Causes, Ethics, and Prevention of the Subprime Crisis

Introduction: Origins of the Subprime Crisis

There were a number of factors that led to the subprime crisis: Fannie Mae, Countrywide Financial, the Federal Reserve, Moody's, Merrill Lynch, Bear Stearns, Goldman Sachs, AIG, Michael Burry (who shorted the mortgage-backed securities being sold to investors that were full of subprime loans), and others like him — the ones depicted in Michael Lewis's The Big Short — all had a role to play in the subprime crisis of 2007–2008 (McLean, Nocera). The lead-up to the crisis, however, started well before the actual collapse of the market. It began with housing in the 1990s, though one could trace its roots even further back to the 1970s, when Lewis Ranieri of Salomon Brothers invented the mortgage-backed security (MBS) — a bond made up of thousands of home mortgages bundled together, sliced up, and sold to investors who would collect the interest (Lewis). It was a way for original lenders to offload risk onto other investors and a way for new investors to collect a solid return on investment (ROI). This instrument was ultimately at the heart of the subprime crisis.

So long as MBSs were legitimate — and so long as ratings agencies did their part to rate them accurately (giving a AAA rating to securities with a slim-to-none chance of default, or a junk rating to those facing likely imminent default) — they could function as legitimate investments. It was when they were not rated honestly that the trouble began, or rather worsened. Junk bonds would pay a higher return, but the risk of receiving nothing was also far greater. AAA-rated MBSs were supposed to be a sure thing: little to no risk and a decent, predictable return. When Moody's and other ratings agencies became sloppy in their ratings of MBSs leading up to the 2007 collapse, many investors failed to realize they were buying junk that had been mistakenly — or deliberately — labeled AAA (Lewis).

Lenders also played a significant part because they had been incentivized by the government to issue home loans to people who genuinely could not afford them. That problem led directly back to government policies and politicians seeking to promote the American Dream for people who, under traditional lending standards, had no realistic chance of sustaining it. This paper examines the causes of the subprime crisis, the ethical issues that underlay it, and what can be done to prevent a similar crisis in the future.

The Causes

The major root causes of the subprime financial crisis were numerous and interconnected. The dot-com bubble at the end of the 1990s and early 2000s led to a collapse in the federal funds rate, which brought interest rates down to between 1 and 2 percent from 2002 to 2005. Low rates made borrowing more attractive to consumers, increasing demand for houses and driving sellers to raise prices sharply. Mortgage lenders were encouraged to extend loans to subprime borrowers because restrictions had been eased; during the 1990s, the Clinton administration had sought to ensure that everyone had the opportunity to own a home and realize the American Dream (McLean, Nocera). The result was a housing bubble created by artificial demand made possible through risky lending practices, with that risk being sold off to yield-hungry investors.

Personal greed was an ethical issue at every level. The owners of firms like Countrywide Financial wanted to profit from the subprime market. Homeowners sought to get rich by selling into the bubble. Borrowers wanted to feel wealthy by becoming "homeowners" of properties they could not have afforded under traditional lending standards. The dot-com bubble that burst at the start of the twenty-first century also contributed by forcing large fund managers — including those responsible for paying pensions — to seek returns elsewhere. The MBS market looked attractive. A global savings glut had occurred following the dot-com collapse, with developing nations reversing course: they stopped running deficits and began saving more. Subprime borrowing rose, and the banking and financial industries were happy to accommodate it because there was strong international demand for fixed yield, and selling these mortgages as fixed-yield instruments satisfied that market (McLean, Nocera).

The shoddy mortgages were bundled into securities and sold to third parties who would slice them into tranches, rebundle them, and sell them again. These financial instruments were problematic from the outset because they were not what they appeared to be. Ratings agencies were being paid handsomely to overlook the junk subprime mortgages accumulating in those bundles. Only people like Michael Burry, who actually examined what was inside the MBSs, recognized they were ticking time bombs (Lewis). Yet even his response was to bet against them — not to warn the world. Personal greed, in short, pervaded every corner of this fiasco.

