Unraveling the Financial Crisis of 2008

Author(s): Michael Comiskey and Pawan Madhogarhia

Source: PS: Political Science and Politics, Vol. 42, No. 2 (April 2009), pp. 271-275
Published by: American Political Science Association
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IN FOCUS: OUR POLITICALAND FINANCIALCRISIS

OF 2008

theFinancialCrisisof2008
Unraveling

Michael Comiskey Pennsylvania

StateUniversity
Pawan Madhogarhia Pennsylvania
StateUniversity

In thefallof2008,theworldeconomyexperienced
a "oncecredit
tsunami"
in-a-century
(Greenspan2008, 1). Centered in the market for homes and mortgages,the
mechanismsthatunleashedthisfinancialtidalwave are
manyand complex.Indeed,an inadequategraspofmodernfinanceon thepartof"themostsophisticatedinvestors"and
regulators "in the world" was itself a contributingfactor
(Greenspan2008,3).
inwhatfollowstodemystify
We attempt
recentfinancialevents
without-we hope- implyingthatwe have all theanswersor conveyingmoreassurancethanwe intend.We proceedin a questionand-answerformat,moving step by step fromthe financial
matterof assigning
mechanicsto the largerand more difficult
for
the
financial
of
late
2008.
collapse
responsibility

Freddiebegan purchasingsubprimeloans fortheirown portfolios in highvolumescirca2005 (Wallisonand Calomiris2008).

Otherlatecomersto thesubprime-buying
marketwereCitigroup
and MerrillLynch,who stayedin thesubprimemortgagemarket
fartoo long (Dash and Creswell2008; Morgenson2008).
3. What did the buyersofthe subprimemortgages
do with them?

The Wall Streetfirms"securitized"them:bundled them,sliced

thebundleshorizontally
into"tranches"(different
levelsofrisk),
and sold the rightsto the income generatedby these loans as
securities.
Theyoftenmixedmortgageswithcormortgage-backed
and
consumer
debtsto createcomplexstrucporate,government,
turedsecuritiescalledcollateralized
debtobligations,
orCDOs. They
also sold CDOs consistingofpartsof otherCDOs (called CDOs
FREQUENTLYASKED QUESTIONS
CDOs thatmimickedtheperformance
squared),and "synthetic"
real
of
CDOs
2008,
(Morris
73-79).Arcanemathematicalformu1.Why did lendersissue mortgagesto the uncreditworthy?
las, devisedby Ph.D.'s in mathematicsand physicsworkingon
Banks,savingsand loans, and commercialmortgagecompanies Wall
Street,calculatedtheriskand priceoftheseCDOs. Annual
profitedhandsomelyfromthe fees theychargedborrowersfor sales ofCDOs
peakedat about$521billionin 2006 (SIFMA 2009).
etc.They
loan origination,
documents,points(pre-paidinterest),
FannieMae and FreddieMac,whodealtonlyinmortgagedebt,
also made moneywhentheysold thesemortgages.These incenalso securitizedsomeofthemortgagestheybought.Buttheyheld
tives produced a thrivingmarketin "subprime"mortgagesothersin theirown portfolios.
thoseto homebuyerswithlow incomesor poor credithistories.
It'sunclearwhetheranyoneunderstoodtherisksofthesesecuAs early as 1996, subprimemortgagelending reached a fastrities,and many people who bought them went broke when
and Penningtongrowing$100billionannually(Chomsisengphet
holdersbegandefaulting
in largenumbersin
Cross 2006, 37). It peaked at a whopping$625 billion in 2005 subprimemortgage
2006.Forsimplicity's
sake,we willreferto all oftheseinstruments
and Schuermann2008).
(Ashcraft
as mortgage-backed
or MBSs, because all ofthemconsecurities,
tainedeithermortgagesorinvestments
thatmimickedmortgages.
2. Who boughtthesemortgages?
bankssuchas
Atfirst,
themoreaggressiveWall Streetinvestment
So who boughtthem?
LehmanBrothers
and BearStearnsweretheprincipalbuyers.They 4.
Institutional
investors-entitieswitha lotofmoneytoinvest,such
began buyingtens of billionsof dollarsin subprimemortgages
as
insurancecompanies,large banks,university
funds,
in
the
Later
in
the
pension
1990s,
annually
early1990s (Henriques2000).
and hedge funds(large,risky,and mostlyunreguendowments,
Fannie
Mae
and
Freddie
thegovernment-sponsored
corporations
Mac began guaranteeingthatpeople who investedin subprime lated investmentfundsforrichpeople). Most of theseinvestors
werein theU.S., Europe,or Asia.
mortgageswould get themoneydue them.1In 1999,underpresFannieMae relaxedcredit
surefromtheClintonadministration,
fromlenders,hop- 5. Why did theybuy theseMBSs?
on theloans itwouldbuydirectly
requirements
would
increase
the availability To make
that
these
restrictions
easing
ing
money. As formerFederal Reserve chairman Alan
of loans to minorityand low-incomehomebuyers.Fannie and
Greenspantolda House Committeein October2008:"To themost
investorsin the world,theywere . . . viewed as a
sophisticated
Michael Comiskeyis associateprofessor
"
ofpoliticalscienceat PennState.His research
'steal'
(Greenspan2008,3). SubprimeMBSs paid a higherrateof
interests
include
policy.
judicialpoliticsandeconomic
otherinvestments
return
than
because subprimeborrowershad
Pawan Madhogarhia,Ph.D.infinance,is an assistant
professor
offinanceat ThePennto
rates
to
a
Besides,as of2004,interest
State
The
His
research
interests
include
pay
higher
mortgage.
get
sylvania
University, EberlyCampus.
earnings
marketvolatility,
assetallocation,
andinternational
assetpricing,
rateswereat a 50-yearlow,thanksto Greenspan.So mostother
finance.
management,
(101:10.1017/81049096509090556

