Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  One reason might be that the market was irrationally exuberant and believed the poppycock that house prices would never go down. There is, however, mounting evidence that much of the boom and bust was concentrated in low-income housing, suggesting that this was not generalized irrationality and that other factors may have been at play.13

  A more plausible argument is that the strong government push for home ownership by lower-income households led to an enormous increase in the volume of money poured into this sector. The brokers, lenders, packagers, and rating agencies simply did not have the personnel or capacity to manage the enormous workloads effectively. Although they may have worried about potential damage to their reputation from the slipshod work they were doing, the enormous fees they generated apparently allayed those worries.14 For example, many of New Century’s senior managers were industry veterans who knew they had the license to print money only for a limited time: even as New Century’s liquid assets fell in the period 2005–2007, as it was forced to absorb losses on loans it had to take back on its books, its dividends per share increased.15

  This is not a complete argument, for it only kicks the conundrum one step down the road. It explains why the investment banks (and rating agencies) acted as boosters for New Century’s faulty mortgages, but not why they could sell them to others at a hefty premium. Either the final buyers were fooled by ratings or there was strong demand for these originations, without much thought to underlying price or quality.

  Certainly some of the bureaucratic pension funds and foreign banks did not care what they bought so long as it promised a high yield and was rated AAA, though they should have wondered why they seemed to be getting return without risk. Hindsight suggests they should have trusted less and verified more, even if they believed in the institutions of arm’s-length markets, such as rating agencies. But the damage was also done by agencies like Fannie and Freddie, which had to buy an enormous fraction of subprime mortgage-backed securities to meet a government-imposed quota, and by government organizations like the Federal Housing Administration, which contributed to the unsustainable demand in this segment of the housing market. As Peter Wallison of the American Enterprise Institute points out: “As of the end of 2008, the Federal Housing Administration held 4.5 million subprime and Alt-A loans. Ten million were on the books of Fannie Mae and Freddie Mac when they were taken over, and 2.7 million are currently held by banks that purchased them under the requirements of the Community Reinvestment Act (CRA). These government-mandated loans amount to almost two-thirds of all the junk mortgages in the system, and their delinquency rates are nine to fifteen times greater than equivalent rates on prime mortgages.”16

  As problematic as the mandates was the rapidity of the ramp-up. Given the volumes that the agencies and government organizations were pushed to buy quickly, they could not have exercised a lot of quality control, beyond focusing on the obvious hard parameters such as credit scores, which, as we have seen, proved problematic. Perhaps if politicians had been in less of a hurry to extend home ownership to the poor, the mortgage originations could have been more careful, the oversight by rating agencies more thorough, and buyers more circumspect about what they were buying.

  Where did the buck stop? Not with New Century’s founders, who sold their stock holdings as the firm’s fortunes deteriorated. Not with the brokers, who made fat commissions while the gravy train chugged along. Not with the rating agencies, who did not notice, or chose to ignore, the deterioration in the underlying quality of mortgages. Not with some of the homeowners, who spent to excess while treating homes they should never have owned as virtual ATMs. It stopped with the retiree who was fooled into taking out an expensive mortgage and, at an age when she should be without worries, is now facing eviction. It stopped with the pension funds and insurance companies who are now sitting on sizeable losses that will depress the investment returns of every household that relies on them. And above all, it stopped with the taxpayer, whose dollars bailed out Fannie and Freddie, and who stands behind the Federal Housing Administration.

  Summary and Conclusion

  Financial sector performance, especially in an arm’s-length system where the financier does one-off transactions and rarely has a long-term relationship with the final customer, can often only be measured by how much money the financier makes. The personal checks and balances that most of us bring to bear when we are employed in other activities—we ask ourselves if we are producing a socially useful product—operate less well in finance because, with few exceptions, making money is the raison d’être for the financier. In this competitive environment, small distortions to prices can make the financial sector go significantly off track.

  Many have attributed the excesses to greed. But greed, or more prosaically, self-interest, is the driving force in any type of arm’s-length transaction. It is a constant, and it cannot explain boom and bust. The private sector did what it always does: look for the edge. Unquestioning foreign money and domestic money partly driven by government mandates may have given it the impetus to take subprime lending to its disastrous conclusion. This is not meant to hold the private sector blameless but simply to argue that there are enormous risks in bringing together deep-pocketed investors who are not adequately conscious of prices and risks, and the highly motivated private financial sector.

