agencies.

But there was one big false assumption being made. Like most everyone else, the ratings agencies thought that housing prices would keep going up, and even if prices dropped in one place, the agencies assumed the drop would be offset by increases elsewhere. Each individual mortgage-backed security might contain 1,000 mortgages from one state, but the collateralized debt obligation would be made up of tranches from 100 different mortgage-backed securities from all over the place.

Alas, despite the geographical diversity of the mortgages underlying the bonds, they were all built on the same flood plain. When the dam burst, defaults and delinquencies suddenly surged everywhere.

Inside the Black Box

Even five years later, these things are a black box to most people. Unlike previous financial crises, this one involved markets that most people had never heard of and that only a few Wall Street types understood. But they’re not unintelligible, and it is important to comprehend the basic overview in order to bust the myths about the crisis.

Imagine you have a 30-year fixed-rate loan from a bank. The bank might simply keep the mortgage and receive your monthly payments. But if it has many of these, it might prefer to sell them and have cash on hand rather than a bunch of IOUs promising monthly payments for 30 years from homebuyers in Cincinnati and Schenectady. 

The institutions that buy mortgages from banks are called secondary buyers. These could be private investment banks, such as Goldman Sachs or Morgan Stanley, or government sponsored enterprises, such as Fannie Mae and Freddie Mac. But they don’t want to hold an asset that takes 30 years to pay off, either, so they in turn securitize the mortgages, bundling them and selling pieces of the bundle as bonds called mortgage-backed securities. The monthly mortgage payments then pass from the homebuyers through the security to the owners of the securities. 

In a properly functioning market, these securities can serve the important function of diversifying risk and opportunity. As with any real-world investment, however, these financial instruments still come with real-world risks, resulting from people paying their mortgages off early or the Fed changing the interest rate. So, in 1983, investment banks Salomon Brothers and First Boston invented a new type of mortgage-backed security for the new government sponsored enterprise, Freddie Mac. These so-called collateralized mortgage obligations were designed to distribute the risks.

Let’s say you’re an investment bank and you’ve just bought 1,000 fixed-rate 30-year mortgages from 10 different banks — that is, you now have the contractual right to receive monthly payments from 1,000 homebuyers. Imagine each mortgage as a 30-story-high skyscraper, with the first floor of each skyscraper as the part of the mortgage promising the payments for the first year, the second floor promising payments for the second year, and so on up the building. All 1,000 “skyscrapers” would be side by side in a big city.

Now imagine that you could connect these 1,000 individual skyscrapers together with a series of skywalks. All the thirtieth floors are now connected to make one giant thirtieth floor, and so forth, all the way down.

Even five years later, these things are a black box to most people. Unlike previous financial crises, this one involved markets that most people had never heard of and that only a few Wall Street types understood. But they’re not unintelligible.

Like giant penthouse condos, you can sell each floor — or “tranche” (French for “slice”) — separately. You might sell the first tranche to a mutual fund tailored for retirees that requires a super-safe AAA rating. They now own the first year of payments coming from those 1,000 mortgages. Since this is paid off first, it carries both the lowest risk and the lowest return. People willing to risk a bit more for the chance of a greater reward might buy a tranche in the middle, called the mezzanine level. And the high roller who bought the top floor is promised a much higher return on his investment in exchange for a much higher risk; he might get stuck with a security that pays him less than he was promised because the mortgage collateral backing his tranche is paid off early or is in partial or full default.

In this transformation of mortgages, the investor, the originating lender, and potential homebuyers all benefit. Since a lot more money is now available for mortgages than if banks just sat on their mortgage contracts, more people can get loans. Banks also will tend to charge lower interest rates on their home loans, thanks to the law of supply and demand.

Derived from mortgages, these collateralized mortgage obligations are called derivatives. Other derivatives can include other things as collateral; for example, collateralized debt obligations can include all sorts of assets, bonds, and loans. Rather than being structured according to the payment schedule of mortgages, the tranches in a collateralized debt obligation are structured according to the quality of the credit used as collateral, with Alt-A and really risky subprime loans, for example, at the dizzy top. 

Okay. We’re almost done with this tour of Securitization City. Let’s say you’re an investment bank and you have leveraged your money (that is, borrowed) to buy some mezzanine-level collateralized debt obligations that yield 10 percent annual interest. These bonds have a BBB rating, which means that they’re just risky enough to keep you awake at night. (In fact, they’re making me nervous just writing about them.) Here is where credit default swaps come in: they offer a way to hedge against that risk. As with any insurance policy, you pay the issuer of the swap a little bit at a time, on a schedule, and the issuer promises to cover your losses if your bonds go belly-up. 