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PS April2009 271

In Focus:

Unraveling the Financial Crisis 0/2008

bonds didn'tpay much.That made thehigherrateof returnon

subprimeMB Ss especiallyattractive.
For severalreasons,theMBSs, especiallythe complexCDOs,
Forone
werealso perceivedas less riskythanotherinvestments.
the
CDOs
contained
diverse
of
many
types bonds,
thing, complex
debtsfromdiforpromisesto pay- corporatedebts,government
ifone typeofdebt
ferent
consumerdebts,andmortgages;
countries,
wentbad- suchas mortgages-theotherswould stillpay off.For
another,youcouldbuyan insurancepolicycalleda creditdefault
swap thatwouldpayyoujust in case yourMBS did not.Or ifyou
boughtyourMBS fromFannieMae or FreddieMac, theywould
sellyouinsurancethatyouwouldgettheinterest
andprincipaldue
And
with
in
MBSs
invested
rather
thanstocks,
yourmoney
you.
didn't
have
to
about
the
stock
market
you
worry
falling.Finally,
theWall StreetratingagenciesratedtheMBSs as verysafe,and
manypeoplebelievedthatthehomepricesthatstoodbehindthe
valueofmortgageswouldalwaysriseand neverfall.
6. Explain theselast two factors.Why did the rating
agenciesgive MBSs suchhighratings?

Fourreasons.First,someoftheMBSs suchas thecomplexCDOs

containeddiverseinstruments.
And diversityusuallymakes for
as
above.
Second,it's not clear thatthe rating
safety, explained
understood
the
agencies
complexCDOs muchbetterthan any-

(Romano1998).So an earlydefault,combinedwithevena 4% fall

in thehomeprice,wouldproducea loss fortheownerofthemortgagewhenthehomewas foreclosedon and resold.Andfrom2006
to 2008, housingpricesfellby 25% in major marketsacross the
country(S&P 2009).
9. Didn't the creditdefaultswaps pay the owners
ofthe MBSs the moneytheywere owed?

They did at first.But the sellersof the swaps and otherswho

guaranteedthatbuyersof MBSs would get theirprincipaland
interest-such as Fannie Mae and Freddie Mac- did not have
enoughmoneyset aside to pay themoffwhenlargenumbersof
mortgageholdersbegan makinglate paymentsand defaulting.
10. Let's go back to home pricesfora moment.
Why did housingpricesfall?

