2008 Financial Crisis (series 1/2): Housing Market – a complex inter-connectivity of credit system

On Sep 2008, there was an air of tension and panic around the globe, both among the public and the governments, with an alarm triggered by the US market on the upcoming Global Financial Crisis. The recession, over the period of next 2 years resulted in several business and banks closures, job loses, pay cuts to an extent that the national governments had to step in to rescue some of the worlds top-most functioning banks and business firms (notably Bear and Stearns, and AIG respectively) in order to dilute the effect of crisis on the public, yet the havoc caused was a complete disastrous and an out of control market reaction.

Now, with an idea on the intensity of the impact, one particular question that would resonate in the mind would be What caused such a scale of meltdown? Surprisingly, it was the US Housing Market which acted as the core of the disaster with other associated elements adding fuel to the wild fire.  This makes understanding the fundamental functioning of housing market a pre-requisite in process of gaining insights into how 2008 Financial crisis was built up.

The article walks through the cycle of process in the housing market and at the same time talks about the credit banking system and functioning of associated business. Even while discussing about US Housing Market in the article, the concepts derived can very well be associated to any of the nations housing and credit market. 

Credit banking system encapsulates interesting interconnections owing to its nature of complexity than mere lending of loans

How does housing financial market works?

The Housing financial market is split into two broad segments (i) Primary mortgage market (ii) Secondary mortgage market, each operating in their individual space with a strong inter connectivity between each other. One of the easy ways to understand the process flow would be to track the cash flow across the system.

housing-financial-market
Inter-Connective view of the Housing Market and cash in and out flow across the system

How does the primary mortgage market work?

A person willing to buy a house, contacts the mortgage broker, who having business relationship with different mortgage lenders (banks and other private institutions) connects both and on a successful mortgage deal receives a fair compensation. The person owns the house by borrowing credit from the bank with mortgage as collateral and becomes one of the proud house owners. For the credit issued, bank collect periodic payments with certain rate of interest on the principal. Interest is essentially how the depositing banks earn quite a lot more than what they lend. Banks operating in this process are known as Depositing Banks and this entire flow of currency forms the Primary Mortgage Market.

Depositing Banks operates primarily as public savings bank for salary, pension, long term savings, fixed deposits and credit borrowing. To facilitate credit lending it routes the public deposit money into the credit lending cash pool used for lending loans to the borrowers. Over the period of time the amount routed is replenished with periodic loan payments from the borrowers. This is a very tight loop process which need to be continuously flowing for the banks to stay functional and safe and also maintain its growth in the market.

Limitations of Depositing banks:

The way depositing bank functions in mortgage lending, flags up two main problems with long term perspective in mind. First, by keeping the mortgages (property against which loan is issued) on their books for longer periods (20-30 years) these banks are isolating the risk to themselves (risk associated in case of default and devaluation of the collateral) and second, limiting the pool of cash available for lending. As the credit market squeezes, interest rates rise (when there is more demand for loan but less money to lend, interest rates shoots up). Higher interest rates effect the degree of consumability in the market, eventually effecting the economic growth. How do depositing banks ensures continuous credit lending? The solution lies in secondary mortgage market.

Apart from the pool of cash available, interest rates also depends upon the market condition. A safe market brings the interest rates down, as banks are confident of people returning their money back and are willing to divert more cash towards lending.

How does secondary mortgage market works?

Investment Banks invests a lot of money in acquiring mortgages from the depositing banks against which loans were issued. This on one hand writes off the risk from depositing banks and on other ensures the supply of cash flow into the depositing banks, refueling its credit cash pool and encouraging credit lending. This is all good for depositing banks, but how do investment banks deal with the risk and cash pool? Investment Banks in turn use these mortgages to construct long term securities, one such is Mortgage Backed Securities (MBS), for generating instant cash flow for themselves to keep their business running.

Long term securities are investment options available for investors in the form of maturity bonds, promising a profitable return over a longer period of time. MBS bonds are one such investment banking product relevant to housing market and global financial crisis of 2008.

Maturity Bonds like MBS are the contractual agreement between bank and investors with bank promising to deliver certain amount over the period of time for the investment, subject to certain terms and conditions. MBS bonds are backed by mortgages implying the return on the bonds is fulfilled through the loan payments on the underlying mortgages. Also these mortgages act as a security in case of non payment of returns, an event in which the security can be sold to accommodate payments to the investors.

What are these Mortgage Backed Securities (MBS) and how do they generate profits to banks and investors?

The way these MBS are manufactured are quite interesting and at the same time are complex in the way they are calculated, structured and marketed.

