What Were the Banks Doing?

The most interesting and important fact that emerges from this book is that on the brink of the crisis, most of the largest financial institutions in the country were involved in producing many kinds of products for the mortgage markets: prime, subprime, jumbo, interest-only, adjustable-rate, and home equity loans.

In essence, the largest of the savings and loan banks, commercial banks, mortgage banks, and investment banks, which were previously divided by mar­ket and customers (and by statute law before the repeal of the Glass-Steagall Act in 1999), had by 2007 become the same bank. They did this because it was good business. It is easy to forget how profitable the banks were during this period and how much individuals working for those banks were making for themselves. At its peak in 2003, the mortgage market was almost $4 trillion. Even after the conventional refinancing market began to dry up in 2003, the mortgage market remained around $3 trillion until 2007. During this period, the financial sector of the US economy produced almost 40 percent of all of the profits in the entire economy in 2003 with about 10 percent of GDP and 7 percent of the labor force. Good business indeed.

This crucial fact about how banks were vertically integrated and what it meant to their organizations and performance is missing from all existing accounts of the crisis.

This vertical integration explains a lot about how the crisis proceeded and provides answers to our puzzles. While there was a great demand for mortgages and high returns to be had from mortgage securities, financial institutions had money pouring in (and out) from every pore. The CEOs of these institutions were seen as heroes, and everyone working in the industry was making money. Once financial institutions became dependent on a supply of mortgages to make, buy, and sell mortgage-backed securities, it became difficult for them to adjust their business models when the housing market began to turn down in 2006.

Instead of pulling back from the market when the housing market turned down in 2006, all of the financial institutions who had business models based on the integration of mortgages and mortgage securitization doubled down and continued to seek out mortgages even as the quality of those loans deteriorat­ed.

In hindsight, it is easy to see how impossible it was for the banks to figure out what to do, as the entire organization of the bank was predicated on the through­put of mortgages. It was a management consultant's nightmare: a business model that was printing money as late as early 2006 turned, in eighteen months, to one that led the largest banks in the country to insolvency. One of the things that we know is that most of the banks kept desperately chasing mortgage origina­tion as long as possible in order to keep their securitization machines running. This resulted in making loans that were worse and worse over time. They got so desperate that they routinely began to commit mortgage fraud in order to secure mortgages to package into securities. Not surprisingly, foreclosure rates were highest for loans issued in 2006 and 2007, and the securities based on those mortgages were the most likely to be downgraded in value.

The vertical integration of banks also explains why banks turned to sell mort­gages to people with worse and worse credit over time.

But eventually, these nutrients (conventional mortgage refinances) dried up. This meant that the community of financial institutions who had gotten rich and fat during the refinancing wave with their vertically integrated mortgage securities pipelines needed a new source of nutrients. They found these in Alt-A, jumbo, subprime, home equity, interest-only, and adjustable-rate mortgages and packaged these products into securities to continue to grow their businesses. But, by 2005-2007, even these mortgages began to dry up, and financial insti­tutions had to pursue people whose credit was even worse. The problem of the deterioration of loan quality was caused not by an originate-to-distribute model but instead by the need of vertically integrated banks to continue to originate mortgages to produce securities, which they would then sell and buy on their own accounts.

This need for mortgages also explains why banks were pushed toward preda­tory lending and securities fraud. There was an apocryphal story that was widely reported in 2009 about an out-of-work carpenter who lived in Fresno, Califor­nia, who had the previous year made less than $20,000 and was given a $450,000 mortgage. Few at the time asked why banks would do this. But, consistent with the analysis presented here, banks were so desperate to secure mortgages for securitization that they were perfectly willing to lend to people who they knew were not going to be able to pay back their loans.

Once banks had invested in origination businesses, securitization and trad­ing, and buying and holding on to securities as investments on their own ac­counts, they were committed to making profits at all parts of the process. They could not escape the system they had created as prices for homes decreased and mortgages started to be foreclosed on. They continued to need mortgages to fund their securities businesses. But as the value of the securities that banks held came into doubt as foreclosures rose, the largest vertically integrated banks came under financial pressure. The securities they had were being funded by short­term debt, and they needed to find more collateral in order to keep those loans. This meant that all of the banks who were involved in all phases of the indus­try found themselves facing the same financial duress. Because all of the largest banks were implicated in multiple parts of the mortgage market by 2007, they all experienced severe financial distress at the same time. When in the fall of 2008 Lehman Brothers went bankrupt, the panic spread immediately to the holders of the commercial paper for all of the largest banks, all of whom were obvious suspects for having exactly the same problem as Lehman Brothers. In essence, all of the largest financial institutions had ended up with the same business model. When that model proved untenable, they all went down together.

The American banks were so profitable that their counterparts in other devel­oped countries, particularly in Europe, could not help but notice.

When the American banks experienced the pullback from the ABCP mar­ket in 2008, all of the European banks who had heavily invested in mortgage securities or who were involved in mortgage securitization in the United States immediately fell victim to the same forces. The swiftest spread of the crisis was to countries where these banks who had gotten the deepest into the American mortgage securitization industry were located. They were illiquid and then in­solvent. Their governments had to bail them out, and these countries faced a financial meltdown followed by a recession. By understanding what the banks were doing and how they formed a system, we can understand the links between the events leading to the crash.