Financial Shock: A 360 Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis

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9780137142903: Financial Shock: A 360 Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis
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“The obvious place to start is the financial crisis and the clearest guide to it that I’ve read is Financial Shock by Mark Zandi. ... it is an impressively lucid guide to the big issues.”

The New York Times

 

“In Financial Shock, Mr. Zandi provides a concise and lucid account of the economic, political and regulatory forces behind this binge.”

The Wall Street Journal

 

“Aggressive builders, greedy lenders, optimistic home buyers: Zandi succinctly dissects the mortgage mess from start to (one hopes) finish.”

U.S. News and World Report


“A more detailed look at the crisis comes from economist Mark Zandi, co-founder of Moody's Economy.com. His “Financial Shock” delves deeply into the history of the mortgage market, the bad loans, the globalization of trashy subprime paper and how homebuilders ran amok. Zandi's analysis is eye-opening. ... he paints an impressive, more nuanced picture.”

Kiplinger's Personal Finance Magazine

 

“If you wonder how it could be possible for a subprime mortgage loan to bring the global financial system and the U.S. economy to its knees, you should read this book. No one is better qualified to provide this insight and advice than Mark Zandi.”

Larry Kudlow, Host, CNBC’s Kudlow & Company 

 

“Every once in a while a book comes along that’s so important, it commands recognition. This is one of them. Zandi provides a  rilliant blow-by-blow account of how greed, stupidity, and recklessness brought the first major economic crises of the 21st  entury and the most serious since the Great Depression.”

Bernard Baumohl,Managing Director, The Economic Outlook Group and best-selling author, The Secrets of Economic Indicators

 

“Throughout the financial crisis Mark Zandi has played two important roles. He has insightfully analyzed its causes and thoughtfully recommended steps to alleviate it. This book continues those tasks and adds a third—providing a comprehensive and comprehensible explanation of the issues that is accessible to the general public and extremely useful to those who specialize in the area.”

Barney Frank, Chairman, House Financial Services Committee

 

The subprime crisis created a gigantic financial catastrophe. What happened? How did it happen? How can we prevent similar crises from happening again? Mark Zandi answers all these critical questions—systematically, carefully, and in plain English.

Zandi begins with a fast-paced overview and then illuminates the deepest causes, from the psychology of homeownership to Alan Greenspan’s missteps. You’ll see the home “flippers” at work and the real estate agents who cheered them on. You’ll learn how Internet technology and access to global capital transformed the mortgage industry, helping irresponsible lenders drive out good ones.

Zandi demystifies the complex financial engineering that enabled lenders to hide deepening risks, shows how global investors eagerly bought in, and explains how flummoxed regulators failed to prevent disaster, despite crucial warning signs.

Most important, Zandi offers indispensable advice for investors who must recognize emerging bubbles, policymakers who must improve oversight, and citizens who must survive whatever comes next.

 

  • Liar’s loans, flippers, predatory lenders, delusional homebuilders
    How the housing market came unhinged, and the whirlwind came together
  • Alan Greenspan’s trillion-dollar bet
    Betting on the boom, ignoring the bubble
  • The subprime market goes global
    Worldwide investors get a piece of the action—and reap the results
  • Wall Street’s alchemists: conjuring up Frankenstein
    New financial instruments and their hidden contents
  • Back to the future: risk management for the 21st century
    Respecting the “animal spirits” that drive even the most sophisticated markets

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About the Author:

Mark Zandi is Chief Economist and co-founder of Moody’s Economy.com, Inc., where he directs the firm’s research and consulting activities. Moody’s Economy.com is an independent subsidiary of the Moody’s Corporation and provides economic research and consulting services to global businesses, governments and other institutions. His research interests include macroeconomic and financial economics, and his recent areas of research include an assessment of the economic impacts of various tax and government spending policies, the incorporation of economic information into credit risk analysis, and an assessment of the appropriate policy response to real estate and stock market bubbles. He received his PhD from the University of Pennsylvania, where he did his PhD research with Gerard Adams and Nobel Laureate Lawrence Klein, and his BS degree from the Wharton School at the University of Pennsylvania.

