What was headline news has become the primary topic of day-to-day discussion and in many cases, the unfortunate cause of recent pain for many. The question recently posed by several has been – how and why did this happen?
A number of books have been written on the topic and attempting to encompass the entirety of this event within six pages is unrealistic. However, the purpose for this report is to attempt to provide an overview of EquityBridge’s views regarding the highlight causes associated with the existing Global Economic Crisis.
Many assume that the global economic crisis is the result of a credit crisis that began in July 2007 but the roots reach far beyond. The causes of the crisis are various and in some manners obscure. Unlike past economic crises, despite what has been conveyed by the media, the culprits are many: mortgage bankers and brokers enticed unqualified purchasers to over-extend themselves financially; realtors profited by promoting the perception of an ever-appreciating market.
The government failed to intervene when provided the opportunity; rating agencies failed to provide an accurate valuation of risk; the financial sector profited via the negligent and abusive use of risky instruments and the public succumbed to the enticement of greed and self entitlement. Professor Willem Buiter described it best by using the cliché, the “perfect storm” (2008).
In September 2005, the State of Florida experienced the unfortunate Hurricane Wilma that cost $29billion of physical damage and 63 lives. What most failed to mention is that Wilma was also responsible for bringing Florida’s ever appreciating property market to a grinding halt. Floridian realtors claimed that the market would shortly recover but savvy analysts such as Nouriel Roubini and nobel prize winner Paul Krugman knew better – this was the beginning of the inevitable. Property owners responded in the obvious manner – in anticipation of a promised short-term recovery, they held on to their pricing. Shortly thereafter, in what EquityBridge Managing Director Eric Jafari calls the “Four Horsemen”, Florida, Arizona, California and Nevada, began to experience a comparable decline in absorption in 2006.
Consequently, resulting from the lack of absorption and inability to resell properties within the anticipated periods of time they were previously able to, speculative flippers commenced walking away from their mortgage obligations. Thus 2006 experienced a sudden increase in sub-prime mortgages delinquencies and foreclosures. Despite popular opinion, these initial sub prime delinquencies were not mortgage delinquencies resulting from lower income families unable to service their mortgage obligations. These were predominantly speculators who had purchased homes through “100% financing” sub prime mortgage facilities and no longer had reason to continue to servicing such obligations. It was shortly thereafter that the snowball of events took its course.
"To understand the causes, one must first understand the history of the mortgage industry"
What caused the sudden unraveling and why did the industry allow such irresponsible lending practices?
To understand the causes, one must first understand the history of the mortgage industry. These delinquencies were not confined to any particular subprime mortgage market but included everything from fixed-rate, adjustable-rate, refinancing, no documentation and even full documentation loans. In other words, the industry had experienced a significant decline in loan quality. Subsequently, high interest rates and low credit ratings further caused the level of delinquencies to spike.
Considering the loan quality, many reports indicate that the average loan-to-value ratio had increased considerably since 2001. This was in part a reaction to monetary expansion and ensuing price competition. The number of low documentation loans had dangerously increased, as did the subprime market. Subsequently, the lending boom was marked by an increasing demand in mortgage-back securities (MBS’s). Within the US alone, large domestically chartered bank’s MBS market value grew on average 11.6% year on year.
Two forms of MBS’s were issued. The first type was issued by agencies. These were either US government agencies (Ginnie Mae) or government-sponsored agencies (Fannie Mae or Freddie Mac). With the backing of the government, these mortgages had the guarantee of credit and were therefore perceived as relatively default free. The second type of MBS was considered a non-agency issuance or “private label” mortgage security.
This type was backed by a private institution, a brokerage firm, bank or homebuilder due to the borrower’s inability to meet all agency classification requirements. In the run-up to the financial crisis, non-agency MBS issuance experienced a sudden increase in popularity. Unsurprisingly, this increase in non-agency MBS’s also corresponded with the increase in below prime loans.
The ease at which MBS’s were issued was, to a certain extent, a result of technological and structural innovation. Automation, for example, impeded the scrutiny of the screening process.
The introduction of FICO scores replaced the need for an extensive background investigation by “point system” credit scoring systems that forecast a credit user’s likelihood of default. Curbing the time and procedure associated with obtaining a mortgage strengthened its widening accessibility.
Another mechanism that encouraged irresponsible lending practices was the advancement and growing popularity of off-balance sheet activity. The Off-balance sheet vehicle (OBSV) involved a financial structure providing financial institutions and banks the ability to invest without the obligation to report daily investment activity and therefore removing the activity from their balance sheets.
The most common OBSV included special purpose vehicles (SPVs), structured investment vehicles (SPVs that invested in long-term securitized financial instruments and fund themselves in short-term wholesale markets) and conduits (SIVs that were closely affiliated to a particular bank). These financial institutions were, in many cases, motivated by regulatory arbitrage and tax avoidance. They were distinctly typified by negligible 1) capital requirements, 2) liquidity requirements, 3) constraints on liabilities and assets, 4) reporting requirements and 5) government requirements. OBSV’s provided financial institutions the ability to maintain limited amounts of capital, display little transparency and possess scarce governance.
In 2005 and 2006, a troubling 80% of subprime mortgages were converted into pools rated AAA . How? The loans were spliced and restructured with the objective of mitigating the perceived risk. Sinclair described the lack of transparency in the following manner, calling it “the Vesuvius Condition”.
