The Financial Crisis in the United States
Editor’s Note: This article is part of a series on the geopolitics of the global financial crisis. Here, we examine the roots of the current financial crisis in the United States.
The root of the American credit crisis is similar to that of previous recessions. As profits pile up during economic expansions, investors eventually find it difficult to find investments that generate large returns, so they send their money after riskier prospects. In the expansion that just ended, the most important of those questionable investments was subprime mortgages, culminating in mortgage loans that required minimal to nonexistent credit checks, down payments or even proof of income. In total, some $550 billion of subprime loans (and a separate $725 billion of Alt-A loans — the next quality step up from subprime) are currently outstanding.
The worst of these mortgages granted very low teaser interest rates that adjusted to normal rates after a period of two to five years; there were some $350 billion of these in subprime, and an additional $385 billion in Alt-A. While virtually none of these questionable-quality mortgages have been granted since the credit crunch began roughly a year ago, those resets are now weighing heavily on the housing market. As the rates reset, borrowers with questionable income and credit are often unable to meet the new, grossly enlarged payments based on the new rates. The result is a cascade of foreclosures that gluts the housing market, pushing prices down. So far $55 billion of subprime mortgages are in foreclosure, and just over another $80 billion are in severe delinquency. The numbers for Alt-A are $40 billion and $45 billion, respectively.
Under normal circumstances, this is more or less where things would have ended: A glut in regional housing stocks where subprime mortgages were most overused — especially in the Southern California, Las Vegas and Miami regions — would lead to a recession in those housing markets and perhaps some leakage into the broader national housing market.
But there is another step in the process that made the problem bigger. Mortgages are only rarely kept by their issuers — instead they are bundled into packages and sold to interested investors. This serves three purposes. First, since the mortgage maker can sell his loan for a profit, he can then turn around and make another mortgage. Second, this secondary tier of investors brings an entirely new source of capital into the market. Third, these packaged mortgages can be sold to yet more investors, creating a new series of mortgage-backed assets (and securities) that can be traded abroad. Taken together, this widens and deepens the capital pool and reduces mortgage rates for everyone.
The problem is that as market players chased after ever-shrinking returns, no one treated the dubious mortgages as anything different from normal mortgages — and that includes the ratings agencies whose job it is to evaluate products. All banks and investment houses are required to hold back a percentage of their assets in cold hard cash to keep from becoming overleveraged. This reserve percentage is based upon myriad factors, but the most important one is the risk level of the investments. Mortgage investments are — or were, until recently — widely considered to be among the safest investments available because homeowners will do everything they can to avoid missing payments and losing their homes.
Subprime mortgages are more likely to fall into default. But add in the impact of teaser rates — and the fact that many of these mortgages were granted without requiring down payments so no equity was ever earned — and essentially the effect is that time bombs were hardwired into these packages of tradable mortgages. Beginning in late 2006, these teaser rates began to adjust to normal rates and the bombs started going off. That decreased the value of the mortgage-backed assets directly by their affiliation with subprime in specific, and indirectly via their affiliation with property in general. Suddenly, any one holding the weakening mortgage-backed securities found themselves needing to use those cash reserves to rebalance their asset sheets. As the price drops intensified, any one who might have been willing to purchase or trade these mortgage-backed securities suddenly lost interest. The holder then held an asset of questionable value that he could not unload.
As the cash crunch of individual firms increased, two things happened. First, investment houses started snapping like twigs because they are uniquely vulnerable to credit crunches. Banks, unlike investment houses, are required to hold a certain percentage of their deposits back to cover their losses should disasters strike; right now that percentage is 10 percent. The major investment houses, however — which are regulated by the Securities and Exchange Commission instead of the Treasury — are only required to set aside a minuscule amount of cash, which comes out to less than 1 percent of their total asset list and therefore provides them with a smaller cushion than banks.
By the end of September, the major Wall Street investment houses had been broken (Bear Stearns), gone bankrupt (Lehman Brothers) or were forced to recategorize themselves as banks, thus submitting themselves to the regulatory authority of the Fed (Goldman Sachs). In a few short months, everything on Wall Street changed.
Second, banks also needed to rationalize their balance sheets by dipping into their reserves. Luckily, since banks have a 10 percent reserve ratio, they have much more room to maneuver than investment houses (although some, such as Washington Mutual, still cracked under the pressure).
It is at this point that STRATFOR gets interested in the economics of the issue, because it is at this point the problem transforms from angst for Wall Street into a danger for the broader system.
When an investment house faces a credit crunch (or goes under) the impact is rather limited — the only entities that are truly hurt are those that purchased shares in the house itself — but when a bank faces a crunch, the impact is much greater. The best means that banks have of rebuilding their emergency reserves after a write-down is to reduce lending and hoard their income until their reserves are built up again. Such actions immediately reduce the availability of credit for everyone across the entire economy — homebuyers cannot get mortgages, companies cannot borrow to fund expansions, credit card rates go through the roof. Voila, a Wall Street crisis becomes a national economic crisis.
U.S. Treasury Secretary Hank Paulson's $700 billion bailout plan is an attempt to address the problem at its source: the nonliquidity of the mortgage-backed securities. The government will offer to exchange these securities for cold, hard cash. In one fell swoop, banks can rid themselves of untradable assets of questionable value while recapitalizing their reserves. Flush with cash and sporting newly healthy asset sheets, this should unfreeze the credit picture and allow banks to get back into the business of banking — most notably lending.
Of course, it is not quite that simple, and the "solution" cannot take effect overnight. It will take the Treasury Department weeks to hire and train a sufficient cadre of bureaucrats to run the bailout. The Treasury will not be paying full value for these assets, so time must be allotted for identification, offers and negotiation over price. (The Treasury will eventually sell these assets — buying low and selling high — and so is likely to make a profit for the taxpayer in the long run. Part of the deals struck are likely to grant the Treasury shares in the banks. That will increase again the chances of the Treasury earning a profit — it will choose when and under what market circumstances it sells the shares — but adding this layer of complexity will also lengthen the negotiations.) And even a nation as powerful as the United States cannot raise $700 billion in funding overnight — that will require months, at the very least.
The danger now is that, between today and the point in the future when the Treasury removes the mortgage-backed assets from the credit equation, a broader credit crunch will worsen economic activity which in turn will eat into banks' profits via more traditional means. Normally, in a recession, peoples' incomes suffer and normal — even healthy — loans fall into default. There are two ends to every loan: for a borrower, a loan is a way to purchase something; for a lender, it is a means of making money. Failed loans therefore enervate banks' health in precisely the same way that the subprime crisis has. If this recession-triggered degradation proceeds faster than the Treasury can clear away the mortgage-backed securities, then the credit crunch will persist, widespread bank failures may well become inevitable and a "normal" recession could become something more serious. The Treasury is now in a race against time.
And that is the good news. For while the United States suffers under a time constraint, it has a national plan already in motion to attack the problem at its source. But while the process in progress could mark the beginning of the end of the crisis for the United States, the American credit crunch is only the beginning of the story for the world's other two major economic pillars: Europe and Japan.