  The role of foreign investors is particularly interesting. Foreign central banks were confronted with vast dollar inflows as exports to the United States expanded, and as U.S. investors looked abroad to escape from low U.S. interest rates. As the central banks bought dollar assets in an attempt to keep the domestic exchange rate from appreciating, they looked for a little extra return. Being conservative, they had to invest their dollars in debt, and the implicit protection that Fannie and Freddie’s debt enjoyed led them to gravitate toward it. Thus the money pushed out to developing countries by the Fed’s low-interest policy came back to help expand the agencies’ purchase of subprime mortgage-backed securities. Knowing that the agencies enjoyed the implicit guarantee of the government, the foreign central banks really did not care about the risks the agencies took. Somewhat ironically, the developing country central banks did to the United States what foreign investors had done to them in their own crises.

  Equally problematic were private foreign investors like the German Landesbanks, which trusted the ratings on mortgage-backed securities and, together with Fannie and Freddie, bid up the prices for these securities, making them far more attractive to create than they should have been. The emerging market crises that I described in Chapter 3 indicated the difficulties that arise when a relationship-based system is financed with arm’s-length money. To some extent, what we see in the recent crisis are the problems created when the arm’s-length system is financed with foreign and domestic quasi-government money that is less sensitive to price and risk.

  The story of the current crisis does not end here. Somehow the private financial sector contrived to convert its edge into an instrument of self-destruction, for the commercial and investment banks that packaged the mortgages together and sold mortgage-backed securities ended up holding large quantities of them. More than anything else, this phenomenon is what transformed what would otherwise have been a contained U.S. housing bust into a devastating global financial crisis. To understand why this happened, we have to delve deeper into the motivation of the modern banker, going beyond returns to the nature of risk. I investigate that question in the next chapter.

  CHAPTER SEVEN

  Betting the Bank

  ROUGHLY 60 PERCENT of all asset-backed securities were rated AAA during the lending boom, whereas typically less than 1 percent of all corporate bonds are rated AAA. How could this be, especially when the underlying assets against which the securities were issued were subprime mortgage-backed securities? Was this a sham perpetrated by the rating agencies?

  Theory suggests it did not have to be a sham. In certain circumstances, a significant percentage of the securities issued ag
ainst a package of low-quality loans can be highly rated.1 An example and some simple probability analysis can make the point. Suppose two mortgages, each with a face value of $1 and a 10 percent chance of total default, are packaged together. Suppose further that the investment bank structuring the deal issues two securities against the package—a junior security with face value of $1 that bears the brunt of losses until they exceed $1, and a senior security that bears losses after that.

  The senior security suffers losses only if both mortgages default. If mortgage defaults occur independently (that is, they are uncorrelated), then the senior security defaults only 1 percent of the time. This is the magic of combining diversification with tranching the liabilities—that is, creating securities of different seniority. Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low.

  In normal times, the correlation between residential mortgage defaults is low, because people default only because of personal circumstances such as ill health or because they lose their jobs (for cause, rather than as part of a general layoff). No one really knew what that correlation would be in bad times, when many people might lose jobs because of the poor economy and house prices might fall across the country, making refinancing hard. If the correlation was still low, then the ratings were appropriate. If the correlation was high, then all bets were off—if, for example, the correlation was 1, then the senior securities would default as often as the junior securities, that is 10 percent of the time.

  The AAA-rated tranches of mortgage-backed securities looked very attractive because they offered a higher return than similarly rated corporate securities. But some should have paid a far higher return because they were in fact very risky. Default correlations were much higher than the rating agencies or investors anticipated. First, the quality of the originated mortgages was low, and many borrowers relied on refinancing as house prices rose to make their payments, so a fall in house prices and the drying up of refinancing almost ensured default for many. Second, far too many packages were poorly diversified across areas: too many mortgages came from the same suspect, aggressive broker from the same subdivision in California.

  Indeed, the fact that so many banks were exposed to the same diversified pools increased the likely default correlations, for banks across the country would simultaneously cut back on mortgage lending and refinancing if there was a problem in the market. This collective response would ensure that the problem spread across the country. Of course, the good times gave no inkling of the size of the problem, because in an atmosphere of rising prices and easy refinancing, no one defaulted. Much like a financial Venus flytrap, though, AAA mortgage-backed securities masked their risk with their ratings, and their attractive returns drew in many an investor innocent about finance and many more who should have known better.

  Among the firms that should have understood the risk better was the American International Group (AIG). Its now-infamous financial products unit (AIGFP) sold insurance through credit-default swaps on billions of dollars of asset-backed securities, including senior (AAA-rated) tranches of the mortgage-backed securities described above. It promised buyers of the swaps that if the insured securities defaulted, AIGFP would make good on them. The unit was thus betting that defaults would be far rarer even than the market anticipated. Privately, AIGFP executives said the swaps contracts were like selling insurance for catastrophic events that would never happen: they brought in money for nothing! As was widely reported in the media, AIG recognized billions of dollars of profits over this period, and AIGFP’s head, Joseph Cassano, pocketed over $200 million in compensation.2

