A faulty foundation

Derivatives were not the root cause of the global financial crisis.

By VIVA HAMMER
House made of cards 311 (photo credit: Courtesy)
House made of cards 311
(photo credit: Courtesy)
In ancient times, a queen presiding over a financial crisis might distract the masses by launching a crusade, a pogrom or a courtship with a foreign king. Today, our elected leaders blame derivatives. One could say it’s an improvement in morality but not necessarily in sophistication.
The American financial collapse is both simple and complex. At its root are mortgages that were issued to people who couldn’t afford them. Those mortgages were sold and bundled, the bundles were sliced up and resold, and then derivatives were written on the slices. Pieces of those bad mortgages were cherished by banks, pension plans, hedge funds and governments.
Derivatives meant that the exposure could be multiplied ad infinitum. When the bottom of the economic pile – the mortgages – turned rotten, the entire structure collapsed.
Let’s start at the bottom of the pile. In the early 2000s, interest rates were low, and that made homes more affordable. In America, people with good credit can get 30-year fixed interest mortgages. During the same period, home loans became available to people with poor credit: The government wanted to increase home ownership, investors wanted higher yields and new types of loans were being engineered.
When I was at the US Treasury, we used to whisper in the corridors about the phenomenon of the NINJA loan. That is, home loans to people with no income, no job, no assets. Shockingly often, the loans were made based on information falsified by greedy mortgage brokers. These loans had terms too complicated for borrowers, with interest that reset after a honeymoon period. In the early 2000s, lenders weren’t worried about loan repayments because housing prices were appreciating, and if you couldn’t pay, you could always sell.
NINJA loans were then sold to institutions that pooled them and then securitized them. That means, they divided the expected cash flows from the loans and sold the rights to the cash flows to investors. The cash flows were divided so that the people buying the top “tranche” would get the first cash flows coming from the mortgages, up to a certain rate of return; the second tranche would get whatever was left over after the first tranche up to a certain rate of return; and so on until the bottom tranche – that was called nuclear waste.
The tranches were given ratings by specialized agencies – an assessment of how likely they were to pay out what they promised. Banks, pension funds and regulators relied on these ratings to determine how risky the investments were.
Then, other financial institutions wrote credit derivatives on these tranches of bundles of mortgages. Those credit derivatives were contracts that required one party to pay another party the exact replica of the payments on the tranches – in exchange for premium payments. Those same institutions wrote other kinds of credit derivatives, too.
Particularly, credit default swaps, in which one party pays another party the face value of a bond if the bond defaults – in exchange for premium payments.
The credit derivatives allowed exposure to the mortgages to be multiplied infinitely. There is no requirement for anyone to own the bond or tranche in order to write a derivative on it. It’s just a financial bet.
What happened when interest rates increased in the mid-2000s? People with floating interest loans couldn’t pay the increased rates; and when they tried to sell, they found that their homes were no longer appreciating. New home buyers could only look at less costly homes because interest was a bigger part of their monthly mortgage payment. Loans started defaulting.
Investors who had bought “safe” tranches from securitizations found that they were not getting the cash they expected. Credit derivative sellers were making payouts they never expected to make. Interest rates continued to rise, defaults increased, home prices declined and the effects were felt in a geometric fashion.
It was as if the bad mortgages had been reproduced and hung on the walls of every financial institution. When one was shown to be a forgery, all the reproductions fell, too. Then panic set in, and that’s the complex part there’s no space to talk about here. But the basics are simple: Loans were made to people who couldn’t pay, then the loans were sold and pooled and sliced and diced and shared around, then reproduced. One late payment reverberated everywhere.
Wisely, the governor of the Bank of Israel forced Israeli banks to get rid of their derivative investments in these bad loans early enough for Israel to escape from the worst effects of the crisis. He was unpopular at the time, but all prophets are.
The first rule of civilization is to tell the truth. If an entire economic system is built on making loans based on false documents to people who are never expected to pay back, that system will collapse. You can blame it on derivatives or on any number of other things, but really it’s the natural consequence of bad morals.
Americans are now paying the price for their insatiable appetites and profligacy in the form of the gargantuan 2,300-page Dodd-Frank financial reform law. Another exercise in profligacy – this time of the legal kind. Americans do seem to think that the bigger something is, the better it must be.
But you only need one rule, which takes up half a line: Midvar sheker tirhak. Keep far away from falsehood.
The writer is a tax partner at a firm in Washington. She was formerly associate tax legislative counsel in the Office of Tax Policy at the US Treasury Department. vhammer@brandeis.edu