The Perfect Financial Storm

The root of current problems lies in the very unlikely confluence of three factors. None of the three factors would have independently resulted in the current financial mess. But in combination, they proved deadly – creating a perfect financial storm, which will be difficult to escape. It has already wiped out investment banking from the face of the U.S. financial landscape and could threaten to unravel the real economy.

First, after the asset price bubble burst and the U.S. suffered the attacks on 9/11, fears of a deflationary spiral similar to Japan’s experience during the 1990s prompted monetary policymakers to reduce interest rates and keep them low. Unfortunately, they were kept low for very long. The fed fund’s rate was maintained below 2 percent for three years – during early 2002 through late 2005 (see chart).

Low interest rates stimulated competition in the home loan industry. Mortgage brokers, financiers, banks and others ramped up lending and the competition depressed mortgage interest rates stimulating housing demand. This process was abetted by the voracious appetite of government guaranteed Fannie and Freddie who had an interest in expanding their business volume in securitizing mortgages and issuing bonds. The government guarantee enabled them to sell bonds cheaply to finance purchases of bundled mortgages. The higher expected return on the mortgage pools would fatten shareholder profits – so the larger the volume of such operations, the better.

The chart below shows the close correspondence between low interest rates and the surge in mortgage originations. During the peak in 2003, mortgage originations worth 1.2 trillion were originated – double that from just 2 years before. At the same time low interest rates boosted home values and enabled households to withdraw home equity and boost consumption spending. The rising tide of high home building and consumption led to a sharp increase in global economic growth. At the time, the innovations in home lending whereby loans were securitized – that is bundled and sold to investors – was hailed as a signal achievement that enabled even those with marginal creditworthiness to obtain loans for purchasing homes.

These sentiments induced mistakes by policymakers – especially financial regulators who stayed their hands in reining in bad lending practices. Loan originators and securitizers were not subject to any restrictions on requiring proper documentation and maintaining appropriately low loan-to-value ratios. High LTV ratios imply risks that homeowners would not be interested in servicing their mortgages should house values decline below their outstanding mortgage balances. But home values had never declined on a nation-wide basis and any local declines could be tolerated – that is, offset by good performance in other booming areas – precisely the advantage conferred by the bundling and reselling of loans.

That shows why government licensed security ratings agencies – Standard & Poor, Moody’s and Fitch – also failed to catch the dangers inherent in the new and innovative financial paper. The fundamental rules of hedging require holding disparate securities so that losses on one can be offset by gains on the others. Under normal economic circumstances, all securities are expected to provide positive returns. As long as returns are not perfectly correlated, securities can be added to the mix to reduce the total risk for a given expected return.

That logic is inherent in the bundling of mortgages. A securitizing agency purchases many mortgages – in disparate locations. Issuing securities funds the purchases. And the securities are serviced by income from mortgage repayments. As long as only a few questionable mortgages turn up in the pool, the risk of losing principal on the agency’s securities is negligibly small.

The logic of hedging risks through diversification – especially because a widespread decline in home prices had never previously occurred – led rating agencies to conclude that such mortgage-pool based financial paper was very secure. Unfortunately, the one contingency that everyone assumed would not occur – a nationwide decline in home prices followed by many homeowners inviting foreclosure – became a reality. Why? Look at the first chart once more: The Fed became concerned about rising inflationary pressures as a result of the economic boom during 2005 and began a gradual process of increasing the fed funds rate. Those increases pushed up mortgage interest rates and choked off the demand for homes. Now expected increases in home prices failed to materialize stranding those who had bought homes with the intention of re-selling them for a profit. With home prices sinking below mortgage balances these homeowners opted to stop servicing their loans. Excess homes and poor performing mortgages are now on the rise as home prices have continued to plummet. As a result, even AAA rated mortgage backed securities are turning in below BBB (investment grade) performance.

What is the likelihood that three things – a lax monetary policy, pressure to expand home loan volume, and the failure to monitor home lending quality – would occur simultaneously? Note that the three factors are logically related. Each contains a rationale for inviting policymaker biases that promote risk-taking by private decision makers. This is primarily a failure of the troika of monetary, fiscal, and regulatory policies all at once.

They say that euphoria during economic booms causes private investors to make serious mistakes. But then Fed Chairman Alan Greenspan lauded the new financial intermediation technology (of bundling and securitizing) that extended sub-prime mortgage eligibility to those who normally would not have qualified. So it’s not just private market-participants’ perceptions that are too rosy during economic booms. Even the most astute policymakers’ can suffer from similar delusions.

Now Fed and Treasury policymakers are calling for a new and sizable bailout initiative. One of which the Fed wants no part. Being involved in it would mean stepping on Congress’ toes, which could invite retaliation by compromise the Fed’s monetary-policy-making independence.

A successful resolution of the current financial mess may require a substantial and appropriate fiscal initiative. The figure below suggests that credit flows may slow in the future as banks increase lending standards – that are already at levels seen during the 2001 recession.

But our rough-and-tumble election year political process may not deliver the right policy response in time.

Any new program should emphasize the predominance of private investment over the commitment of taxpayer funds. The debt-value discovery process should minimize incentives for corruption and gaming. Although executives that made bad investments should suffer losses, they should not be wiped out in most companies. Oversight should be the responsibility of an independent agency – that should be structured to automatically wind down its involvement as soon as debt values are resolved and the risis has blown over.