Buildersoverbuilt.And the FederalReserveraisedinterestrates

frommid2004 tomid2006 topreventinflationfromrising.When
ratesrose,so didpaymentson theadjustable-rate
mortgages
many
had takenout,and theycouldno longermake
subprimeborrowers
theirmortgagepayments.That producedmoreforeclosures
and
morehousesgoingon themarket,
whichdepressedhousingprices
evenmore.

Webelievethatliberalpoliciesaimedat expanding
homeownership
bearsomeoftheblame.
Butwealsothinkthatmostofthemessresulted
mechanisms.
frommarket
one else (SEC 2008b,10-13).Third,theratingagencies(Standard
and Poor's,Moody's,and Fitch) werepaid by the sellersof the
MBSs, notbythebuyers.So theagencieshad a perverseincentive
to overstatethe soundnessof the MBS- like a home inspector
workingforthesellerofa homeratherthanthebuyer(SEC 2008b,
mostpeople,includingtheratingagen23-27,31-33).Andfourth,
assumed
that
homepriceswouldriseforever.
cies,implicitly

11.Who's to blame forthismess?

As we'llsee,thereis plentyofblameto go around.We believethat

liberalpoliciesaimedat expandinghomeownershipbearsomeof
theblame.But we also thinkthatmostofthemess resultedfrom
marketmechanisms.The financialinstitutionsthatcreatedand
sold MBSs, and thelargeinvestorsthatboughtthem,tookexcessiverisks.Theydid so largelybecause theyfoolishlybelievedthat
homepricescouldneverfalland thattheprocessofsecuritization
transformed
home loans to high-riskborrowersintosafeinvest7. Why did home prices,and the beliefthattheywould
ments.Theyalso tookon too muchleverage:theyoperatedwith
always rise,matter?
too muchborrowedmoneyand not enoughof theirown funds.
As longas homepricesrose,defaultson mortgagesdid notpose a
major problemforthe financialsystem.In an environmentof Doing so threatenedthem with ruin if theirsubprimeMBSs
declinedin value even a little.Smartregulationcould have limrisinghome prices,ifyou can't pay yourmortgage,you can sell
ited
boththeoperationofthesemechanismsand thedamagethey
yourhouse formorethanyoupaid forit,use theproceedsto pay
offthe mortgage,and even make a profiton the deal. In effect, did.
than someone who borrowedmoney and
you'reno different
a
house
with
theintentof"flipping"
it.In bothinstances, 12.What do liberal
bought
policieshave to do withit?
thebank- or themortgageholder-getsits money.So there'sno
Conservativeschargethatthe Clintonadministration
and conbig problemforthefinancialsystem.But ifhome pricesfall,the
Democrats
used
federal
and
the
agencies
Community
lenderor mortgageholdermighthave to repossessthe house, gressional
Reinvestment
Actof1977to pressurelendersto issue mortgages
resellit forless than thevalue of the mortgage,and take a loss.
tolow-income,
andless-than-creditworthy
homelargelyminority,
When thatbegan to happen a lot,around2006,people holding
also claim thatthe federalgovernment
too
buyers.
They
poured
MBSs began to realize theywere not going to get the income
much money into the housing marketby pressing the two
fromtheMBSs thattheyhad thoughttheywould.
Fannie Mae and
government-sponsored
mortgagecorporations,
FreddieMac, to buyhundredsofbillionsin subprimemortgages.
8. If the home buyermakes a standard20% down payment,
These purchases,theyallege,inflatedhome pricesand produced
wouldn'thome priceshave to fallby 20% or moreforthe
thewave ofdefaultson subprimemortgagesthatstartedin 2006
mortgageholderto lose moneyon a repossessionand resale?
(see,e.g.,Brook2008).
Yes. But twothingshappened.First,bythelate 1990s,homebuyWe rejecttheclaimsabouttheCommunityReinvestment
Act
ers could oftenget mortgageswithdownpaymentsof3% or less
(CRA) fortwo reasons.First,if the CRA werea primecause of
272 PS April2009

