This is the first of three posts that I hope to put up on my thoughts on what we see unfolding in financial markets. Here is my take on what happened:
1. The ultimate sources of this turmoil are the real estate market and the bond market. Between 2002 and 2007, housing prices increased at rates unseen in decades and well above the inflation rate. At the same time, default spreads on bond markets converged on historical lows.
2. As housing prices increased, funded by cheap mortgage financing, the mortgages themselves were bundled into mortgage backed securities, entitling buyers to different layers of the collective cash flows on the mortgages, with the first layers having the least risk and the last layers of the cash flows having the most risk.
3. The same optimism that pervaded the housing market (about future housing prices) and the bond market (about future default spreads) led to the mispricing of every layer of these mortgate backed securities, with the mispricing being greatest at the riskiest (or top) layers of the cashflows.
4. Financial services companies (banks, investment banks, insurance companies) were the primary investors in these mortgage backed securities, with the former using debt to fund much of their holdings. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.
Here is how it unraveled:
1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.
2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.
3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around.
4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms.
5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).
6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.
7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation.
8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall.
9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).
I am hoping that the next phase is a happier one but we are watching financial history get written as we speak!