Thursday, August 05, 2010

Causes of the Crisis: Shadow Banking

When Alan Greenspan kept interest rates low, housing and housing prices took off. It is, as Zandi points out, a well-established rule that asset prices and interest rates move in opposite directions because an asset that can be purchased as a lower rate of interest has a higher present value. Unfortunately, unlike earlier booms, the housing boom was not based on any technological advances in how houses were built, but only on easy credit. Mortgages, in turn, were fed into an insatiable pit informally known as the shadow banking system.

Despite its colorful name, the shadow banking system simply refers to any financial institution that is not a traditional commercial bank. Shadow banks are nothing new. In fact, as this paper points out, all banks could once be considered shadow banks, in the sense that they were loosely regulated and financially fragile. The FDIC brought commercial banks out of the shadows, insured deposits, and tightly regulated lending, but left a small "shadow" financial industry in the form of investment banks playing the stock market. Since then a wide range of non-traditional institutions have grown up, from money market mutual funds that are almost like traditional banks, to wild west hedge funds.

One of the things the shadow banking industry does (or did) is securitize. Someone, either a commercial bank or a finance company backed by an investment bank, would make a mortgage loan. Instead of keeping the loan, the originator would sell it to a "loan warehouse," either a "conduit" belonging to the bank holding company but off the balance sheet of the commercial bank, or a federally backed conduit. Once there, someone, Fannie, Freddie, or the Special Purpose Vehicle (SPV) for a bank holding company or investment bank, would pool loans and slice them into tranches (slices) for sale. Senior tranches got priority in payments, but the lowest interest rates, with risk and payment escalating up the ladder. Securitized loans were bought by banks, insurance companies, pension funds, asset managers, and hedge funds.

By this time, any kind of loan receiving regular payments could be similarly sliced and diced. Here is one thing that was never made clear to me. Different types of loans carry different interest rates. A home mortgage, for instance, is traditionally considered very safe. Defaults are (traditionally) rare because defaulting means losing one's home, and even when they do happen, the loan is backed by a stable asset, easily located, and (until recently) reliably appreciating. A car loan, by contrast, has a higher default rate and is backed by a very portable asset that is easier to hide and depreciates rapidly, so it carries a higher rate. And a credit card is an unsecured loan with no downpayment, so interest rates are very high indeed. So were these different rates of risk and return reflected in the security slices? Or were all senior tranches treated as equivalent, regardless of the loans behind them, with safer loans simply creating more senior tranches and riskier loans more high-risk tranches?

As housing prices continued to escalate and the securitization machine kept wanting more, several things happened, some in the world of housing, and some in the world of high finance. In the world of housing, the building boom started reaching its natural limit, as booms always do. This one came faster than most because it was not, after all, based on any technological advance that made housing cheaper to make, but only on easy credit. People had been buying houses at an unsustainable rate. And so, as often happens when a boom reaches its natural limits, people tried to artificially sustain it, creating a bubble. In the world of housing, that meant moving more and more into sub-prime territory. Sub-prime lending, as a share of the total, had fairly stable from 1997 to 2003. From 2004 to 2006, it took off.
Making so many sub-prime loans, notoriously, also led to the abandonment of common sense underwriting standards. Lenders all too often stopped doing assets checks or asking for proof of income. As housing prices soared higher and higher, they increasingly went out of reach to many buyers. Lenders started asking less and less for down payments, sometimes waiving them altogether. When even that failed to make a house affordable, lenders offered "teaser" rates, with artificially low interests rates for two years, to increase later. Loan originators who tried to maintain reasonable underwriting standards found themselves undercut by less scrupulous rivals and had little choice but to lower their standards as well. A similar process went on with regulation. Financial regulation was hopelessly fragmented. If any regulatory agency attempted to maintain discipline, lenders could simply choose a laxer agency. So regulators, too, saw little choice but to lower standards or lose out to rival agencies.

So how did high finance deal with all these bad loans? By disguising them through ever more complex systems of securitization. The favored form was a collateralized debt obligation or CDO. These, too, were well established forms of securitization before the 2000's, usually a custom-made pool of corporate bonds or loans that were securitized. If an asset-backed security or sub-slice of such a security started looking shaky, financial companies would pool together the shaky securities and securitize them. The product was known as an ABS CDO, short for asset-backed security collateralized debt obligation. A more accurate name might have been "chef's special" because an ABS CDO essentially took the leftovers no one wanted, threw them in the same pot, and offered up slices (tranches) of the resulting product. Toward the end, securitizers started making CDO's of CDO's, known as CDO's squared, or even CDO's cubed.

Credit ratings agencies regularly certified senior tranches of the chef's special as triple A. Credit ratings agencies had the same problems as everyone else -- if the didn't tell securitizers what they wanted to hear about their securities, securitizers would simply hire some other agency to do their ratings.

And about the time sub-prime lending the starting to take off, the SEC relaxed standards limiting how much debt the five major investment banks could run, relative to their equity.

All of which raises an obvious question. Couldn't anyone see the system was headed for trouble. The answer appears to be yes, some people did indeed see that the system was headed for trouble -- and set out to make a buck off it.



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