“What does this mean?” asked Moody’s CEO. “And how should we respond to it?” It was Sunday afternoon, September 7, 2008, and the U.S. Treasury had just nationalized Fannie Mae and Freddie Mac, the twin behemoths of U.S. housing finance. On a hastily scheduled call, the CEO was asking Moody’s executives to consider how this previously unimaginable event might affect their research and ratings. Although Moody’s was on the front line of the financial system, CEOs across America would soon be asking their executives these same questions.
Even before that fateful weekend, Wall Street had been experiencing a bear market—the S&P 500 stock index was more than 20% beneath the all-time high it had achieved the previous year. Investors were nervous about falling house prices, rising mortgage defaults, and big losses at financial institutions. Housing had gone from boom to bust and the broader economy was struggling, with unemployment on the rise.
At the heart of the problem was a colossal failure of the vaunted U.S. financial system. Trillions of dollars had poured into the United States from emerging economies flush with trade surpluses. Fearful of deflation after the 2000 technology bust, central banks such as the Federal Reserve added to the flood by pushing interest rates to record lows. Cash was everywhere, and financial institutions weren’t sure what to do with it all.
Wall Street came up with an answer: securities backed by residential mortgages, credit cards, auto loans, and more. But the market for securitized loans was deeply flawed. Although securitization had been around for decades, it had been mainly limited to top-quality loans, to borrowers who were carefully screened for income and payment history. Attempts to securitize loans to lesser-quality borrowers had failed, but these were small scale experiments, so the financial damage was limited. Now with house prices booming, lenders and investment banks were securitizing trillions of dollars in loans to borrowers of all types, even to those with poor credit histories and little or no income. Securitization empowered increasingly risky lending, prompting lenders to invent ever-more exotic types of mortgages with confusing names such as “subprime,” “alt-A,” and “option-ARMs.”
The government regulators and credit agencies charged with policing the securitization process seemed to be asleep. At the Federal Reserve, the nation’s principal financial regulator, officials believed investors’ own self-interest would ensure the process worked. The rating agencies used information from the investment banks to evaluate their securities and applied models that failed to account for their complexity.
As sketchy borrowers stopped paying on their loans, the securities they backed fell in value, putting severe pressure on the financial institutions that owned them. The problem began to surface early in 2007 when HSBC, one of the world’s largest banks and a major subprime mortgage lender, reported shocking losses. Other lenders soon produced their own dismal reports. That summer Bear Stearns, a blue-chip investment house, had to shore up some hedge funds that had bet wrong on mortgage-backed securities. By spring 2008, Bear’s own capital was largely depleted and, and as other banks abandoned it, the firm collapsed.
At this point, Wall Street’s troubles were newsworthy but not particularly catastrophic. The U.S. financial system had been through worse, in the form of failing banks, slumping markets and even economic recessions. The selloff through the summer of 2008 was orderly. Even Bear Stearns’ collapse, while surprising, seemed manageable; the U.S. Treasury and Federal Reserve had stepped in and successfully sold the investment firm’s assets to the banking giant JPMorgan Chase. Something similar had occurred a decade earlier when regulators engineered an orderly break-up of hedge fund Long Term Capital Management. Bear Stearns vanished, leaving not much more than a ripple.
But the takeover of Fannie Mae and Freddie Mac set off a tsunami that, within a few days, hit the next weakest institution on Wall Street, investment house Lehman Brothers. Although Lehman’s failure is often blamed for starting the financial panic, it probably had its genesis the previous week, with the forced takeover of Fannie and Freddie. As shareholders in the two mortgage finance firms were all but wiped out, all investors in financial institutions were put on notice; no institution was too big to fail. And when the government refused to protect Lehman’s creditors as it had Fannie’s and Freddie’s, investors’ worst fears were realized.
The result was financial panic. Stock prices cratered, bond markets and money markets froze, and a string of institutions previously seen as rock-solid evaporated over the next few weeks. Wachovia, Washington Mutual, Countrywide Mortgage, and Merrill Lynch were among the fallen.
The decision not to save Fannie and Freddie set off a chain of events that ultimately gave policymakers no choice but to bail out the entire financial system. Only when the government went all-in, acquiring stakes and guaranteeing the debt and deposits of the biggest U.S. financial institutions, did the system’s free fall stop. Without such action the system would have collapsed and taken the economy with it. As it was, the financial system was brought to its knees and the U.S. economy was enveloped in what came to be known as the Great Recession—the sharpest economic contraction since the Great Depression of the 1930s.
A financial system exists to connect savers with borrowers, prudently investing a nation’s capital for the future. For decades, the U.S. system did this better than any in the world, efficiently putting the savings of American households to its best uses, producing benefits for savers, borrowers, and the broader economy.
The system had had its ups and downs. Pressed by competition and unshackled by regulators, bankers had tended to let their guard down in good times, making loans that even under reasonable assumptions were unlikely to be repaid. For a while, freely flowing credit masked the mistakes made by borrowers. But when defaults mounted, bankers pulled back, sometimes suddenly and all at once, triggering financial crises and recessions. Yet most times, the pain was short-lived and manageable.
Not so in the 2000s. For one thing, the scale of the financial system had grown. Along with the savings of American households, U.S.-based banks now managed a growing mountain of cash for savers in China, India, Brazil, and other developing economies. These nations were earning hundreds of billions of dollars per year in trade, as U.S. consumers snapped up the lower-priced apparel, furniture, toys, consumer electronics, and other goods they made.
Adding to the emerging world’s cash hoard was the surge in global demand for energy, agriculture, and other commodities. Oil, which sold for $20 per barrel in 2000, surged to a record high of $120 per barrel by summer 2008. Commodity producers in the Middle East, South America, and Asia received a windfall, most of it in U.S. dollars.
All these dollars needed to be invested. At first, cautious emerging-world investors bought U.S. Treasury bonds, the safest of all investments. High returns weren’t as important as safety for these investors. Foreign holdings of Treasury bonds increased more than three-fold in the 2000s to $3 trillion, about half of all publicly held U.S. bonds. By the end of the decade, China alone owned nearly $1 trillion in Treasuries (see Figure 1.1).
Figure 1.1. Share of publicly traded Treasury debt owned by foreigners, %.
Source: U.S. Treasury Department
Yet as their Treasury holdings mounted, global investors grew more interested in achieving higher returns. They had little appetite for stocks, remembering the technology bust a few years earlier, when stock prices had fallen nearly in half. Real assets, such as businesses or office buildings, offered an alternative, but these investments required expertise that non-U.S. investors didn’t possess, and the political barriers were formidable. U.S. lawmakers had no problem selling the Chinese a Treasury bond but were queasy about allowing foreign ownership of large U.S. companies.
For overseas investors, the next best thing appeared to be bonds backed by mortgages. These seemed reasonably safe: U.S. house prices had not fallen since the 1930s Great Depression, and delinquency rates on mortgages were consistently low, even during recessions. Foreclosures were rare. Global investors also took comfort in the U.S. government’s participation in the housing market, directly through the FHA and implicitly through Fannie Mae and Freddie Mac. From U.S. Treasury bonds, it wasn’t much of a leap to investing in mortgage bonds issued and backed by Fannie and Freddie, and from there it seemed natural to move into privately issued securities backed by U.S. homeowners.