The Subprime Mortgage Crisis and Aftermath

What caused the subprime mortgage crisis and what was the result of the Treasury's and Federal Reserve's response to that crisis? Most people are familiar with the overall story of events leading up to 2008. They may have seen the film The Big Short, which helped the public to learn about collateralized debt obligations (CDOs) and credit default swaps (CDSs). However, there is a lot more to the story than that one movie could tell. This paper will explain. The reality is that the subprime mortgage crisis was caused by a complex variety of systemic factors, and the response—rather than address the systemic issues—ensured that a similar crisis would occur again down the road; and that crisis has been seen in 2020.
Overview of Causes
The Financial Accounting Standards Board (FASB) was a big reason the crisis occurred in the first place. What did the FASB do? It had the opportunity to restrict the use of mark-to-market accounting, i.e., fair value accounting practices, in the 1990s and yet it did not. This was the type of accounting used by Enron, facilitated by Andersen—the accounting legends whose high standards set the bar for the industry. If Andersen could promote fair value accounting consultancy services, everyone could do it—and that is what happened (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008). So why was this a problem? Not every researcher agrees it is or was a problem (Posen, 2009). Some argue that fair value accounting helps companies to maintain a more accurate system of book keeping because they can show the value of their assets based on the going-rate in the market.
Traditional historical cost book-keeping simply shows the price paid for an asset and a loss or profit is not recorded until the asset is sold. Fair value recording allowed companies to book profits (or losses as the case might be) without ever having actually sold the asset. It was an accounting trick and the FASB failed to put a stop to it. The case of Enron shows just badly it could get out of control.
But the 2008 economic implosion is a better case in point illustration because suddenly every company using mark-to-market accounting had to book substantial losses as asset prices plummeted when the housing bubble exploded and the market crashed. As every company uses leverage, the margin calls were quick and fierce; selling begat more selling, and a vicious cycle of selling was the result, as companies were forced to offload assets because their books showed them losing capital, even though they had not actually lost anything. The magic of fair value accounting looks great when asset prices are on their way up: companies can increase their leverage, borrow more and buy more. It is a sudden curse when the market turns and asset prices decline. That is what happened when demand for mortgage backed securities collapsed as a result of subprime borrowers defaulting on their mortgages. Banks like Lehman Brothers and Bear Stearns felt the full brunt of fair value accounting principles coming back to bite them. As Flegm (2008) points out, historical cost is more reliable in accounting than fair value accounting. Had firms used historical cost approach they would not have suffered when the crisis hit—but neither would they have benefitted via leverage as much on the way up.
Relaxed Lending Standards
Relaxed lending standards were another problem that contributed to the crisis. Under the Clinton Administration they idea of getting subprime borrowers into homes and thus fulfilling the American Dream was proposed and implemented. Lending standards were relaxed and borrowers found it easier than ever before to get a loan for a house (or two or three if they wanted) (Lewis, 2010). Previously, lending standards had been more restrictive—just as they would again be after the crisis. Lenders were forced to make sure borrowers could actually pay back their loans. During the housing bubble lenders were incentivized to lend to anyone as the standards had been relaxed and loan originators profited on each commission.
These loans were then bundled together and sold as mortgage-backed securities (MBS) to investors in search of yield. Since the Dot Com implosion of 2000, the Federal Reserve had suppressed interest rates to encourage more investment in the risk-on assets. Traditional savings and Treasuries did not provide the kind of yield investors needed; insurance funds and pension funds, for example, rely on a high ROI as part of their promises to keep payments coming. Thus, they turn to whatever is offering the best yield with the least risk. MBS looked like a sure-thing for investors, but it was not and few people noticed (Lewis, 2010). Investors were confident that they could collect the interest on the mortgages, since, after all, they were investment grade. Companies like Countrywide Financial saw an opportunity to make a lot of money in the subprime market, and they knew they could offload the risk in the MBS market—and with housing spurred on by artificial demand facilitated by relaxed lending standards, it seemed a win-win for all.
Why Investors were Buying
Investors were buying because low interest rates were causing investors to adopt risk-on strategies in their chase for yield. They saw MBS and CDOs as low-risk since the ratings agencies such as Moody’s were giving them AAA-ratings, meaning they could be viewed as investment grade by institutions and funds. The ratings agencies were not doing their job and were either negligent in actually looking at the way the mortgages were bundled together or deliberately engaging in fraud (Lewis, 2010). Whatever the case may be, these securities were not and should not have been seen as investment grade.
