Clarifying the Financial Crisis: The Banks
The Big Short, a recent Hollywood movie detailing the underdogs who bet on the housing collapse and ensuing recession, has once again refocused society’s attention on the financial system and its shortcomings during the Great Recession of 2008. Grossing $132 million worldwide since its release, the film brings to life Michael Lewis’s depiction of the brilliant men who “went short (bet against) the global financial system.”
What did these underdog investors see, which economists and government regulators missed? On a larger scale, what impact did this crisis have on the global banking system? In order to answer these questions, we must examine what instigated the crisis. Most people who watched the film would offer answers such as “subprime mortgages,” “CDO’s,” or “derivatives.” These were, indeed, some of the reasons why the entire financial system almost came crashing down during the economically grim years of 2007-2009. For those who aren’t familiar with these terms because they didn’t see the movie or (spoiler alert!) didn’t pay attention to the film using Selena Gomez to describe these terms, here’s a rundown.
Starting in the early-mid 1990’s, the world, particularly the United States, started to experience positive trends in GDP (global production), job creation, low inflation and all the good things that go along with these conditions, including a stock market boom. Libertarians and Republicans might attribute the boom to lesser government regulation originating during the Reagan administration. Others might credit the success to the proliferation of technology and to the increasingly global economy which resulted in higher trade output for many developed countries. Regardless of the exact cause, people were happy, especially the ones who had invested in the stock market. Although there were some bumps in the road, corporate earnings and global growth were on the rise. As conditions consistently improved, the providers of capital, the banks, got a little too giddy. With government encouragement, they attempted to boost or inflate homeownership rates for minorities and low income borrowers, which would lead to higher revenue from the loan interest. They executed this by relaxing their loan quality discretion so that they could provide more loans to people. However, it wasn’t only the government and private sector that acted negligently. Consumers also became irresponsibly aggressive, buying houses they couldn’t afford, hoping that they could sell it for a premium a year or two later. This created a real estate bubble. Housing prices kept going up but without any real fundamental reason for it.
Banks started to experiment with the creation of new financial instruments using a process known as securitization. The technical details of these instruments and the process of securitization are complex. Securitization is basically the following: banks purchased individual residential loans or mortgages, packaged them together into a MBS (the Mortgage Backed Security is a derivative, in other words it’s value is based off the performance of an underlying entity- for example a mortgage), then sold them to “sophisticated” investors, and collected on fees. Investors purchased these instruments often with little due diligence on the quality of the loans. Instead, they focused on the lucratively high rates of interest received from the mortgages. These new products started to trade like any other financial instrument, or security. As opposed to a stock or bond which is basic, or plain vanilla security, banks and insurance companies started to dabble with more complex, or exotic instruments. These complex sounding instruments became a large part of the banks’ balance sheets over the 1990’s and into the 2000’s. To sum it all up, with the globalization of the world economy and the complexity of the derivatives market, few realized what the effects of a potential downturn in the housing market would have on the underlying value of these instruments, and the grave consequences a downturn would have on financial markets.
In addition to the banks pushing these reckless mortgages, another major contributor to the meltdown was a concept known as leverage. In other words, many of the big investment banks (think Goldman Sachs, Lehman Brothers, Morgan Stanley, etc.) used debt (borrowing) to buy new assets, instead of just using profits received from regular business operations. This allowed for them to put less money down for a higher dollar amount of assets, since the debt covered most of their purchases. If those assets rose in value, the banks’ profits would be significantly higher relative to their initial investment, but if the value went the other way, the cost of borrowing would be much higher than the investment. In response, the bank would have to sell off other assets to pay back the loans used to execute the leverage.
Leverage allowed banks, for instance Lehman Brothers, to hold assets worth $691 billion while only having a shareholder’s equity (amount they in actuality own) of $22 billion in 2007, an astounding debt-to-equity ratio of 31 to 1. As the housing market rode higher, more and more of these leveraged instruments were mortgage-intensive insurance contracts. The premiums from these insurance contracts were seen as easy money, as almost no one saw a significant decline in the housing market as a real risk.
