The recent economic events and financial market volatility have largely been driven by the decline in U.S. home values and the related devaluation of the mortgage securities market. These problems have become vast because of the interconnected nature of the global credit markets. At first pass, it may seem astounding that something as simple as a loan to purchase one’s home could cause a crisis of historic magnitude throughout the world’s financial markets. To best grasp this situation, it is important to recognize the huge size of the residential mortgage and associated mortgage securities markets. At the end of 2007, those markets totaled $11.1 trillion and $7.2 trillion, respectively, each well in excess of the $5.1 trillion in total U.S. Treasury securities outstanding. 

The situation developed out of good intentions backed by a variety of policy decisions geared to make home ownership easier for many Americans. Easy money policies, begun in the Clinton/Greenspan era and continued under Bush/Greenspan, lowered the cost of financing and helped drive one of the longest and largest U.S. housing market booms. In fact, the decade ending in 2005 was one of the strongest periods of U.S. housing growth since the post-WWII boom. 

In the 1990s, an innovation called subprime mortgage loans – or loans to individuals with limited or impaired credit histories – was introduced. Subprime mortgage loan originations grew 25% per year between 1994 and 2003. By the end of 2006, subprime mortgages approximated $1.5 trillion and accounted for over 20% of all mortgage originations, up from 6% in 2002. Home ownership became an option for millions of borrowers who would not qualify for conventional loans. At the height of the frenzy, lenders were offering subprime mortgages with little or no money down and no income verification. During this time, climbing housing prices supported increasingly lax lending policies, which fueled more demand for houses, leading to even-higher housing prices. 

In a low-rate environment, investors thirsted for higher-yielding options, and Wall Street saw these subprime mortgages as great sources of higher yield. “Structured financing” wizards came up with ways to pool subprime mortgages with other mortgage loans and use different combinations of the cash flows to create new securities offering supposedly graduated levels of risk and return. The most popular version was called Collateralized Debt Obligations (“CDOs”). Hedge funds and other institutions were using leverage (in some cases above 30:1) to acquire vast sums of these higher-yielding securities, at what they believed was risk comparable to that of corporate securities. The use of leverage left little room for error in the risk assessment of these mortgage securities. During this time mortgage defaults had been at all-time lows for an extended period and everyone “knew” housing prices only went up. Relying on these faulty assumptions and failing to detect the deteriorating fundamentals of the underlying loans led credit agencies to assign overly rosy credit ratings and lenders to relax credit standards. By the end of 2007, the result was $7.2 trillion in mortgage-related securities, more than double the $3.3 trillion that existed at the start of the decade. 


Meanwhile, the first signs of rising home-loan foreclosures began in 2004 in the Rust Belt cities. By 2006, however, foreclosures had begun a steady rise across the country and had spread to most major markets. Also in 2004, the Fed began a series of rate increases to counter the threat of inflation from robust global economic growth. These increases posed a problem for the many subprime adjustable interest loans predicated on initial low “teaser” rates. On the pricing side, the S&P/Case-Shiller U.S. National Home Price Index, a broad composite of single-family home price indices for the nine U.S. Census divisions, peaked in mid-2006 and began what has since been a steady decline. Subprime problems hit the prime-time press in March 2007 when Countrywide Financial, the country’s largest mortgage lender at the time, reported in an SEC filing on March 1, 2007 that payments were late on 19% of its subprime loans – up from 15.2% at the end of 2005 and 11.3% at the end of 2004. In April 2007, New Century Financial Corp, the second largest subprime lender in 2006, filed for bankruptcy. By August 2007, Bloomberg reported that over 100 subprime lenders had halted operations or had sought buyers since the beginning of 2006. In January 2008, Countrywide Financial agreed to be taken over by Bank of America, becoming yet another addition to the list of casualties. 

As the cycle of easy money supporting rising housing prices collapsed, it triggered a credit crisis of unprecedented proportions. Why? In the simplest terms, it came down to two things: a crisis of confidence by lenders in the credit-worthiness of their counterparties and a scramble by sophisticated investors to unwind the huge amounts of leverage they had taken on in the easy-money environment. 

As 2007 progressed, this credit crisis was becoming more apparent and the devaluation of the mortgage securities market started gaining momentum. In late July 2007, two mortgage-related hedge funds run by Bear Stearns went bankrupt. Banks began to realize they did not know the extent to which they or their borrowers had exposure to subprime loans, as these loans were now pooled with others and repackaged into CDOs. As banks absorbed huge losses from the mortgage market, the credit contagion spread to all corners of the liquidity market, and investor concerns about the future of the economy mounted. In early March 2008, a spate of highly leveraged hedge funds closed amid steep losses and margin defaults. Of course, the most dramatic casualty of the crisis to date was the demise of Bear Stearns in mid-March, as it apparently faced a run by both customers and creditors. 

The Federal Reserve (“the Fed”) took swift and, in some cases, unconventional actions during the second half of 2007 and into 2008. Since last August, the Fed has slashed the Fed funds and discount rates cumulatively by 300 and 375 basis points (3.0% and 3.75%), respectively. To inject even more liquidity, the Fed established the Term Securities Lending Facility on March 11, 2008, which enables the Federal Reserve Bank of New York to lend up to $200 billion of Treasury securities to primary dealers collateralized by a broad range of securities. This is the first time since the 1930s that the Fed has used its authority to lend to non-banks. Also in an unprecedented move, the Fed extended $30 billion in financing to J.P. Morgan to complete its takeover of Bear Stearns. Meanwhile, the Office of Federal Housing Enterprise Oversight took several steps to allow Fannie Mae and Freddie Mac to increase their lending capabilities.

2. Lessons for Individual Investors from 2007 and Application to Investing in 2008

The following provides a synopsis of remarks to the Wall Street Journal (WSJ) by prominent figures in the investment-fund arena. The interviews were reported by the WSJ 12/3/07 and were prompted by increased market volatility in the second half of 2007 and tens of billions of dollars of losses tallied by predominantly and supposedly sophisticated investors from bad bets on complicated mortgage-backed securities. What’s almost uncanny is the overlap of themes and recommendations elicited from these experts.

Synopsis of Remarks to Wall Street Journal