How did the US mortgage crisis transform into a general banking crisis?
(For a simpler explanation watch this 11-minute video)
This essay will take the US mortgage crisis as a given, and focus on the mechanisms by which the housing crisis was turned into a banking crisis. The emphasis on this essay then lies not on the origin and causes of the subprime mortgage crisis, but rather how that crisis was amplified and transformed into a general banking crisis. Before turning to the first mechanism though, I will briefly outline how the market underestimated the risk inherit in the subprime mortgage market. Against this backdrop, I will show how the introduction of the ABX index exposed the weakness of the housing market and the subsequent deterioration in the balance sheets of banks. But we also need to look at the global scale from which the US mortgage crisis was transformed into a general banking crisis. It began with two German banks, which heavily invested in the US subprime mortgage crisis and this then led to a general worry in banking institutions. These worries rippled through to US banks such as Bear Stearns and Lehman Brothers, which then increased volatility and uncertainty in financial markets.
Further, I will evaluate the liquidity of the assset-backed commercial paper market and how the loss and margin spiral precipitated a general banking crisis. I will then examine three further mechanisms. First, the lending channel that dried up between banks and that led banks to hoard additional funds. Second, runs on financial institutions, such as the one on Northern Rock or to a lesser degree the indirect run on Bear Stearns. Third, network effects, which arise when financial institutions become both borrower and lender help contribute to exacerbate the US mortgage crisis.
The first mechanism by which the US mortgage crisis turned into a general banking crisis was the introduction of the ABX index in early 2006, which exposed the risk that had been underestimated by everyone in the financial sector in the year leading up to the crisis. Subprime default risk was excessive and substantially underestimated during 2003-2007. Forward-looking estimates of risk were ignored and compensation for asset managers created incentives to undertake underestimated risks. The U.S. Federal Reserve since 1982 gradually decreased interest rates and large inflows of foreign capital flooded into the U.S. economy. The government encouraged risk-taking in the mortgage market and created an environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. For example, Fannie Mae and Freddie Mac actively promoted affordable housing and this resulted in investments into highly risky subprime mortgages.
Between 1980 and 2007 the volume of GSE-backed mortgage-backed securities grew from $200 million to $4 trillion. The Federal Home Loan Bank System subsidized lending for housing finance, and the Federal Housing Administration subsidized extremely high mortgage leverage and risk. Further, in 2006, government legislation encouraged rating agencies to ease standards for subprime securitization. President Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases among lower income groups, whereby lenders were encouraged by the administration not to press subprime borrowers for full documentation. Those who knew best the flakiness of subprime loans bore the least risk, because they could make a hundred percent loan-to-value loan to someone who had no income, job or assets and sell it on the same day to one of the big banks in the CDO business.  By 2006, over half a trillion dollars of CDOs had been sold, of which around half contained subprime exposure and as it turned out many of these CDOs had been seriously over-priced, as a result of erroneous estimates of likely subprime default rates.
The mechanism that exposed all of this was the ABX index that started trading in early 2006. Prior to the index, there was no mechanism for the revelation and aggregation of diverse information about the effects of the house price decline and the foreclosures. Even though dealer banks had the information about the subprime-related structures, there was no way to learn the consensus value of these bonds and structures until the ABX index started trading. The ABX index provided a transparent price of subprime risk and it allowed for efficiently shorting of the subprime market. The introduction of the ABX index coincided with the fall of house prices, so ultimately the index revealed that the value of subprime mortgages was declining, and it was rather declining quickly. The information that the ABX index revealed was then slowly translating into a general banking crisis. Many banks had been heavily involved in the US mortgage market, and when the weakness of that market became exposed, many banks had to write down huge losses.
The next mechanism by which the US mortgage crisis turned into a general banking crisis came through Europe, which then precipitated a banking crisis in the United States. It began with the failure of two relatively small German institutions, the IKB and the Landesbank Girozentrale Sachsen. These apparently isolated incidents led nevertheless to generalized worry about the stability of banking institutions, and many banks started to worry about the stability of banking institutions. Later, the bailout of Bear Stearns was interpreted as a sign that Wall Street had failed, but also as an indication of the willingness of the government and the regulatory authorities to step in with dramatic measures that stretched the legal limits on their capacity for action. 
There was an attempt by banks to help themselves, but those steps were not sufficient because of the speed at which securities fell. As housing prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses. When UBS announced a fourth quarter loss of $11.3 billion, it sent a shockwave through the financial system. Despite the saving of Bear Stearns and the increased lending activity of the Federal Reserve, it did not stop the spread of problems in the financial sector. When Henry Paulson decided against bailing out Lehman Brothers, he was first hailed for not putting taxpayer money on the line.
