What caused the subprime mortgage crisis and what was the result of the Treasury's and Federal Reserve's response to that crisis? Most people are familiar with the overall story of events leading up to 2008. They may have seen the film The Big Short, which helped the public to learn about collateralized debt obligations (CDOs) and credit default swaps (CDSs). However, there is a lot more to the story than that one movie could tell. This paper will explain. The reality is that the subprime mortgage crisis was caused by a complex variety of systemic factors, and the response—rather than address the systemic issues—ensured that a similar crisis would occur again down the road; and that crisis has been seen in 2020.
Overview of Causes

The Financial Accounting Standards Board (FASB) was a big reason the crisis occurred in the first place. What did the FASB do? It had the opportunity to restrict the use of mark-to-market accounting, i.e., fair value accounting practices, in the 1990s and yet it did not. This was the type of accounting used by Enron, facilitated by Andersen—the accounting legends whose high standards set the bar for the industry. If Andersen could promote fair value accounting consultancy services, everyone could do it—and that is what happened (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008). So why was this a problem? Not every researcher agrees it is or was a problem (Posen, 2009). Some argue that fair value accounting helps companies to maintain a more accurate system of book keeping because they can show the value of their assets based on the going-rate in the market.

Traditional historical cost book-keeping simply shows the price paid for an asset and a loss or profit is not recorded until the asset is sold. Fair value recording allowed companies to book profits (or losses as the case might be) without ever having actually sold the asset. It was an accounting trick and the FASB failed to put a stop to it. The case of Enron shows just badly it could get out of control.

But the 2008 economic implosion is a better case in point illustration because suddenly every company using mark-to-market accounting had to book substantial losses as asset prices plummeted when the housing bubble exploded and the market crashed. As every company uses leverage, the margin calls were quick and fierce; selling begat more selling, and a vicious cycle of selling was the result, as companies were forced to offload assets because their books showed them losing capital, even though they had not actually lost anything. The magic of fair value accounting looks great when asset prices are on their way up: companies can increase their leverage, borrow more and buy more. It is a sudden curse when the market turns and asset prices decline. That is what happened when demand for mortgage backed securities collapsed as a result of subprime borrowers defaulting on their mortgages. Banks like Lehman Brothers and Bear Stearns felt the full brunt of fair value accounting principles coming back to bite them. As Flegm (2008) points out, historical cost is more reliable in accounting than fair value accounting. Had firms used historical cost approach they would not have suffered when the crisis hit—but neither would they have benefitted via leverage as much on the way up.

Relaxed Lending Standards

Relaxed lending standards were another problem that contributed to the crisis. Under the Clinton Administration they idea of getting subprime borrowers into homes and thus fulfilling the American Dream was proposed and implemented. Lending standards were relaxed and borrowers found it easier than ever before to get a loan for a house (or two or three if they wanted) (Lewis, 2010). Previously, lending standards had been more restrictive—just as they would again be after the crisis. Lenders were forced to make sure borrowers could actually pay back their loans. During the housing bubble lenders were incentivized to lend to anyone as the standards had been relaxed and loan originators profited on each commission.

These loans were then bundled together and sold as mortgage-backed securities (MBS) to investors in search of yield. Since the Dot Com implosion of 2000, the Federal Reserve had suppressed interest rates to encourage more investment in the risk-on assets. Traditional savings and Treasuries did not provide the kind of yield investors needed; insurance funds and pension funds, for example, rely on a high ROI as part of their promises to keep payments coming. Thus, they turn to whatever is offering the best yield with the least risk. MBS looked like a sure-thing for investors, but it was not and few people noticed (Lewis, 2010). Investors were confident that they could collect the interest on the mortgages, since, after all, they were investment grade. Companies like Countrywide Financial saw an opportunity to make a lot of money in the subprime market, and they knew they could offload the risk in the MBS market—and with housing spurred on by artificial demand facilitated by relaxed lending standards, it seemed a win-win for all.

Why Investors were Buying

Investors were buying because low interest rates were causing investors to adopt risk-on strategies in their chase for yield. They saw MBS and CDOs as low-risk since the ratings agencies such as Moody’s were giving them AAA-ratings, meaning they could be viewed as investment grade by institutions and funds. The ratings agencies were not doing their job and were either negligent in actually looking at the way the mortgages were bundled together or deliberately engaging in fraud (Lewis, 2010). Whatever the case may be, these securities were not and should not have been seen as investment grade.

Some hedge fund investors like Dr. Michael Burry did look at them and did realize that the subprime borrowers could kill these securities if they began to default. Most investors were not looking at these securities very closely and were simply buying what they were told by banks like Goldman and JP Morgan were good investments. The investors wanted yield and these securities could provide that—so long as no wave of defaults hit. The AAA-rating was supposed to ensure that no such wave would come. Burry saw that the ratings were wrong and began buying insurance against these securities in the way of CDS. Few people were buying CDS at the time when Burry began convincing firms to sell it to him. By the time the crisis would hit, people would be liquidating MBS and CDOs at bargain-basement prices and falling all over themselves to buy the CDS that the few people...…liquidate or face margin calls since their books reflected the decline in value of assets that the market began rejecting in 2008. For firms holding MBS or CDOs, the book value suddenly fell drastically even if the firm had not sold. Historical cost accounting would not have resulted in such a situation for these firms. The firms could have simply sat tight and waited for the market to rebound. Fair value accounting created an altogether different situation in that it reflected a book value of worthless, causing selling to beget more selling.

However, it is true that firms would not have been in that situation in the first place had there not been a relaxation of standards. Those who argue that fair value accounting was not to blame make the argument that instead it was actually the standards in lending practices that were to blame. It is true that these standards had changed and that borrowers needed to show next to nothing in order to qualify for a loan. Companies like Countrywide Financial were quick to provide these loans because there was a market for offloading the mortgages. But the reason there was a market for MBS was because the Federal Reserve had suppressed interest rates and funds in need of yield were looking for an attractive ROI. Thus, those who argue that the Federal Reserve was really to blame for the crisis are also correct. The reality of the situation is that all are correct—every part of the puzzle was important. None could be excluded. Each had an impact on the crisis.

The response by the federal government (TARP) and by the Federal Reserve (QE) not only essentially sanctioned the end of moral hazard but also laid the groundwork for a future crisis. The Treasury Department bailed out the too-big-to-fail firms like AIG and the banks that were left holding the bag of MBS (which would be offloaded to the Federal Reserve) or CDSs that could not be made good on unless the insurance company was bailed out. Why AIG could not be made to liquidate is a question that only Goldman Sachs can answer, since it made billions off the bailout. Regardless, the market was backstopped, interest rates were further suppressed, and inflationary prices were seen in everything from food costs to housing to precious metals to equities.

Now that America (and the rest of the world) has a Soviet-style planned economy in which the central planners take care to ensure that prices always rise and that free markets never fail as a result of their own moral hazard, the question is: how much longer can this type of system be sustained? Inevitably the Soviet Union collapsed. It is quite fair to surmise that the system will also fail in the US and around the world, and that may be one reason why nations appear to be prepping for war at a rapid clip. In the Middle East one sees unlikely allies forming (Israel and the Arab Gulf States, for instance). War games in South China Sea are on the rise. The drums of war in Belarus are betting. And Iran is always identified as a threat. If 2020 was a reshuffling of the economy, 2021 may be the start of an entirely new economic world order.

Bibliography

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