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the crisis,we would expectto see largerun-upsin home prices,

and a subsequentcrash,onlyor mainlyin theU.S. In fact,however,therewas a hugeglobalboom in home pricesfromthemid
1990s to 2005 or 2006, with pricesrisingmuch more in some
countriesthan in the U.S. The Economistmagazine called this
inflationin home prices"thebiggestbubble in history"(Economist2005,73). The CRA, in forceonlyin the U.S., did not cause
thisglobal phenomenon.
We also rejecttheblame-the-CRA
argumentbecause thetimThe
CRA's
had
been waning foryears
is
not
impact
right.
ing
beforethecrisisstruck(JointCenterforHousing Studies2002);
theshareofhomeloans underCRA supervisionfellsteadilyunder
presidentsClintonand Bush,from40% in 1994 to under25%by
2005 (Park2008,3). UnderBush,however,"thesubprimemortgage marketexperiencedexplosivegrowthfrom2001 to 2006":
the subprimeshareof the marketrose from8% to 20%,and the
securitizedsharefrom54%to 75%,in thoseyears(Demyanykand
Van Hemert2008,31-32).
Moreover,thereallyexplosivegrowthin thesubprimemarket
issuedyearly
startedaround2003:thevalueofsubprimemortgages
rose by 42% from1998 to 2002,and by 159%from2002 to 2006
and Pennington-Cross
2006,37; Ashcraftand
(Chomsisengphet
Schuermann2008,2). Andthevastexpansionofmortgages"containingveryhighriskcombinations"(such as 40-yearloans, no
oftheborrower's
documentation
income,and/orlittleto no down
payment)began around2004 (SEC 2008b,33).
undera RepublicanCongressand
occurred
Thesedevelopments
whose
administration
curtailedCRA
W.
president,
George Bush,
but championedtheexpansionofhome ownership
enforcement
as well as thereal estateand financialindustries(Marsico 2006;
Becker,Stolberg,and Labaton2008).We therefore
agreewiththe
thesurgeofsubprimelendingafter2002
economistswhoattribute
not to the CRA,but to increaseddemandby investorsforMBSs
(AngeliandRowley2006;KiffandMills2007;Mian and Sufi2008).
Fannieand FreddiearemoresubstanThe chargesconcerning
tial. In the 1990s,these companiesloweredthe down-payment
formortgagestheywould buy.Late in thatdecade,
requirement
theirwillingnessto buy mortgagesissued to
announced
they
with
creditscores previouslyconsideredsubstanhomebuyers
dard (NFR Communications1997; Holmes 1999). Then, under
Departmentof
growingpressurefromtheBush administration's
to
Urban
and
(HUD)
supportmore"affordDevelopment
Housing
able" lending,theybegan buyingmassiveamountsof securities
backedbysubprimeloans- S434 billionworthjust from2004 to
2006 (Leonnig2008).These purchasessuppliedsubprimelenders
withmassivesumsto use foradditionalsubprimeloans. Fannie,
Freddie,and HUD failedto checkwhethertheseloans trulywere
and manyof themwerenot (Calomiris2008a; Leonaffordable,
2008).
nig
It is unclear,however,whetherFannieand Freddiereallymade
thingsmuchworse.It is possiblethatwithoutthosetwocompanies,othersubprimeinvestorswouldhave done whatFannieand
at least (Calomiris2008a, 8-10).2 And it
Freddiedid- eventually,
mustbe rememberedthatFannie and Freddiedid not startthe
subprimegame,and immersedthemselvesin it onlyin its late