However, the rapidity of the Lehman collapse and the scale of its losses were clearly problems not just for Lehman, but also for every financial institution that had dealings with it.  For example, Lehman had $130 billion in outstanding bonds. As a result remaining investment banks became highly vulnerable. Goldman Sachs and Morgan Stanley filed to be recognized as a bank holding groups rather than an investment banks. On account of a financial system that had been very much interconnected, the failure of Lehman had also affected AIG. The problem was that AIG had written over $400 billion in derivative contracts, mostly credit default swaps that protected contracts, mostly credit default swaps. Even though AIG was not a bank, it essentially behaved that way. More generally, the broader aspects of a bank rescue plan remained shrouded in uncertainty, with frequent policy reversals.  This uncertainty probably exacerbated the problems further. The fact that the US mortgage crisis originated in the United States, but spread throughout the rest of the world is testament of the globalized and interconnected against which we have to understand the mechanism by which the US subprime mortgage crisis was turned into a general banking crisis.
The world may have been interconnected in the past, as in the first era of globalization, or as exemplified with the first Baring crisis at the end of the 19th century, but the rapidity through which the US subprime mortgage market transformed into a general banking crisis throughout the world is hard to find elsewhere.
Another mechanism by which the US mortgage crisis turned into a general banking crisis was through liquidity spirals. When asset prices drop, financial institutions’ capital erodes while lending standards and margins tighten at the same time and this causes fire sales, pushing down prices and tightening funding even further. The mechanisms that explain why liquidity can suddenly evaporate operate through the interaction of market liquidity and funding liquidity. When liquidity then dries up, it can transform a small shock into a financial crisis. The first spiral through which the US mortgage crisis turned into a general banking crisis was the loss spiral.
A loss spiral arises for leveraged investors because a decline in the value of assets erodes the investors’ net worth much faster than their gross worth and the amount that they can borrow falls. Given that many banks and hedge funds were highly leveraged, and leveraging is financed through short-term debt, it created a contagion effect whereby everyone sold at the same time, and this depreciated prices rapidly. Others even engaged in predatory trading by shorting the subprime mortgage market. The second spiral through which the US mortgage crisis transformed into a general banking crisis was the margin spiral. As margins rise, the investor has to sell even more because the investor needs to reduce its leverage ratio and this leads to a general tightening of lending. A vicious cycle then emerges, whereby higher margins force deleveraging and more sales, which increase margins further and force more sales, leading to the possibility of multiple equilibria. Margins usually increase when volatility is expected to rise. Prior to 2007, the asset-backed commercial paper market was considered risk-free, but in the fall of 2007 it completely dried up.
In August 2007, the over-collateralization cushion evaporated, making the assets much more risky and investors unwilling to let structured investment vehicles rollover their debt. Further, because of increased volatility and uncertainty about the asset-backed commercial paper market, financiers are much more careful about accepting assets as collateral, because they do not want to be stuck with the less valuable portion of the collateral. This effect is exacerbated by the fact that the asset-backed commercial paper market in 2007 was comparatively not as liquid as the bond and the stock market. Therefore, being highly leveraged in a relatively illiquid market was a recipe for disaster and made the US mortgage crisis much harder to contain.
There are three further mechanisms by which the US mortgage crisis turned into a general banking crisis: through the lending channel, runs on financial institutions, and network effects. Whenever banks become concerned about their future access to capital markets and start hoarding funds consequently, regardless of whether the creditworthiness of borrowers is impaired or not, the lending channel dries up. A run on financial institutions such as Lehman Brothers or Bear Stearns can then quickly trigger a domino effect in the financial system. The problems in the interbank lending market in 2007 are a good example of precautionary hoarding by individual banks. As it became apparent that conduits, structured investment vehicles, and other off-balance-sheet vehicles would likely draw on credit lines extended by their sponsored bank, each bank’s uncertainty about its own funding needs skyrocketed.
Further, banks did not really know to what extent other banks were affected and therefore uncertainty about accessing the interbank market arose. As a result, the interbank market interest rate LIBOR increased substantially. Even though classic bank runs, such as the one on Northern Rock, are the exception on account of deposit insurance, there were other kinds of bank runs. When hedge funds, which typically park a sizable amount of liquid wealth with their prime brokers, pulled out their funds out of Bear Stearns, it caused a bank run. AIG later experienced a margin run. Therefore, in 2007-2008 we had a situation by which lending between banks was extremely tightened and the collapse of Lehman Brothers, in addition to extreme fragility of other financial institutions such as Bear Stearns and AIG, heightened uncertainty and volatility.
