There is a well known rule in investing that says the higher the return, the higher the risk. Unfortunately, as tends to happens during investment bubbles or Dutch Tulip Crazes, the risk sometimes gets far out in front of the reward. This was the case with mortgage investments in 2005. Investors in mortgage securities and the derivative instruments backed by these securities were treating mortgage investments as if they were only slightly riskier than high quality corporate or U.S. Treasury bonds. The problem was that these securities were actually backed by hundreds or more individual mortgage loans and that tranches (or slices) of these securities were becoming riskier and riskier. As governments around the world lowered interest rates in hopes of spurring struggling economies, investors raced to new investment options that would produce higher yields than more secure government-backed fixed investment options.
The Post 9/11 Money Bubble
After the devastating .com bust, the U.S. economy was struggling in the summer of 2001. The terrorist attacks of 9/11 threatened to send the U.S. economy into a further tailspin. Acting aggressively, Alan Greenspan and the Federal Reserve Bank began one of the most concerted interest rate reductions in U.S. history. These low rates drove down returns on bonds of all types, especially U.S Treasury bonds. The rapid expansion of the U.S. economy, fueled by easy credit and expansionist monetary policy, set off a new wave of U.S. imports and a rapidly increasing trade deficit. This cash outflow sent billions of U.S. dollars to foreign countries. China was the biggest benefactor. Anxious to find some place to invest these newfound dollars, foreign investors sought out the attractive returns offered by the mortgage securities of U.S. investment banks.
This trend continued into 2003, 2004 and 2005. More and more dollars went abroad and then came back into the country through investments in U.S. mortgage securities. Pension funds, insurance companies, foreign governments and other investors seeking high but ostensibly safe yields flocked to this booming market. More than $1 trillion of new mortgage securities were originated, securitized and sold in 2005 and 2006.
Investors seemed to have found nirvana, a state of high returns and low risk due to the safe and predictable nature of mortgage payments. The securities were issued by leading Wall Street firms like Bear Stearns, Lehman Brothers and Merrill Lynch. Rating agencies stood behind the solid credit rating of these mortgage-backed investment instruments. As global and U.S. investors screamed for more mortgage securities, the industry did its best to churn out more through new mortgage products while lowering its underwriting standards. Aggressive marketing drove record volume and revenue to the mortgage world.
A Web of Complexity
As new mortgage securities were originated and sold, investors looked for ways to balance their risk and take even further leverage on their investment positions. New derivative securities such as Collateralized Debt Obligations (CDOs) were created and began trading. These offered trillions of new dollars of investment positions. Here investors could bet on direction shifts of the mortgage market, interest rates and other factors. Soon these derivative contracts dwarfed the size of the underlying mortgages. By some estimates the volume reached $40 trillion. Companies such as American International Group (AIG) became big players in this market, which eventually crippled them.
The Bottom Drops Out
When risk and return no longer have real correlations, someone is bound to get burned. This is what happened to the mortgage security markets in 2006: there was a monster lurking in the basement. When borrowers began struggling to make their mortgage payments, investors got rocked. Their hugely leveraged positions only magnified their losses.
Some banks invested through off balance sheet called Special Investment Vehicles (SIVs). Large Wall Street banks could not support the escalating losses and write-offs of their mortgage securities and derivative mortgage investments. These huge write-offs began wiping out the balance sheets and credit bases for these companies, leading many to their downfall. Meanwhile, investors around the world were stung by enormous losses. Billions of dollars were being written off. The downward spiral began to accelerate.
Still Counting the Chickens
There are still widely differing estimates for the total amount of current and expected losses related to mortgage related investments. Some of the biggest Wall Street banks have been shut down or sold off. Large deposit banks and insurance companies have been decimated. Pension funds and global investors continue to count their losses and try to salvage their current positions. Where these losses will bottom is still anyone’s guess. There is no question that investors’ appetite and their inability to understand the relationship between risk and reward have been the primary reasons for our global economic challenges.