"Skewed incentives, amidst the complexity of pooling, tranching and securitization techniques, rendered the market increasingly more opaque. An unchallenged belief briefly upheld the house of cards"
‘Imagine a farmer on the slopes of Mount Vesuvius in 78 AD, reporting that he had farmed there continuously for 20 years and never observed the slightest sign of an eruption. “I look at the mountain every few minutes, and I can tell you with complete confidence that my thousands of observations suggest that there is absolutely nothing whatever to worry about”’.
Unfortunately, credit rating trends became increasingly loose in an attempt to compete. Standard and Poor’s reported 77,294 credit rating downgrades from 2006 to 2008 (Bloomberg data), predominantly resulting an initial mis-rating. The feasibility of the mortgage market was founded on the ideal of linear history and an era of economic prosperity. The blame therefore was not that of credit rating agencies alone but the entire chain of agents.
The “Vesuvius Condition” blinded the majority of participants within the chain. As the saying goes, “I can only but assume that which I have seen”. Consequently, skewed incentives, amidst the complexity of pooling, tranching and securitization techniques, rendered the market increasingly more opaque. An unchallenged belief briefly upheld the house of cards.
In many ways, the dot-com disaster signified the end of returns from the Internet age. Bouleau describes the “property bonanza” as the US Federal Reserve’s “master plan” in an attempt to avoid recession. The methods utilized by the Federal Reserve to avoid recession included the following: 1) Reduced interest rates to encourage spending and 2) Reduced 30-year bond issues to increase the prices.
The ensuing confidence in the economy, encouraged increased spending and declining yields and mortgage costs, resulted in propelling property demand. This plan was designed to avoid a recession through the stimulation of spending. What came of it however was an enormous property boom.
Let us now turn to the height of the property boom, and what it meant to live through it. Reckless regulatory abandonment globally provided markets the ability to assume a “wisdom” of its own. As an example, Asian capital inflow made for new elements of a modern global economy. In hindsight, economists now call this phenomenon the “New Era” syndrome; a belief that superior knowledge and production provide the appearance of a “new decade of growth” .
The new era syndrome of the 1920’s was due in part to a combination of sentiments including eight years of general prosperity, the creation of the Federal Reserve Board, the expansion of free trade, post war peace outlook and the rise of large corporates such as Ford . The reasons are more often than not rational. Productivity in the “Roaring 20’s” did in fact markedly rise, up 50% from its 1919 levels.
The Federal Reserve was a revolutionary solution to the growing corporate society and the flourish of new products, cars, telephones and radio were undeniably radical. The underlying reasons may have been rational but the extent of people’s expectations was not – not in Roaring 20s and not this decade. This phenomenon is commonly called the “Wealth Effect”.
The Wealth Effect commonly fosters an environment where people’s choice of whether to spend or save can often be influenced by the euphoric belief that future prices will continue to rise. As an example, this can encourage the emotional purchase of a second home with the sale of stock and withdrawal of a new mortgage. The capital outlay is not perceived as an expenditure. The reason is that the amount is not deducted from earnings accordingly creating no visible change to the consumer’s balance sheet. However, in reality, the cavity is heavily imprinted.
Total assets increase, debt increases and thus the consumer’s risks are greater. Less risky investors may re-mortgage with a larger loan and those that are risk-averse would utilize stock profits to repay outstanding debt. The problem with all three instances, however, is that people, consumed by the Wealth Effect, expect prices to continue to inexhaustibly rise.
The Great Wealth Transfer
"The financial sector’s need for operating capital has forced banks and financial institutions to dispose of assets at discounts historically unavailable"
All things either come to an end or change. The events of 2007 and 2008 are unlike anything experienced by our generation. As a result of the Credit Crisis, the global capital markets experienced a $30 trillion loss in 2008, with more to come. From the dramatic rise in mortgage delinquencies, to the declining capital in banks to the nationalization of financial institutions and the shocking sums of liquidity required to rescue the financial economy, the consequences have made its way to the general public.
Unemployment, tax rises, pay cuts and universal uncertainty about the future collectively haunt the general economy creating an equitable opportunity that most recognize will not reoccur during our lifetimes. Analysts and economists globally project the largest transfer of wealth to takes its course in the next five to ten years, the majority of which resulting from the market stabilization of acquired distressed assets.
Much like the Wall Street Stock Market Crash in 1929, the Japanese asset bubble in 1980, the Asian Financial Crisis in 1970, the Dot Com bubble in 2000 and the US Savings and Loan Crisis of 1989, this $30trillion transfer of wealth will accrue to the pockets of those that are disciplined enough to embrace the Warren Buffett principle that the profit is generated by the purchase price, not the sell. The number of mortgage delinquencies, the liquidity crunch, bank regulatory requirements to shore up capital and the financial sector’s need for operating capital has forced banks and financial institutions to dispose of assets at discounts historically unavailable.
Eric Jafari is the Chief Executive Officer of BridgePoint Ventures, LLC, Vertical Realty Advisors, LLC and Managing Director of EquityBridge Capital, Ltd
Sheba Jafari is Senior Analyst for EquityBridge Capital, Ltd