Lesson 17: Anatomy of a Recession Part 2: The Housing Bubble
Between 2000 and 2002, the United States suffered a series of economic injuries which drove us into recession: 1. The dot-com bubble burst as President Clinton was leaving office. 2. September 11, 2001. 3. An extensive culture of accounting fraud was uncovered, epitomized by major scandals at Enron, Fannie Mae, WorldCom and Tyco. In order to prevent these blows from knocking us into a depression, President Bush passed a series of tax cuts, and the Federal Reserve a series of interest rate cuts. In fact, the fed cut rates all they way down to 1%, which ignited home buying. The buying frenzy was fueled by actions taken by the Clinton administration to promote low-income mortgages, called sub-prime mortgages. (See Lesson 16). This was a whole new borrowing population and a big market. As greed took hold, banks trolled for poorer and poorer borrowers. They devised attractive packages, such as the temporary, interest-only loan and the adjustable rate mortgages (ARMs) with "teaser" rates. Banks and borrowers became increasingly sloppy or dishonest about income verification. As housing prices rose, new lending opportunities arose across income brackets with products such as home equity loans. Bankers and borrowers alike assumed that housing values would keep rising, interest rates would stay low, and a day of reckoning would never come.
How could risky loans possibly be profitable for any bank? Because they didn't collect them. They bundled them into packages called Mortgage-Backed Securities (MBS) and sold them to bigger banks. Why would a bigger bank buy them? To turn them into investment products and sell them to investors. They were able to sell them by splitting them up into risk categories called tranches. (Tranche is the french word for slice.) Loans of the same tranche were packaged together into investment products called Collateralized Debt Obligations (CDOs). High-grade (low risk) and even medium-grade CDO's could be sold to highly regulated institutions such as pension funds, mutual funds and insurance companies. The riskier CDO's could be sold to hedge funds, who needed risk to round out their portfolios. Unfortunately, the Gramm-Leach-Bliley Act of 1999 allowed most of these different activities to occur in the same company. (See Lesson 16). Even more unfortunately, all of these CDO's were being over-estimated.
Why were they being overestimated? For 2 reasons: 1. The ratings companies, such as Moody's or Standard & Poor, were on the take. (Conflict of interest is the polite expression). They were being paid by the same companies that sold the securities that were being rated. 2. The risky bonds could always be sold to Fannie Mae and Freddie Mac, who were buying them up like crazy. They were buying them up because they (Fannie and Freddie) were insured by the government, which is insured by you and me.