The panic of 2008 that led to the freezing up of credit markets and the subsequent financial crisis began with the Congress passing legislation that promoted granting the disadvantaged mortgages that they could barely afford. This was called the Community Reinvestment Act. It required banks to make a percentage of their loans to below medium income applicants. These were the first sub prime loans.

 

Sub prime loans were eventually packaged by originating banks into mortgage backed securities (MBS’s), and sold off to insurance companies, pension funds, investment banks, hedge funds, etc., and eventually ended up in the far corners of the world. Rating agencies were charged with rating the quality of mortgages. If a mortgage was rated AAA it could be sold to almost anyone, anywhere. And it was.

Fanny Mae and Freddie Mac, formed as government sponsored enterprises (GSE's), bought mortgages on the secondary market. They pooled them and sold them as mortgage backed securities to investors. Since GSE's are partly government owned, investors rated these mortgages higher than their competitors. It was after all implied that the taxpayer would back these mortgages if ever needed—which is exactly what eventually happened.

Mortgage companies and banks started offering no doc loans ("liar loans" as they referred to in the mortgage business), low teaser rates, and up to 125% mortgages which further increased the amount of mortgage backed securities available to package. Time tested credit standards were dispensed with. Applicants and loan officers alike lied about income and other "deal breaker" details, allowing more sub prime mortgages to enter the system. Soon mortgages became non-recourse loans, meaning that the originators of these fraudulent loans were no longer liable for any losses. They simply sold them off. Mortgage bankers and other financial institutions no longer had any “skin in the game.”  Free of any liability, everyone wanted in on the act. For an in-depth look at what really caused the real estate boom please read my article In Defense of Alan Greenspan.

Wall Street jumped on the bandwagon and created collateralized debt obligations (CDO's). They sliced and diced up mortgages from all parts of the country and from all spectrum's of the risk curve and bundled them into multibillion dollar packages. These non-transparent investment vehicles made it so that no one really knew what they were buying. Normally investors wouldn't touch such an investment but these were rated AAA and sold all over the world.

The Securities and Exchange Commission (SEC), was sadly lacking in performing their oversight duties and actually contributed to the problem. They eliminated all controls on leverage for non-bank parties just as the mortgage frenzy was really getting going. For decades leverage had been held to around 12 to 1 in the commercial and S&L banking system. But a "shadow banking system" developed consisting mainly of unregulated investment banks. Most adhered to the long held 12 to 1 leverage rule that extended to all financial institutions and this general rule provided a degree of risk management.

When the SEC discarded this rule for all non-bank “banks” leverage increased to as high as 45 to 1, levels unseen since the roaring 20's. Hedge funds margined not only fraudulent mortgages but now fraudulent CDO's in billion dollar bundles. The goal had been to spread risk, but in fact the SEC had just allowed it to increase fourfold.

Soon credit default swaps (CDS's) were increasingly being employed to manage risk. These were insurance against defaults on such things as mortgages, municipal bonds, money market funds, etc. AIG led the sale of these instruments and guaranteed them despite not having the money to back up what they were selling. Mortgages were never supposed to go down in value, at least to any large extent, so reserves adequate to back these CDS's weren’t deemed necessary. In most circles this would be called fraud. The world decided to look the other way.

Meanwhile, long-term interest rates fell to historic lows all over the world as savings increased from the worldwide creation and accumulation of wealth--especially in China and India. At the same time the Baby Boomers who were looking to retire soon were buying second homes and/or vacation homes. This led to a real estate boom. Compounding the run into real estate were new investors who’d recently been burned by the stock market dot com crash in 2000. They were looking for an alternative investment, so why not real estate? Real estate always goes up, right? It certainly has to be safer than the volatile stock market…

From 2001 to 2007 home prices doubled despite national inflation rates remaining historically low, and at times there was even a little deflation.  Despite this, real estate continued to skyrocket. “Flippers” and speculators stoked the housing boom. And through all of this, real estate appraisers served their banking clients and investors by valuing homes at whatever the selling price was. Fuel was being added to the fire.

By July 2007 sub prime loans began to default. A few hedge funds began to experience runs. Investors spooked and liquidity started drying up. But mortgages are not liquid like stocks, so many funds could not de-leverage fast enough. What amounted to a slow run on financial institutions, especially the shadow banks, began to affect almost every investment bank and hedge fund around the world. Soon brokerage firms like Merrill Lynch, insurance companies like AIG, and mortgage banks like Countrywide Financial came under suspicion.

As home prices began to fall in 2007 and some institutions bankrupted, the stock market began to decline. All eyes turned to the Federal Reserve Board. What was the Fed's policy? The Fed had held interest rates at very high real rates for over a year. Even though all other market rates had been falling and a whiff of deflation was in the air the Fed, under new Chairman Ben Bernanke, artificially held the Fed funds rate up to an artificially high 5.25%. Even though signs of credit deterioration and liquidity problems were emerging they kept the money supply growth at zero percent. This exasperated the liquidity crisis. Finally, the Fed realized it needed to move and it moved quickly to lower interest rates and increase money growth. But it was too late. Sadly it was behind the curve for over a year.

Adding injury to insult, at the very time the stock market entered a bear market the government made two disastrous moves. First, it imposed the mark to market rule. Mark to market is common in free trade transactions but a government imposed mark to market rule is quite different. Mark to market forced an "official" devaluation of assets and thereby triggered margin calls which only forced further selling of assets. This might be fine in orderly markets, but not in a time of panic, and especially not at a time when there is no market to sell into. Again, mortgages are not liquid like stocks, and by insisting they be marked to a non-existent market; the government accelerated the crisis.

Further, the government allowed the uptick rule to expire for the first time since the Great Depression. The uptick rule discouraged massive short selling. By removing it as a governor on short-selling it encouraged shorting just as the market began to dive. Not only were these questionable moves, they couldn’t have come at a worse time, reducing liquidity just when increased liquidity was critical.

By September 2008, Lehman Bros, a firm that had been around for over a hundred years and survived the Great Depression and every panic and crisis of the 20th century, was being squeezed to the point of possibly going bankrupt. The Fed had the authority to open the discount window and allow it to gain liquidity and at least some breathing room but decided against it. Lehman Bros. folded that Friday. As the ramifications reverberated around the world things worsened dramatically. Bear Stearns and Merrill Lynch came under attack and it was rumored either could “go under” by Monday. The Fed opened the discount window to all comers and prevented a major international monetary crisis from deteriorating into collapse.

Eventually Merrill Lynch and Countrywide were bought by BOA, and Washington Mutual was bought by Chase. AIG, Freddie and Fanny were taken over outright by the government. I believe that the failure of the Fed and the Treasury to come to the rescue of Lehman Bros. led to the subsequent credit crisis which still is with us today.