This, ultimately, led to credit markets being frozen, especially considering that many positions in the subprime market had been highly leveraged, and the asset-backed commercial paper market until 2007 was neither transparent nor highly liquid. Network effects arise when financial institutions are lenders and borrowers at the same time and this may cause a gridlock in which multiple trading parties fail to cancel out offsettng positions because of concerns about counterparty credit risk. This leads banks to hold additional funds to protect themselves against that risk. For example, when Lehman filed for bankruptcy, in the following week all major investment banks were worried that their counterparties might default.  To protect against that risk, those banks all bought credit default swaps. The already high prices on credit default swaps of the major investment banks almost doubled. 
Theoretically, within a given network of interest rate swap arrangements, all positions could be fully netted out in a multilateral netting agreement. However, the introduction of structured products that are typically traded over the counter has made the web of obligations in the financial system more opaque, consequently increasing systemic risk. It was the interplay between mechanisms such as the lending channel, runs on financial institutions, and network effects that pushed the US mortgage crisis into a general banking crisis.
The mechanisms by which the US mortgage crisis was turned into a general banking crisis are multi-fold. It was not one single mechanism, but rather the interplay of different mechanisms that exposed the US mortgage crisis so viciously and rapidly. The ABX index revealed information that had been previously lacking and when this information shifted into the public, and investors became aware of the underlying problems with the US mortgage crisis it quickly turned into a banking crisis. The global character of the crisis can been seen through the European specter when German banks affected by buying up subprime mortgages send a bad signal to the market, and thus, in turn, affected American banks. Further, the risk-inviting government policy, which offered cheap credit, built up credit, and subsidized risk via GSEs, explains not only the origin of the US mortgage crisis but also why it could not be contained and spread into a general banking crisis.
The liquidity problem, which arose from short-term financing and a maturity mismatch further exacerbated the US mortgage crisis. The other three mechanisms in terms of network effects, run on financial institutions, and lending channels tipped the balance of the US mortgage crisis and made it contagious. The uncertainty and fear that was then created spread to the banking sector, which later caused a stock market crash. In 2007, Chuck Prince, the former chairman and chief executive of Citigroup compared the impending crisis with a game of musical chairs. When the music stops, in terms of liquidity, things will be complicated but as long as the music is playing, you have got to get up and dance. Everybody was so busy making profits, that not much thought was given to what would happen if the housing market stopped rising.
What stands out above all is the irrational exuberance that could be exhibited within the housing market. This bubble was fueled by the government and the private sector, and led to a huge mispricing of the subprime market. The crisis turned into a banking crisis because risk across the board was underestimated, and transparency was all together lacking.
Essay on The Subprime Mortgage Crisis
1374 Words6 Pages
The subprime mortgage crisis
The argument over who is at fault for the housing market collapse has been a heated issue amongst government, politicians, banking institutions, and mortgage lenders. The subprime mortgage crisis is an ongoing financial issue and real estate nightmare for the United States economy. A dramatic increase in mortgage delinquencies and foreclosures has caused a significant adverse effect on banking institutions and financial markets. Due to this mortgage crisis, the housing market subsequently has crumbled resulting in a record numbers of home foreclosure and more are still looming in the horizon. For many, the dream of home ownership has become a real nightmare. Who is really at fault? Should minorities groups…show more content…
Joseph E. Stiglitz, a professor at Columbia University points out the causes proposed include the inability of homeowners to make their mortgage payments, due primarily to adjustable-rate mortgages resetting, borrowers overextending, predatory lending, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, bad monetary and housing policies, international trade imbalances, and inappropriate government regulation, (Stiglitz, 2008).
Subprime mortgages loans were those attractively packaged and offered to people who normally did not qualify to get an ordinary loan. Because the default rate is much higher, banks would charge a lot more for people in this high risk group. That will mean people who could not qualify for a home loan ended up paying more for their mortgage. These loans were provided to people with poor credit or no credit from poor neighborhood, and minorities groups. Specially targeted were the African-American and Hispanics groups. It has been argued that subprime mortgages and lending practices towards minorities by the banking and mortgage lending institutions has been a growing and heated political discussion. “Democrats and their advocacy groups also prodded Fannie Mae and Freddie Mac to buy the high-risk NINJA (no