Some hedge fund investors like Dr. Michael Burry did look at them and did realize that the subprime borrowers could kill these securities if they began to default. Most investors were not looking at these securities very closely and were simply buying what they were told by banks like Goldman and JP Morgan were good investments. The investors wanted yield and these securities could provide that—so long as no wave of defaults hit. The AAA-rating was supposed to ensure that no such wave would come. Burry saw that the ratings were wrong and began buying insurance against these securities in the way of CDS. Few people were buying CDS at the time when Burry began convincing firms to sell it to him. By the time the crisis would hit, people would be liquidating MBS and CDOs at bargain-basement prices and falling all over themselves to buy the CDS that the few people such as Burry had bought in the years and months preceding the bursting of the housing bubble and the giant wave of subprime borrower defaults that triggered the crash in MBS and CDO prices and ruined the books of all the firms using mark-to-market accounting to inflate their own book value.
What Happened When Borrowers Defaulted
The US Treasury Department bailed out the too-big-to-fail banks and firms like AIG, which owed a great deal to Goldman, since Goldman had followed in Burry’s footsteps and begun purchasing CDS from American International Group (AIG). It was a complicated chain of events but it can be explained in this way: the government papered over the very real risk of moral hazard by engaging in financial crony capitalism. Thus they set the stage for a repeat of the crisis, which has been seen in 2020.
First, what happened when subprime borrowers began defaulting on their loans was that the securities sold to investors began plummeting in value. Suddenly they were not worth anything because they had no value: the yield would not be paid if the borrowers were defaulting. The way the bundles of loans were organized was supposed to prevent such a problem from arising; however, as Lewis (2010) points out, the bundles were not organized as they were theoretically supposed to be—there was simply far too much subprime in them. They were valueless. They were not anywhere near being AAA-rated. Investors had been duped and large banks like Lehman were holding vast amounts of these securities simply because they had been speculating and the market for them was hot.
Lehman was not the only firm in trouble, however. AIG had been writing CDSs to investors at a tremendous rate, happy to collect a commission on the sales, believing that the bottom would never fall out of the MBS market. AIG was wrong, and when the bottom fell out in 2008 it was left having to pay out enormous sums to other firms like Goldman, which had correctly identified the problem and hedged accordingly. The problem for Goldman was that if AIG went under, Goldman would not get paid. Fortunately, Wall Street had a friend in the Treasury Department—namely Hank Paulson, former Goldman Sachs CEO and head of the Treasury Department in 2008. He would be followed by Tim Geithner, former head of the New York Fed. In short, the too-big-to-fail banks and firms had friends in high places in the US government: they would not be left to face the consequences of their own actions. Instead, they would be bailed out because the system could not, in their view, be allowed to crash and correct itself naturally. Thus, the Troubled Asset Relief Program (TARP) was implemented; AIG was bailed out by the Treasury, and the Federal Reserve set about acting as the buyer of last resort: it spent trillions to buy up Treasuries and MBS in order to supply the markets with liquidity and stimulate demand.
These steps by the Federal Reserve were known as unconventional monetary policy, or quantitative easing (QE). QE was unique because it was the Federal Reserve directly intervening in the markets by buying what no one else wanted. These actions essentially acted as a signal to the markets that the Federal Reserve would not allow a depression to happen. If anything, it would insist that asset bubbles be re-blown. As Bernhard and Ebner (2017) point out, a spillover effect resulted with money flowing into bonds then spilling over into the equities market, inflating asset prices. Paulson made sure Goldman would make money, and Geithner made sure there would be someone to buy the federal government’s debt. QE remained in effect for years. Today, it has been brought back into effect with even greater force, with the Federal Reserve not only buying Treasuries and MBS but also corporate debt and even some Federal Reserve members openly talking about the central banks buying equities should there be another downturn.
Why what the Treasury and Federal Reserve Did Ensured a Repeat of the Crisis
The subprime crisis should not have resulted in a situation wherein the same thing would just be repeated a decade later—but that is essentially exactly what happened. The subprime crisis itself was merely an extension of the Dot Com bubble blowout and an effect of the Federal Reserve’s response to that. Instead of obliging AIG to liquidate, the firm was bailed out, which meant that Goldman in turn was saved. Yet, what happened to the idea of moral hazard, the notion that actions have consequences, or the concept of accountability?
A lot of talk focuses on regulations and how important they are in this day and age of too-big-to-fail banks. Yet, as Posner (2014) shows, regulations are actually part of the problem. Though regulations are meant to ensure quality in the market, Posner (2014) has argued that they hurt more than they help because they handcuff institutions from being able to use capital as they see fit. Regulations prevent financial institutions from having the option of deciding how to allocate resources, and they prevent smaller institutions from participating in the market. Instead of a free market deciding which firms fail and which succeed, the central planners decide which firms are “too-big-to-fail” and which firms can be sacrificed to feed the “essential” businesses. Lehman and Bear Stearns were allowed to fail, and their assets were quickly bought up for pennies on the dollar by JP Morgan, Wells-Fargo, and others. In the end, this type of planned economy is beset with problems. Regulations prevent smaller firms from participating because such firms lack the capital needed to meet regulatory guidelines (Posner, 2014). Thus, the big firms are enabled to maintain a monopoly.