Excerpt. Reprinted by permission. All rights reserved.:

Introduction

Introduction

"If it's growing like a weed, it's probably a weed." So I was once told by the CEO of a major financial institution. He was talking about the credit card business in the mid-1990s, a time when lenders were mailing out new cards with abandon and cardholders were piling up huge debts. He was worried, and correctly so. Debt-swollen households were soon filing for bankruptcy at a record rate, contributing to the financial crisis that ultimately culminated in the collapse of mega-hedge fund Long-Term Capital Management. The CEO's bank didn't survive.

A decade later the world was engulfed by an even more severe financial crisis. This time the weed was the subprime mortgage: a loan to someone with a less-than-perfect credit history.

Financial crises are disconcerting events. At first they seem impenetrable, even as their damage undeniably grows and becomes increasingly widespread. Behind the confusion often lie esoteric and complicated financial institutions and instruments: program-trading during the 1987 stock market crash; junk corporate bonds in the savings & loan debacle in the early 1990s; the Thai baht and Russian bonds in the late 1990s; and the technology-stock bust at the turn of the millennium.

Yet the genesis of the subprime financial shock has been even more baffling than past crises. Lending money to American homebuyers had been one of the least risky and most profitable businesses a bank could engage in for nearly a century. How could so many mortgages have gone bad? And even if they did, how could even a couple of trillion dollars in bad loans come so close to derailing a global financial system that is valued in the hundreds of trillions?

Adding to the puzzlement is the complexity of the financial institutions and securities involved in the subprime financial shock. What are subprime, Alt-A, and jumbo IO mortgages, asset-backed securities, CDOs, CPDOs, CDSs, and SIVs? How did this mélange of acronyms lead to plunging house prices, soaring foreclosures, wobbling stock markets, inflation, and recession? Who or what is to blame?

The reality is that there is plenty of blame to go around. A financial calamity of this magnitude could not have taken root without a great many hands tilling the soil and planting the seeds. Among the elements that fed the crisis were a rapidly evolving financial system, an eroding sense of responsibility in the lending process among both lenders and borrowers, the explosive growth of new, emerging economies amassing cash for their low-cost goods, lax oversight by policymakers skeptical of market regulation, incorrect ratings, and of course, what economists call the "animal spirits" of investors and entrepreneurs.

America's financial system has long been the envy of the world. It is incredibly efficient at investing the nation's savings—so efficient, in fact, that although our savings are meager by world standards, they bring returns greater than those nations that save many times more. So it wasn't surprising when Wall Street engineers devised a new and ingenious way for global money managers to finance ordinary Americans buying homes: Bundle the mortgages and sell them as securities. Henceforth, when the average family in Anytown, U.S.A. wrote a monthly mortgage check, the cash would become part of a money machine as sophisticated as anything ever designed in any of the world's financial capitals.

But the machine didn't work as so carefully planned. First it spun out of control—turning U.S. housing markets white-hot—then it broke, its financial nuts and bolts seizing up while springs and wires flew out, spreading damage in all directions.

What went wrong? First and foremost, the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined. At every point in the financial system, there was a belief that someone—someone else—would catch mistakes and preserve the integrity of the process. The mortgage lender counted on the Wall Street investment banker who counted on the regulator or the ratings analyst, who had assumed global investors were doing their own due diligence. As the process went badly awry, everybody assumed someone else was in control. No one was.

Global investors weren't cognizant of the true risks of the securities they had bought from Wall Street. Investors were awash in cash because global central bankers had opened the money spigots wide in the wake of the dotcom bust, 9/11, and the invasion of Iraq. The stunning economic ascent of China, which had forced prices lower for so many manufactured goods, also had central bankers focused on fighting deflation, which meant keeping interest rates low for a long time. A ballooning U.S. trade deficit, driven by a strong dollar and America's appetite for cheap imports, was also sending a flood of dollars overseas.