CDS
Manufacturing of MBS bonds and structured flow of currency around it

Hundred’s of mortgages purchased by investment banks from depositing banks are pooled together and packaged as a single financial product named MBS bond. The core concept underlying is of risk pooling, which essentially means on pooling all the mortgages together the risk possessed by the individual ones can be highly mitigated. Lets think about it,  If a mortgage backed security is made based on each one separately and one of the mortgage borrower defaults, the security based on that mortgage will immediately fail. But if all the mortgages are pooled together, even when one of the mortgage borrower defaults, all the security stays secure with other borrowers paying the payments and none of the investor will be affected.

These MBS bonds are marketed by slicing them into 3 trenches –  (1) no risk and guaranteed return (2) no risk under normal market condition and high possibility of return (3) high risk and non-guaranteed return. These bonds are accordingly given AAA , BBB and CCC ratings respectively, but “Why will somebody prefer risky investment bonds?” Strategically investors are lured to invest on high risk bonds by providing quite a higher percentage of return compared to low risky ones. Hedge funds, Pension and Insurance funds are some of the investors preferring risky investments.

Once the mortgages are converted into MBS bonds, investment banks no longer holds the mortgages under their umbrella, the periodic mortgage loan payments made by the house owners to the banks against the loans issued is redirected to the investors as part of their return on the investment. This spreads the isolated risk from the bank to the outside market and exposes the investors to the risks which depositing banks were holding earlier (risk of default on the loans borrowed).

How do trenches define “guarantee on returns”?

One can view this process as flow of water across 3 parallel trays kept one under the other with each tray defining a trench. Under this analogy as the stream of water starts to flow the upper tray gets filled first followed by second and third subject to the quantity of water flowing in .Similarly under the normal market circumstances, the return on AAA bonds are first fulfilled post which BBB bonds are serviced followed by CCC bonds. Given an event of default over the loan payments CCC bond returns are the ones first effected and in cases where percentage of default rate increases even the BBB bonds having high possibility of returns will fail and at extreme rate of defaults even AAA bonds will earn no returns which would essentially mean a great miscalculation on part of manufacturing the bond and complete failure of the financial product itself.

Investors forecasting profitable returns on these bonds invests in these securities. To facilitate investors to choose from the wider number of investment options available in the market and calculate the risk they will undertake, Credit Rating Agencies rates these securities based on the risk on bonds. Rating agency also rates the institutions providing these bonds based on the valuation of the securities these institutions hold which can be used as an option in case of any miss payments, guaranteeing investors their returns.

Talked about depositing and investment banks role in the market system, investment banks work with high risk and are high risk tolerant due to its investment nature when compared to depositing banks which have low risk tolerance due to its operation with public savings . However there is an added benefit for an institution to act as both depositing and investment banks. The investment banks can spread the isolated risk from the books of depositing banks to the outside market and also free up the pool of cash which will facilitate extensive lending and keep interest rates low. However this also has a grave danger considering the case of bankruptcy of the bank due to its poor investments and it shutting down its operations. In such an event with banks operating as both depositing and investment bank, apart from banks failing on its investments the people will loose their lifelong savings, pension money and financial assets saved with the bank. Well, the big question open for discussion is how safe is such a combination of public savings and risky investments? This has come under scrutiny of many and 2008 crisis case study is quite an apt answer for it.

With an increasing market the risk also grew up on the MBS bonds. To leverage the growing business opportunity Credit default swap (CDS) market started to rise in the housing market space, which was previously mostly heard in stock markets. The institutions writing CDS transfers the risk onto their books from the investment banks or investors for a periodic premium fee, similar to an insurance cover. In cases of failed returns on the MBS bonds the firm covers the institutions/individuals of the investment loss and in absence of any such an event the firm profits through the premium payments without having to pay anything at all. Premium amount increases based on the calculation of the amount of risk the firm is ready to undertake. This complete loop of cash exchange frames the Secondary Mortgage Market.

Regulators in the form of government and central banks manage the governance of this whole financial system, providing security by keeping in check any fraudulent activities and framing the standardized operating procedure for the best interest of the financial market.

At the end of the walk-through of the housing financial market cycle one thing evident is Housing Financial Market is a consortium of various business operating in inter connection to each other. This inter-linkage converts the whole system into a domino block with any effect on one, rippling across the entire system. With all these complex inter-connectivity among the multiple elements, housing financial market masks quite a lot of transparency and accountability which can escape the surveillance of the regulators. The havoc this wide well connected network can cause in any such an event can only be learned from 2008 Housing bubble burst which has gone down in the financial books as the global financial crisis and as one of the most disastrous financial time period the world has ever witnessed.

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