Broken Record
How the Recent Collapse Mirrors the Past
Americans are constantly reminded that they are in the worst financial crisis since the Great Depression. But the causes of America’s current economic plight also have historical precedent. The Imagineer looks at past events from which America could have learned before the most recent collapse occurred.
On December 23, 1975, William Jennings received clearance from the FDIC to acquire the Penn Square Bank, located in a shopping mall in Oklahoma City. Jennings was a banker who had barely escaped indictment for his involvement in the Four Seasons Nursing Home Centers scam, in which investors were defrauded of more than $400 million. Jennings, with ambitions of turning Penn Square into the largest bank in Oklahoma City, began making questionable loans to friends and business associates.
Around the same time Jennings took over Penn Square, Oklahoma was experiencing an energy boom as a result of gas price deregulation. Penn Square took full advantage of the boom, lending millions of dollars to everyone from established oilmen to potential oilmen to flat-out con men. The bank soon approached its lending limits but managed to continue lending by selling its loans to much larger banks hungry for the high returns from energy loans, like Continental Illinois and later Michigan National and Seafirst of Seattle. By 1982, the boom had led to a saturated energy market and Penn Square Bank’s precarious house of cards began to collapse as its customers began defaulting on loans. On July 5, 1982, FDIC liquidators assumed control over the bank. The bad loans from Penn Square led to the virtual collapse of Continental Illinois and Michigan National. The little shopping mall bank in Oklahoma City was responsible for bringing down two of the largest banks in the country and wiping out thousands of smaller investors.
What does this obscure tale have to do with the modern financial crisis? While close to thirty years ago, the story of Penn Square and other past failures are in many ways identical to the present predicament. Like Penn Square and many other past fiduciary calamities, the current predicament was caused by a mixture of greed, apathy, short-sightedness, and a disregard of basic principles.
The world financial system has been rocked by several crises in the past thirty years that in many ways mirror the Penn Square debacle. One was the collapse of the Japanese real estate bubble that developed in the early 1990s. Government deregulation of the financial industry led to excessive lending and created a real estate and consumer-spending bubble. When the bubble collapsed, housing prices fell drastically and banks were essentially wiped out. The Japanese government’s reaction was to prop up the banks with cash infusions. This did not work; indeed, combined with a low-interest monetary policy, this plan dragged out the crisis and did far more damage to Japan’s economy in the long term.
The collapse of Long-Term Capital Management in 1998 holds many similarities to the collapse in 2008 of Bear Sterns and Lehman Brothers. Long-Term was a hedge fund that applied complex mathematical formulas to the bond market. In its heyday in the mid-1990s, Long-Term returned an average of over 40 percent per year to its investors. However, Long-Term was forced to hold a heavily leveraged position to make these returns and became involved in more and more risky investments. In 1998, its position collapsed when the Russian economy tanked. Wall Street banks were forced to bail Long-Term out to stop the damage from spreading further.
The causes of the current crisis facing the financial world share many similarities with the causes of past crises. New, complex financial “products” combined with high leverage mirrored the investment strategies of Long-Term Capital Management. Around the same time these “products” were developed, government deregulation and low interest rates created a real estate and consumer-spending bubble, like the Japanese bubble. Combined, these ingredients proved to be a recipe for disaster.
In the early 1990s, mathematicians employed by some of the largest banks in the country devised new methods of securitizing loans, which is basically backing bonds and other securities with assets like mortgages or accounts receivable. These new financial products were referred to as collateralized debt obligations (CDOs). CDOs are securities backed with a potpourri of assets. For example, one CDO might be backed with $1 billion of credit-card loans, $1 billion of mortgages, and $1 billion of corporate bonds. The extremely complicated structure of these investment vehicles made it near-impossible for investors to assess their true value.
One way investors tried to salve their uncertainty about these new investments was with credit-default swaps, which are agreements akin to insurance where the purchaser agrees to pay a certain fee for the seller to assume the default risks on the investments. While good in theory, credit-default swaps had a few inherent problems. Since they were not covered by federal regulations, holders of credit-default swaps were not required to retain enough capital to guarantee the swaps. Later on, this would come back to haunt companies deeply involved in backing the swaps, for example American International Group (AIG).
Around the same time CDOs were created, mathematicians and economists were busy at work trying to make the subprime loan market profitable for banks. The subprime sector, defined as any borrower with a credit score below 620, had traditionally been avoided due to the high rates of default. However, with new statistical models, financial leaders became convinced that they could vastly increase their returns with subprime lending. While these models were based on sound mathematical principles, there were two problems with the subprime lending market: the borrowers and the appraisals of the housing market.
Owning a home is often an unreachable dream for many American families. At least, this was the case until the late 1990s, when banks began offering mortgages to borrowers in the subprime category. Potential borrowers were enticed with low "teaser rates" that generally lasted for a few years and then adjusted to much higher rates. Since banks, armed with their statistical formulas, believed that most mortgagees would be able to pay the higher interest rates, they pushed loan officers to make as many loans as possible. Loan officers would often ignore the applicant's assets and income because of their confidence in their models. This meant that millions of applicants received loans with interest payments that alone exceeded the applicant’s ability to pay.
One reason banks were confident in lending to individuals who could not afford their interest payments was their appraisals of the housing market. Basing their statistical models on data from the early 1990s, economists predicted that since the housing market had grown in the 1990s, it would continue to grow in value forever. Bankers believed that even if borrowers didn’t have enough income to cover their payments, the rising value of their home would cover the shortfall, and borrowers gladly went along with this sentiment. Builders took out easy-access, low-interest loans to build large developments; individual investors took out easy-access, low-interest loans to purchase homes, then sell them for a much higher price with a technique called "flipping." This practice was encouraged by both real-estate agents and shows like Flip This House, in which ordinary people would purchase a house, usually with an easy-access, low-interest loan, then improve it slightly and sell it for a much higher price.
Like Penn Square in the early 1980s, mortgage lenders quickly approached their lending limits. The only way for them to continue their participation in the "hot" subprime market was to sell their loans to other investors, primarily other financial institutions. When bankers had the bright idea of combining subprime mortgages with collateralized debt obligations, the world's financial system was set on the brink of disaster. When early investors in CDOs, like investment firms Lehman Brothers and Bear Sterns, began to receive high returns, leading investors in other institutions began clamoring for their company to invest in the subprime market. When the demand for CDOs skyrocketed, the originators of the CDOs responded by creating more CDOs backed by worse and worse loans. Demand for more security in the CDO market led companies like AIG to sell more and more credit-default swaps. Everyone from the borrower to the lender to the CDO purchaser to the insurer of the CDO was happy and making money.
Unfortunately, all good things must come to an end, and the subprime market was no exception. Cracks began developing even as the market reached its peak. The speculative building encouraged by the boom had led to an oversupply of real estate, and housing prices began falling. At the same time, the adjustable-rate mortgages began adjusting to their higher interest rates. The millions of subprime mortgagees without sufficient income to cover this adjustment took the only option left to them and defaulted on their mortgages. Big holders of the CDOs like Lehman Brothers and Bear Sterns collapsed, partly due to the fact that both had been heavily leveraged. Both they and other institutions attempted to collect on their credit-default swaps; unfortunately, the main guarantor of the swaps, AIG, did not have enough cash to back the swaps, leading to AIG's near collapse and government bailout. These failures shocked investors and led to a pullout from financial stocks, the stock market imploded, and the U.S. entered what has come to be known as the Great Recession.
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