Unlike most insurance policies, you can buy a credit default swap on a security even if you do not own that security — like buying collision insurance on your neighbor’s car rather than on your own. Perhaps you know that your neighbor (despite his perfect driving record and low car insurance rates) has been driving erratically lately. There’s a company willing to sell you coverage, no questions asked, which will pay off if your neighbor has a wreck. Macabre? Yes. But not a bad investment, if you can get it. Such are credit default swaps.

But how to hedge against a whole portfolio of securities, rather than just one? In 1997, the synthetic collateralized debt obligation was invented, where the tranches are slices of bundled credit default swaps. After the financial crisis, Goldman Sachs was criticized for buying such synthetic CDOs to hedge against the very mortgage-backed securities they sold. Essentially, the investment bank was denounced for being smart enough to take precautions against their losses — losses that turned out to be real.

Complexity Wasn’t the Problem

There. That wasn’t so bad, was it? Of course, I’m not saying that a CDO is as simple as a mousetrap. But the market for securitized mortgages is far less complicated than many other markets that work just fine.

Consider any piece of modern technology, such as a smartphone. Before you can buy an iPhone at the Apple store, the work of millions of people, from miners to truck drivers to software programmers and silicon wafer fabricators, has to be coordinated. Everyone involved in this process is ignorant of the vast majority of these steps. In fact, most people involved in building an iPhone know only about their own step, and many may not even know that their work contributes to iPhones. The guy at the bauxite mine in Australia doesn’t know anything about how the aluminum he extracts from the earth will be molded to become part of an iPhone body; the assembler doesn’t know how to fabricate wafers for computer chips or write operating systems; the woman putting computers in boxes in China doesn’t know how to organize the transport of the boxes on a ship to the United States.

The complexity of mortgage securities pales in comparison to high-tech markets for smartphones that work well, which suggests that complexity per se wasn’t what caused the financial crisis.

Leonard Read taught us that no one knows how to build even a simple no. 2 pencil from scratch. How much more complicated is a smartphone? No one person on the planet could build an iPhone or even one of its components from scratch. And yet corporations such as Apple sell high-quality smartphones to hundreds of millions of customers worldwide. Somehow, a complex network of information connects mines to manufacturers to retailers to customers, even though no one person knows more than a minute fraction of the details. A manual that fully described every step required to create an iPhone from scratch would fill many rows of shelves in a library. But no such manual exists, or needs to. For markets to work, participants simply need to have access to certain facts relevant to their part of the transaction.

The process that gives rise to an iPhone involves an information chain. And as with all information chains, each link doesn’t need to connect to every other link, it just needs to connect to the links on either side of it. If all the links are strong, the chain is strong.

The complexity of mortgage securities pales in comparison to high-tech markets for smartphones that work well, which suggests that complexity per se wasn’t what caused the financial crisis.

AEI’s Peter Wallison and Edward Pinto were courageous in identifying the real causes from the very beginning, and the numbers that subsequently emerged confirmed their claims. As a result of government efforts to expand homeownership, by 2008 about half of the loans in the market — some 27 million loans — were risky, subprime, or otherwise nontraditional. Of these, Fannie Mae and Freddie Mac held almost half — 12 million. FHA and other federal agencies (such as the Veterans Administration and Federal Home Loan Banks) held 5 million, and Community Reinvestment Act and HUD programs had another 2.2 million. That’s a whopping total of 19.2 million risky loans held by entities controlled by or within the federal government, leaving just 7.8 million for Countrywide, Wall Street, and other private institutions.

Five years on, it should be obvious that the federal government’s well-meaning but misguided affordable housing policies played a decisive role in the crisis.

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Jay W. Richards, PhD, is the author of Infiltrated (McGraw-Hill), and Distinguished Fellow at the Institute for Faith, Work, and Economics. This essay is adapted from the book.

FURTHER READING: Richards also writes “Greed is Not Good, and It’s Not Capitalism” and “The Immateriality of Wealth.” Alex J. Pollock says “No, Virginia, Nothing is Really Risk Free,” Arnold Kling looks at “Regulating Risk,” Peter J. Wallison says “The Left Refuses to Face Facts on Fannie and Freddie’s Role in the Financial Crisis” and Edward Pinto writes “Angelides Ignores Two Elephants in the Room.” Tanya D. Marsh wants to “Treat Community Banks Differently” and Phillip Swagel looks at “Progress on Housing Finance Reform.”

Image by Dianna Ingram/Bergman Group

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