13.Werefreemarketpoliciesto blame?
Again,partly.Late in PresidentClinton'stenuretheadministration,the FederalReserve,the Securitiesand ExchangeCommission (SEC), and bipartisanmajoritiesin Congressblocked the
of"derivatives,"
proposedregulation
includingcreditdefaultswaps
These
made
(Goodman 2008).
swaps
potentiallyriskyinvestmentslike MBSs appearsafer,because thebuyerofa swap gota
guaranteefromthesellerthatifan MBS did notpayoff,theseller
of the swap would make up the difference.3
One large sellerof
theseguaranteeswas theworld'slargestinsurancecompany,
AIG.
When it ran shortofmoneyto honorits guarantees,its possible
millionsofitscustomersaroundtheworld
threatened
bankruptcy
(Economist2008).
We willneverknow,however,whethertheregulationofderivatives would have dampened the voraciousglobal demand for
safe-ratedMBSs by"themostsophisticatedinveshigh-yielding,
torsin theworld"(Greenspan2008,3).
In 2004,the SEC also agreedto requestsfromtheinvestment
banks- includingGoldman Sachs, thenheaded by futureTreaHenryPaulson- to let themtakeon moreleverage
surysecretary
(operatewithmoreborrowedmoney)(Labaton 2008). The SEC
thenfailedto enforcetheweak "voluntary"
programitadoptedas
a substitutesafeguardagainst excessiveleverage (SEC 2008a,
viii-x).
ShortlybeforeBear Stearns,Lehman Brothers,and Merrill
Lynchcollapsed,theywereoperatingwithabout30 borroweddollars foreverydollarof theirown (SEC 2008a, 120). At thishighflyinglevel,even a 3-4% declinein thevalue of theirassets was
enough to wipe themout. The SEC also knew thatthe firstof
thesefirmsto fail-Bear Stearns-was dangerouslyoverconcentratedin subprimesecurities,
yetdid nothing(SEC 2008a,17-18).

14. Was the Federal Reserveto blame?

Yet again, the answer is partly.In 2000, Fed chairmanAlan
GreenspanrejectedfellowFed governorNed Gramlich'surgings
to curb predatorylendingin the subprimemarket,a step that
mighthave mitigatedthe subsequent meltdown.Greenspan
believedthatsubprimelendersweretoo numerousto audit,and
thatactionagainstthemmightchokeoffdesirablesubprimelending (Ip 2007).
One responseto these twinobjectionsis thatthe Fed could
have made "examples"out of a fewof the mostabusivelenders.
Butgiventhelureofrichprofitsin subprimelendingbefore2007,
would have requireda sustained,high-profile,
a successfuleffort
and possiblydraconiancampaign.And it would have been only
fromcombecausemostsubprimeloans originated
partlyeffective
mercialmortgagecompaniesoutsidetheFed's control,as Grmlichlateracknowledged(Ip 2007).
PerhapsthemostseriouschargeagainstGreenspanis thathe
ratestoolowfortoolongup to2004,thenraisedthem
keptinterest
thecurrent
crisis(Morris2008,59-65).
toofartoofast,precipitating
attacksofSeptember2001,Greenspandropped
Aftertheterror
the federalfundsrate- the interestrate the Fed most directly
low of 1%,and keptit under2% until
controls-to a near-record
late 2004. These rates spurreda frenzyof mortgagelending.
Greenspanand his successor,Ben Bernanke,thenraisedthefedinnings.
What is clear is thatthe profitmotiveand the politicaland eral fundsrate to 5.25%by mid-2006.Because paymentsin the
legal imperativesto expandhome ownershipeventuallypushed earlyyearsof a mortgageconsistmainlyof interestratherthan
thetwogovernment-sponsored
companiestosupplythesubprime principal,an interestratehike of thismagnitudecan doublethe
marketwithlargesumsofmoney.
mortgage.4
paymentson an adjustable-rate
PS -April2009 273

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In Focus:

Unraveling

the Financial

Crisis 0/2008

a speech
madehimself
lookespecially
badbygiving
Greenspan
to
in February
2004 (Greenspan
2004)urgingmoreAmericans
before
takeoutadjustable-rate
(ARM's)-fivemonths
mortgages
heengineered
theratehikesthatwouldcostperhapsseveralmillionARMholderstheirhomes(Colpitts
2008).
rateincreases
of2004to2006werenotespecially
Theinterest
to previous
periodsofmonetary
tightensharpwhencompared
mortas
But,
2004speechon adjustable-rate
Greenspan's
ing.
holders
he
did
not
realize
that
American
indicates,
mortgage
gages
did Berwereas overextended
as theywere.Nor,apparently,
were
interest
ratehikes,
unremarkable
nanke.So their
they
though
standards,
collapse.
byhistorical
helpedsparka historic