In reality, even in any environment, the kind of leverage the banks were taking was extremely risky, but unfortunately, the banks were indirectly encouraged to pursue high leverage by the government. Fannie Mae and Freddie Mac, both government backed private companies, were pushed to promote an increase in homeownership rates among lower income demographics. This automatically entailed higher risk of defaults. Along with low mortgage rates, average Americans were enticed by the little restrictions put on new types of mortgages. Many people bought houses using adjustable rate mortgages or teaser rates that they would not be able to afford if mortgage rates rose. While most of America was blind to all of these flaws within the housing market, the underdog investors in The Big Short seized on the housing bubble. They did the unthinkable and bet directly against the housing market, the heart of the American economy.
In 2007, with the banks’ balance sheets at record highs and the market for credit default swaps growing daily, banks and insurance companies of all sizes, many of them levered up, became interconnected in this complex web of derivatives contracts. The impact of all these firms being connected was that if an unusual event took place and one firm had too big of a loss on its contracts and couldn’t pay up, a domino effect would occur leaving all firms affected by the one insolvent party. Soon enough, the unusual event, a drop in housing prices, became a reality. As mortgage rates went up, so did the defaults on many home mortgages. A lot of the loans the banks made were losing value. As a result of the high leverage, the losses were magnified and then liquidity (cash available to pay back debts) started to dry up at the big banks. As losses mounted, the investment bank Bear Stearns fell in early 2008 and Lehman Brothers famously followed in September. Many mortgage and insurance companies similarly collapsed. AIG, one of the biggest global insurance companies, had to be bailed out by the government to the amount of $85 billion.
As the dust settled, new regulation was prepared. Banks were going to have to answer for a lot of their risky dealings during the boom years. The most impactful piece of regulations was the Dodd-Frank Wall Street Reform Act of 2010, especially sec. 619, the Volcker Rule. This rule forced banks to rethink how to replace much of their profits made during the boom years.
To understand the Volcker Rule, it helps to gain familiarity with legislation that came about from an earlier economic crisis, The Great Depression. After the Depression, Congress passed the Glass-Steagall Act, which barred banks from engaging in stock trading. To put it simply, banks would be disallowed from trading using their customer’s deposits. Instead, they would have to choose between becoming a commercial banking operation or investment banking operation. (Think your local bank branch in town versus the big skyscrapers in New York City.) This act was in place for 66 years but was repealed in 1999, opening the floodgates for financial firms to bank on (pun intended) bigger profits with their newly accessible client capital.
Similar to the Glass-Steagall Act, the Volcker Rule set up restrictions on banks to engage in proprietary trading, or using the bank’s own money for direct gain from securities. Preventing prop trading would keep the banks from taking too much risk on their own capital. If certain high risk bets went the wrong way, the government would have to step in again to protect the banks from failing. After being passed in 2013, the Volcker Rule cut off what used to be a high profit center for the banks.
Getting back to my initial question of what the effect the crisis has had on the global banking system, although many banks haven’t shrunk in terms of asset size since the crisis, they’ve had to rethink their business models to respond to the new regulation enforced on them by Congress. For example, one of the leading investment banks, Morgan Stanley, has beefed up its wealth management department by focusing more of its resources on wealth management services and by buying out Citigroup’s wealth management arm, Smith Barney. Additionally, banks have also had to put aside money for settlements with the government over the misconduct during the crisis. One of the largest settlements came in 2014, when Bank of America had to settle for $16 billion. The most recent settlement was a $5 billion penalty levied against Goldman Sachs.
Looking forward, it is tough to be sure what the future of banking holds, but for the time being, there is no question that banks have to keep much more capital in reserve for those “just-in-case” scenarios. They also can’t act as carelessly as they did pre-crisis as a means of soaking up profits; rather, what banks will need to do is focus on their core operations and what really brings value to the economy. This includes providing credit for corporate and individual clients, advising companies on corporate actions, and making markets for equity and fixed income products. As the global economy grows, banks will be there to provide for the capital needs of the people and companies so that they can all reach their financial goals. Regarding the social perception of banks, financial institutions have to work towards regaining the public’s trust and show how they are for the individual’s economic progress along with their own corporation’s growth.