One of the biggest contributors to the problem was the ratings agencies, which were supposed to assess the likelihood of default on these securities. Moody's and its peers failed to rate them appropriately, so investors believed they were buying AAA-rated securities when in reality they were buying what amounted to junk bonds — mortgage-backed securities, asset-backed commercial paper (ABCP), and collateralized debt obligations (CDOs). The intended logic was to place high-risk mortgages inside bundles alongside low-risk ones so that the high-risk component would be neutralized. The problem was that roughly one in five mortgages was high-risk. When the Federal Reserve began raising rates again in 2006 and the adjustable-rate loans reset higher, defaults cascaded. There were no more buyers, and sellers could not unload fast enough. The MBSs that had seemed like a reliable yield suddenly imploded, and those who had purchased insurance — credit default swaps (CDSs) — on the MBSs stood to make enormous profits, as Michael Burry did. The banks that had sold all those credit default swaps now had to make good on them and, absent a federal government bailout, would have been forced to liquidate.

The Role of AIG and Credit Default Swaps

American International Group (AIG) was a major player in the financial crisis of 2007–2009. The company had been selling credit default swaps and collecting commissions on those sales (McLean, Nocera). AIG had not anticipated that the subprime lending market would turn south as quickly or as devastatingly as it did. The result was disastrous for the global economy: parties around the world were left holding toxic debt and scrambled to buy the kind of insurance that only Michael Burry and a few others had secured. Among those others were the banks that eventually recognized the fraud — Goldman Sachs chief among them — and positioned themselves to profit from the collapse rather than alert investors to what was happening (McLean, Nocera; Lewis).

Credit default swaps functioned as insurance on the bundles of home loans sold to investors. Investors would buy the mortgages for the fixed return, and more sophisticated investors would then purchase CDSs to hedge against the risk of the mortgages not being repaid. Those bundles were supposedly composed of home loans from borrowers unlikely to default, according to their AAA ratings — which was precisely where Moody's was supposed to act as referee and confirm that everything was above board. Moody's, however, was not even watching the game. Many loan bundles ended up packed with tranches of nothing but subprime mortgages carrying high default risk. Investors who recognized this immediately began purchasing CDSs, anticipating a massive wave of defaults — which is exactly what Burry and the other protagonists of The Big Short did (Lewis).

AIG was largely oblivious to all of this and was content collecting its commission on CDS sales, treating the insurance as something that would never need to be paid out. Then the bottom fell out. A flood of defaults arrived, starting with the subprime mortgages that filled the loan bundles being sold to investors. Those who held CDSs now wanted to cash them in — or sell them back at dramatically higher prices — which Lewis describes in detail as the "big short" play.

The largest buyer of AIG's CDSs was Goldman Sachs. Goldman was determined to be paid, which is why AIG received a government bailout: Goldman has historically maintained close relationships in high places. Henry Paulson, former CEO of Goldman Sachs, was serving as U.S. Treasury Secretary at the time of the crisis, and he ensured that AIG could make good on the CDSs it had sold to Goldman. The bailout of AIG was thus, in substantial part, a mechanism for ensuring that Goldman came out whole.

AIG's sales agents were indifferent throughout the lead-up to the explosion in 2007–2008. They collected their commissions on CDS sales that ultimately blew up in everyone else's faces, and then their company received a taxpayer-funded bailout, sparing them from real accountability. AIG survived — unlike Lehman Brothers and Bear Stearns — and continued to operate profitably. The only casualty, it seems, was ethics. But ethics had long since taken a back seat to the business of making money and making sure someone else was left holding the bag when the music finally stopped.

Works Cited

Lewis, Michael. The Big Short. NY: W. W. Norton, 2010.

McLean, Bethany, and Joe Nocera. All the Devils Are Here: The Hidden History of the Financial Crisis. Penguin, 2011.