The Subprime Crisis Began in June 2007 When Merrill Lynch Asked Bear Stearns’s Hedge Funds for More Collateral

Since the subprime mortgage market began to turn sour in the early summer of 2007, shockwaves have been spreading through all the world’s credit markets, wiping out some hedge funds and costing hundreds of billions of dollars to banks and other financial companies. The main problem lay with CDOs [Collateralized Debt Obligations], over half a trillion dollars of which had been sold in 2006, of which around half contained subprime exposure. It turned out that many of these CDOs had been seriously over-priced, as a result of erroneous estimates of likely subprime default rates. As even triple-A-rated securities began going into default, hedge funds that had specialized in buying the highest-risk CDO tranches were the first to suffer. Although there had been signs of trouble since February 2007, when HSBC admitted to heavy losses on US mortgages, most analysts would date the beginning of the subprime crisis from June of that year, when two hedge funds owned by Bear Stearns were asked to post additional collateral by Merrill Lynch, another investment bank that had lent them money but was now concerned about their excessive exposure to subprime-backed assets. Bear bailed out one fund, but let the other collapse. The following month the ratings agencies began to downgrade scores of RMBS CDOs (short for ‘residential mortgage-backed security collateralized debt obligations,’ the very term testifying to the over-complex nature of these products). As they did so, all kinds of financial institutions holding such assets found themselves staring huge losses in the face. The problem was greatly magnified by the amount of leverage (debt) in the system. Hedge funds in particular had borrowed vast sums from their prime brokers — banks — in order to magnify the returns they could generate. The banks, meanwhile, had been disguising their own exposure by parking subprime-related assets in off-balance-sheet entities known as conduits and strategic investment vehicles (SIVs, surely the most apt of all the acronyms of the crisis), which relied for funding on short-term borrowings on the markets for commercial paper and overnight interbank loans. As fears rose about counterparty risk (the danger that the other party in a financial transaction may go bust), those credit markets seized up.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 271-272.

The Process of “Securitization” Was to Reinvent Mortgages and to Convert Mortgages into Bonds

The idea was to reinvent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds — in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into ‘strips’ with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a collateralized mortgage obligation) happened in June 1983. It was the dawn of a new era in American finance.

The process was called securitization and it was an innovation that fundamentally transformed Wall Street, blowing the dust off a previously sleepy bond market and ushering in a new era in which anonymous transactions would count for more than personal relationships. Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie or Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtually government bonds, and hence ‘investment grade.’ Between 1980 and 2007 the volume of such GSE-backed mortgage-backed securities grew from $200 million to $4 trillion. With the advent of private bond insurers, firms like Salomon could also offer to securitize so-called nonconforming loans not eligible for GSE guarantees. By 2007 private pools of capital sufficed to securitize $2 trillion in residential mortgage debt. In 1980 only 10 per cent of the home mortgage market had been securitized; by 2007 it had risen to 56 per cent.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 259-260.

‘Subprime’ Mortgages Were Typically Both Adjustable-Rate (ARMs) and Interest-Only Mortgages with ‘Teaser’ Periods

‘Subprime’ mortgage loans are aimed by local brokers at families or neighbourhoods with poor or patchy credit histories. Just as jumbo mortgages are too big to qualify for Fannie Mae’s seal of approval (and implicit government guarantee), subprime mortgages are too risky. Yet it was precisely their riskiness that made them seem potentially lucrative to lenders. These were not the old thirty-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages (ARMs) — in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 per cent of the assessed value of the mortgaged property. And most had introductory ‘teaser’ periods, whereby the initial interest payments — usually for the first two years — were kept artificially low, back-loading the cost of the loan. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower. But the small print of subprime contracts implied major gains for the lender. One particularly egregious subprime loan in Detroit carried an interest rate of 9.75 per cent for the first two years, but after that a margin of 9.125 percentage points over the benchmark short-term rate at which banks lend each other money: conventionally the London interbank offered rate (Libor). Even before the subprime crisis struck, that already stood above 5 per cent, implying a huge upward leap in interest payments in the third year of the loan.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 264-265.