The recipients of all those dollars needed some place to put them. At first, U.S. Treasury bonds seemed an easy choice; they were safe and liquid, even if they didn't pay much in interest. But after accumulating hundreds of billions of dollars in low-yielding Treasuries, investors began to worry less about safety and more about returns. Wall Street's new designer mortgage securities appeared on the surface to be an attractive alternative. Investors were told they were safe—at most a step or two riskier than a U.S. Treasury bond but offered significantly higher returns—which itself should have served as a warning signal to investors. But with more and more U.S. dollars to invest, the quest for higher returns became more concerted and investors warmed to increasingly sophisticated and complex mortgage and corporate securities, indifferent to the risks that they were taking.

The financial world was stunned when U.S. homeowners began defaulting on their mortgages in record numbers. Some likened it to the mid-1980s, when a boom in loans to Latin American nations (financed largely with Middle Eastern oil wealth) went bust. That financial crisis had taken more than a decade to sort through. Few thought that subprime mortgages from across the U.S. could have so much in common with those third-world loans of yesteryear.

Still more disconcerting was the notion that the subprime mortgage losses meant investors had badly misjudged the level of risk in all their investments. The mortgage crisis crystallized what had long been troubling many in the financial markets; assets of all types were overvalued, from Chinese stocks to Las Vegas condominiums. The subprime meltdown began a top-to-bottom reevaluation of the risks inherent in financial markets, and thus a repricing of all investments, from stocks to insurance. That process would affect every aspect of economic life, from the cost of starting a business to the value of retirees' pensions, for years to come.

Policymakers and regulators had an unappreciated sense of the flaws in the financial system, and those few who felt something was amiss lacked the authority to do anything about it. A deregulatory zeal had overtaken the federal government, including the Federal Reserve, the nation's key regulator. The legal and regulatory fetters that had been placed on financial institutions since the Great Depression had been broken. There was a new faith that market forces would impose discipline; lenders didn't need regulators telling them what loans to make or not make. Newly designed global capital standards and the credit rating agencies would substitute for the discipline of the regulators.

Even after mortgage loans started going bad en masse, the confusing mix of federal and state agencies that made up the nation's regulatory structure had difficulty responding. After regulators finally began to speak up about subprime and the other types of mortgage loans that had spun out of control, such lending was already on its way to extinction. What regulators had to say was all but irrelevant.

Yet even the combination of a flawed financial system, cash-flush global investors and lax regulators could not, by itself, have created the subprime financial shock. The essential final ingredient was hubris: a belief that the ordinary rules of economics and finance no longer applied. Everyone involved—homebuyers, mortgage lenders, builders, regulators, ratings agencies, investment bankers, central bankers—believed they had a better formula, a more accurate model, or would just be luckier than their predecessors. Even the bursting tech stock bubble just a few years earlier seemed to hold no particular lessons for the soaring housing market; this time, the thinking went, things were truly different. Though house prices shot up far faster than household incomes or rents—just as dotcom-era stock prices had left corporate earnings far behind—markets were convinced that houses, for a variety of reasons, weren't like stocks, and so could skyrocket in price without later falling back to earth, as the Dow and NASDAQ had.

Skyrocketing house prices fed many dreams and papered over many ills. Households long locked out of the American dream finally saw a way in. While most were forthright and prudent, too many weren't. Borrowers and lenders implicitly or explicitly conspired to fudge or lie on loan applications, dismissing any moral qualms with the thought that appreciating property values would make it all right in the end. Rising house prices would allow homeowners to refinance again and again, freeing cash while keeping mortgage payments low. That meant more fees for lenders as well. Investment bankers, empowered by surging home values, invented increasingly sophisticated and complex securities that kept the money flowing into ever hotter and faster growing housing markets.