mustbailthemoutwithbillionsofdollarsin the
thattaxpayers
tolimittherisks
hasevery
eventtheyfounder,
right
government
theymaytake.
from
a public-private
messresulted
themortgage
Third,
partcredit
to
formed
to
home
ownership
byextending
nership
expand
of
stanthe
themarginal
borrower
through degradation lending
thecostsexplicitly
thanbyfacing
2008b,
dards,rather
(Calomiris
a related
desire
imbalances
result
from
other
3-4).Several
byAmermostimporincomepermits,
icanstoconsume
morethancurrent
onforeign
U.S. foreign
debtanddependence
thegrowing
tantly
onwhether,
andforhowlong,AmerExperts
borrowing.
disagree
icanscanindulgethisdesire(RoubiniandSetser2004;Bernanke

Toidentify
bubbles
atleasttemporarily.
assets
Bubbles
makeowners
richer,
oftheaffected
isa difficult
thewealth
andtodeflate
them,
ofpeople,
thereby
deflating
ofmillions
correctly
as the
Butsois thedeflationary
economic
andpolitical
burst,
problem.
aftermath
ofa bubble
crisis
show.
Great
andthecurrent
Depression
topaythe
No onewilleverknowwhether
orperhapsBer- 2005;White2006,10-11).Buta heightened
Greenspan,
willingness
woulddiminish
thepotenwithnational
thatcrisis.Butwe believethatsome costsassociated
nanke,couldhaveaverted
purposes

of theregulation
financial
combination
discussedabove,and a greater tialforfuture
upheavals.
awareness
oftheprecarious
finances
bythemonetary
authority
ofsubprime
couldhavelessenedthefinancial
borrowers,
upheav- NOTES
alsofautumn
2008.
1. Fannieand Freddiemade moneyfromthepremiumstheychargedtheinvesIn a sense,however,
itis irrelevant
toaskwhether
Greenspan torsin returnfortheseguarantees.
Congresshad createdFannieMae in 1938to
couldhaveaverted
thecrisis.Byhis ownadmission,
he trusted encouragelendingbybuyingmortgages
fromlenders.(The lendersknewthey
markets
topolicethemselves,
andstoodbyin"shocked
disbelief" could alwayssell theirmortgagesto Fannie Mae iftheyneededto raisecash.)
CongressprivatizedFannieMae in 1968,and in 1970createdFreddieMac,
2008,2) as theynearly
anotherprivately
ownedcompany,to competewithFannie.
(Greenspan
imploded.
2. Calomiris

mostoftheblame on Fannieand Freddie.

places
15.Whatis tobe done?
3. A derivativeis anythingthatderivesitsvalue fromsomethingelse. A credit
Thisquestionis thehardestone to answer.Goldstein's
(2008)
defaultswap,whichinsuresagainstloss fromsomethingdecliningin value,
becomesmorevaluableas thevalue oftheinsuredasset falls.
a solidstarting
oncestabilizaproposals
provide
pointforreform,
tionefforts
return
thefinancial
tonearnormalcy:
some othersdid
system
require 4. Many mortgagesin recentyearswereactuallyinterest-only;
not requireborrowersto pay even theaccumulatinginterest,
at least in the
banksand insurance
to
with
more
of
their
companies operate
earlyyearsofthemortgage,
leavingborrowersdeeperin debt (Kiffand Mills
ownmoneyandlessleverage;
lendersandsecuritizers
to
require
2007,8).
a
operatewithmore"skinin thegame,"perhapsbyretaining
5. We go beyondGoldstein,however,byurgingCongressto considerregulation
oftheloansandsecurities
ofthemarketforderivatives,
thevalue ofwhichstood at a staggeringS600
portion
theyissue;gettherating
agentrillionin December2007 (BIS 2008,3).
ciesworking
forlenders
rather
thanborrowers;
scraptheFanniemodelofmortgage
financethatensures
Freddie,
public-private
and
reduce
the
number
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