The Federal Reserve and the Treasury both helped them to maintain that monopoly in 2008 and essentially set the stage for the 2020 collapse and bailout. The 2008 crisis was met with hundreds of billions in bailout money being leant to the too-big-to-fail firms. The Treasury Department leant this money out, and the Federal Reserve made sure there was a buyer of the debt. Meanwhile, rates were suppressed and investors had no choice but to adopt a risk-on strategy once more. So long as the Federal Reserve was increasing its balance sheet to the tune of trillions of dollars, it would make sense to adopt such a strategy, according to the spillover effect theory (Bernhard & Ebner, 2017). The Federal Reserve’s QE policy sent gold prices soaring, as investors turned to the precious metal as a safe haven at a time of unprecedented central bank intervention. Home prices quickly rebounded (an effect of inflation, caused by the rapid increase of the money supply through the Federal Reserve’s emergency intervention). Equity prices rebounded to all-time highs in the coming years. Companies borrowed funds at low interest rates and bought back their own shares.
Yet, when the Federal Reserve began raising interest rates and rolling off its balance sheet, the markets responded by convulsing. Market participants were nervous that the central planners were no longer backstopping them. Liquidity began to dry up so that a crisis in the REPO markets emerged at the end of 2019. When the global economy shut down in March 2020, an enormous sell-off occurred. The Federal Reserve was quick to act, pumping trillions into the market, buying Treasuries, MBS and corporate debt, in order to stave off fears of a systemic collapse. A v-shaped recovery in the equities market occurred over the course of three months. Asset prices rose. Gold soared to new highs. The Federal Reserve essentially showed that it alone had the power to make or break markets: so long as it continued buying, assets appreciated in value. But what happens when the central planners stop buying? And what is the cumulative effect of an increase in the money supply? The answer is inflation. The markets may insist that the Federal Reserve be there to bail out the too-big-to-fails, no matter what industry they are in, but the end result is going to be a decline in the purchasing power of the dollar. The actions taken by the Federal Reserve following the 2008 crisis set the stage for expectations in 2020 and have ensured that the dollar will sooner rather than later lose its reserve currency status.
Conclusion
The main causes of the subprime market crisis of 2008 were, first of all, the FASB’s decision to allow fair value accounting. This may not seem like an important detail on the surface, but it is because it meant that firms using this method of accounting had to liquidate or face margin calls since their books reflected the decline in value of assets that the market began rejecting in 2008. For firms holding MBS or CDOs, the book value suddenly fell drastically even if the firm had not sold. Historical cost accounting would not have resulted in such a situation for these firms. The firms could have simply sat tight and waited for the market to rebound. Fair value accounting created an altogether different situation in that it reflected a book value of worthless, causing selling to beget more selling.
However, it is true that firms would not have been in that situation in the first place had there not been a relaxation of standards. Those who argue that fair value accounting was not to blame make the argument that instead it was actually the standards in lending practices that were to blame. It is true that these standards had changed and that borrowers needed to show next to nothing in order to qualify for a loan. Companies like Countrywide Financial were quick to provide these loans because there was a market for offloading the mortgages. But the reason there was a market for MBS was because the Federal Reserve had suppressed interest rates and funds in need of yield were looking for an attractive ROI. Thus, those who argue that the Federal Reserve was really to blame for the crisis are also correct. The reality of the situation is that all are correct—every part of the puzzle was important. None could be excluded. Each had an impact on the crisis.
The response by the federal government (TARP) and by the Federal Reserve (QE) not only essentially sanctioned the end of moral hazard but also laid the groundwork for a future crisis. The Treasury Department bailed out the too-big-to-fail firms like AIG and the banks that were left holding the bag of MBS (which would be offloaded to the Federal Reserve) or CDSs that could not be made good on unless the insurance company was bailed out. Why AIG could not be made to liquidate is a question that only Goldman Sachs can answer, since it made billions off the bailout. Regardless, the market was backstopped, interest rates were further suppressed, and inflationary prices were seen in everything from food costs to housing to precious metals to equities.
Now that America (and the rest of the world) has a Soviet-style planned economy in which the central planners take care to ensure that prices always rise and that free markets never fail as a result of their own moral hazard, the question is: how much longer can this type of system be sustained? Inevitably the Soviet Union collapsed. It is quite fair to surmise that the system will also fail in the US and around the world, and that may be one reason why nations appear to be prepping for war at a rapid clip. In the Middle East one sees unlikely allies forming (Israel and the Arab Gulf States, for instance). War games in South China Sea are on the rise. The drums of war in Belarus are betting. And Iran is always identified as a threat. If 2020 was a reshuffling of the economy, 2021 may be the start of an entirely new economic world order.
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