  However, in 2007 and 2008, the asset-backed bonds that AIGFP insured plummeted in value as the economy slid into recession, mortgage-default correlations proved larger than anticipated, and defaults became more likely. Even though few bonds actually defaulted, AIGFP’s liability on the swaps it had written increased steadily as it became more likely that AIGFP would have to pay out. As late as 2007, Cassano maintained confidently that “it is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions,” even while AIGFP was losing billions of dollars as it had to mark its portfolio down.3 Eventually, the losses became too heavy to ignore, and Cassano was let go. But he wasn’t fired: he “retired,” with a contract paying him $1 million a month for nine months and protecting his right to further bonus payments. AIG’s counterparties started demanding collateral to ensure that AIG would make good on its swap liabilities. In September 2008 AIG started the process of becoming the recipient of the largest monetary bailout in U.S. history, receiving more than $150 billion from the U.S. government.

  Tail Risk

  Although it is not surprising that risky mortgage-backed securities were created, it is surprising that seemingly sophisticated financial institutions, including those who originated these securities, held on to significant portions of them. These were typically AAA-rated securities, which had some default risk associated with them. Financial firms also took on other kinds of default risk, such as the securities issued by the collateral loan obligations where they had parked the loans made to finance acquisitions and buyouts. To top it all, many of these investments were financed with extremely short-term debt, ensuring that if problems emerged with the asset-backed securities, the financial firms would have immense problems rolling over their debt.

  Why did financial firms take on both the default risk associated with highly rated asset-backed securities and the liquidity risk associated with funding long-term assets with short-term borrowing? As I explain in this chapter, the particular way these risks were constructed made them especially worth taking for large banks—indeed, perverse as it may seem, it made sense for banks to combine both risks.

  There was something special about the nature of these risks. Clearly, banks felt that default was unlikely. Not only were the securities issued against a diversified pool of mortgages or loans, but also the securities the banks held (or that AIG guaranteed) were senior, highly rated ones, so that defaults on the mortgages or loans had to be numerous to trigger off default on the securities. Similarly, the chances that financing would dry up were also deemed small. These risks were, then, what are known as tail risks, because they occur in the tail of the probability distribution—that is, very rarely.

  A second feature of these risks, though, was that systemwide adverse events would be necessary to trigger them: to cause the senior securities to default, mortgages across the country would have to default, suggesting widespread household distress. Similarly, funding would dry up for well-diversified, large banks only if there was a systemwide scare. A third feature, perhaps the most important one from society’s perspective, is that these risks are very costly when they are realized, so they should not be ignored despite their low probability.

  Unfortunately, these very features of systemic tail risks ensure that they are ignored by both financial firms and markets. Ironically, this also increases the probability that they will occur. When bankers attribute their problems to an unlikely event akin to a one-in-ten-thousand-year flood (thereby implicitly absolving themselves, for who could anticipate such a rare event?), they neglect to mention that their actions have increased the probability of such an event—to something like one in every ten years, approximately the periodicity with which Citibank has gotten itself into trouble in the past three decades.

  I describe here how the structure of incentives in the modern financial system leads financiers to take this kind of risk. I next discuss why the corporate governance system did not stop such risk taking, and why various markets, especially markets for bank debt, were also unperturbed.

  Why Did Bankers Take on Tail Risk? Search
ing for Alpha

  To understand the structure of incentives in the financial sector, we have to understand the relationship between risk and return. The central tenet in modern finance is that investors are naturally risk averse, so in exchange for taking on more risk, especially risk that may hit them when they are already in dire straits, they demand a higher return. Therefore, riskier assets tend to have lower prices (per dollar of future expected dividend or interest that they pay) and thus produce higher expected returns: stocks typically return more than Treasury bills. There is therefore an easy way for a banker or fund manager to make higher average returns for his investors; all he has to do is take on more risk by buying stocks instead of Treasury bills. This means the relative performance of a fund manager cannot be judged by returns alone: they must be adjusted downward in proportion to the risk being taken.

  The bread-and-butter work of financial economists is to build careful econometric models describing the “appropriate” or market-determined level of return for taking on a certain level of risk. Financial managers are deemed to outperform the market only if they beat this benchmark return. The lay investor’s version of such benchmarking is to compare the manager’s return with a return on a benchmark portfolio consisting of similar securities: for example, the returns generated by a fund manager investing in large U.S. firms will be compared with the return on the S&P 500 index of large U.S. stocks. Such benchmarking is logical, because the investor can easily achieve the returns on the S&P 500 index by buying a low-cost index fund, and a manager should not earn anything for merely matching this return. Instead, investors will reward a manager handsomely only if the manager consistently generates excess returns, that is, returns exceeding those of the risk-appropriate benchmark. In the jargon, such excess returns are known as “alpha.”