The Vast Proportion of Derivatives Are Custom-Made (Not Standardized) and Sold ‘Over-the-Counter’ (OTC) by Banks

There was a time when most such derivatives were standardized instruments produced by exchanges like the Chicago Mercantile, which has pioneered the market for weather derivatives. Now, however, the vast proportion are custom-made and sold ‘over-the-counter’ (OTC), often by banks which charge attractive commissions for their services. According to the Bank for International Settlements, the total notional amounts outstanding of OTC derivative contracts — arranged on an ad hoc basis between two parties — reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion. Though they have famously been called financial weapons of mass destruction by more traditional investors like Warren Buffett (who has, nonetheless, made use of them), the view in Chicago is that the world's economic system has never been better protected against the unexpected.

The fact nevertheless remains that this financial revolution has effectively divided the world in two: those who are (or can be) hedged, and those who are not (or cannot be). You need money to be hedged. Hedge funds typically ask for a minimum six- or seven-figure investment and charge a management fee of at least 2 per cent of your money (Citadel charges four times that) and 20 per cent of the profits. That means that most big corporations can afford to be hedged against unexpected increases in interest rates, exchange rates or commodity prices. If they want to, they can also hedge against future hurricanes or terrorist attacks by selling cat bonds and other derivatives.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 227-228.

Closely Related, though Distinct from Futures Contracts, Are the Financial Contracts Known as Options

Closely related, though distinct from futures, are the financial contracts known as options. In essence, the buyer of a call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial asset from the seller (‘writer’) of the option at a certain time (the expiration date) for a certain price (known as the strike price). Clearly, the buyer of a call option expects the price of the commodity or underlying instrument to rise in the future. When the price passes the agreed strike price, the option is ‘in the money’ — and so is the smart guy who bought it. A put option is just the opposite: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 227.

A True Futures Contract Is a Standardized Instrument Issued by a Futures Exchange and Hence Tradable

The origins of hedging, appropriately enough, are agricultural. For a farmer planting a crop, nothing is more crucial than the price it will fetch after it has been harvested and taken to market. But that could be lower than he expects or higher. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected; the merchant who sells him the contract naturally hopes it will be higher, leaving him with a profit. As the American prairies were ploughed and planted, and as canals and railways connected them to the major cities of the industrial Northeast, they became the nation’s breadbasket. But supply and demand, and hence prices, fluctuated wildly. Between January 1858 and May 1867, partly as a result of the Civil War, the price of wheat soared from 55 cents to $2.88 per bushel, before plummeting back to 77 cents in March 1870. The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard ‘to arrive’ futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born. Its birthplace was the Windy City: Chicago. The creation of a permanent futures exchange in 1874 — the Chicago Produce Exchange, the ancestor of today’s Chicago Mercantile Exchange — created a home for ‘hedging’ in the US commodity markets.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 225-226.

War Is the Father of All Things, Declared the Greek Philosopher Heraclitus; It Was Certainly the Father of the Bond Market

‘War’ declared the ancient Greek philosopher Heraclitus, ‘is the father of all things.’ It was certainly the father of the bond market. . . . The ability to finance war through a market for government debt was, like so much else in financial history, an invention of the Italian Renaissance.

For much of the fourteenth and fifteenth centuries, the medieval city-states of Tuscany — Florence, Pisa and Siena — were at war with each other or with other Italian towns. This was war waged as much by money as by men. Rather than require their own citizens to do the dirty work of fighting, each city hired military contractors (condottieri) who raised armies to annex land and loot treasure from its rivals. . . .

The cost of incessant war had plunged Italy’s city-states into crises. Expenditures even in years of peace were running at double tax revenues. To pay the likes of Hawkwood [the great mercenary], Florence was drowning in deficits. You can still see in the records of the Tuscan State Archives how the city’s debt burden increased a hundred-fold from 50,000 florins at the beginning of the fourteenth century to 5 million by 1427. It was literally a mountain of debt — hence its name: the monte commune or communal debt mountain. . . .

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 69, 70-71.