In the end there was far less difference between houses and stocks than the markets thought. In many communities, houses were being traded like stocks, bought and sold purely on speculation that they would continue to go up. Builders also got the arithmetic wrong as they calculated the number of potential buyers for their new homes. Most of the mistakes made in the tech-stock bubble were repeated in the housing bubble—and became painfully obvious in the subsequent bust and crash. The housing market fell into a self-reinforcing vicious cycle as house price declines begat defaults and foreclosures, which begat more house price declines.

It's probably no coincidence that financial crises occur about every ten years. It takes about that long for the collective memory of the previous crisis to fade and confidence to become all pervasive once-again. It's human nature. Future financial shocks are assured.

There were a few naysayers along the way. I take some pride in being one of those, but I was early in expressing my doubts and had lost some credibility by the time the housing market unraveled and the financial shock hit. I certainly also misjudged the scale of what eventually happened. I expected house prices to decline and for Wall Street and investors to take some losses, but I never expected the subprime financial shock to reach the ultimate frenzy that it did. Some on Wall Street and in banks were also visibly uncomfortable as the fury intensified. But it was hard to stand against the tide; too much money was being made, and if you wanted to keep doing business, there was little choice but to hold your nose. As another Wall Street CEO famously said just before the bust, "As long as the music was playing, you had to get up and dance." A few government officials did some public hand-wringing, but their complaints lacked much force. Perhaps they were hamstrung by their own self-doubts, or perhaps their timing was off. Perhaps history demanded the dramatic and inevitable arrival of the subprime financial shock to finally make the point that it wasn't different this time.

Any full assessment of the subprime fiasco must also consider the role of the credit rating agencies. Critics argue that the methods and practices of these firms contributed to the crisis, by making exotic mortgage securities seem much safer than they ultimately proved to be. Others see a fatal flaw in the agencies' business model, under which the agencies are paid to rate these securities by the issuers of these securities. The global business of rating credit securities is dominated by three firms: Moody's, Standard & Poor's, and Fitch. In 2005, the company I co-founded was purchased by Moody's, and I have been an employee of that firm since then. To avoid any appearance of a conflict of interest, I have no choice but to leave discussion of this facet of the subprime shock to others. The views expressed in this book are mine alone and do not represent those held or endorsed by Moody's. It is also important for you, the reader, to know that my royalties from the book will be donated to a Philadelphia based non-profit, The Reinvestment Fund (TRF). TRF invests in inner-city projects in the Northeast United States.

Understanding the roots of the subprime financial shock is necessary to better prepare for the next financial crisis. Policymakers must use its lessons to reevaluate the regulatory framework that oversees the financial system. The Federal Reserve should consider whether its hands-off policy toward asset-price bubbles is appropriate. Bankers must build better systems for assessing and managing risk. Investors must prepare for the wild swings in asset prices that are sure to come, and households must relearn the basic financial principles of thrift and portfolio diversification.

The next financial crisis, however, won't likely involve mortgage loans, credit cards, junk bonds, or even those odd-sounding financial securities. The next crisis will be related to our own federal government's daunting fiscal challenges. The U.S. is headed inexorably toward record budget deficits, either measured in total dollars or in proportion to the economy. Global investors are already growing disaffected with U.S. debt, and even the Treasury will have a difficult time finding buyers for all the bonds it will be trying to sell if nothing changes soon. Hopefully, the lessons learned from the subprime financial shock will be the catalyst for facing the tough choices regarding taxes and government spending that we collectively will have to make in the not-too-distant future.

This book isn't filled with juicy financial secrets; it may not even spin a terribly dramatic yarn. It is rather an attempt to make sense of what has been a complex and confusing period, even for a professional economist with 25 years at his craft. I hope you find it organized well enough to come away with a better understanding of what has happened. While nearly every event feels like the most important ever when you are close to it, I'm confident that the subprime financial shock will be judged one of the most significant financial events in our nation's economic history.


© Copyright Pearson Education. All rights reserved.

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