Professor Paul Palley's
          Economics Seminars

The root causes for the recession that started in December 2007, and the financial crisis that erupted in 2008 are usually identified as a combination of the collapse of both the housing market bubble and the value of a group of difficult to understand securities. The terms that we have read and heard a lot about that are associated with the securities side of this equation include; securitization; collateralized debt obligation (C.D.O); derivatives; credit default swap (C.D.S). I will describe each of these below, and discuss how they are used and may have contributed to the financial crisis.

Securitization is a process in which a lender or debt issuer develops a financial instrument or security through the combination of other financial assets and then markets different tiers or tranches of the repackaged instruments to investors. The process can encompass any type of financial asset, including mortgages and credit card debt. This is critical to the process of ensuring liquidity in the marketplace, and as a result is not necessarily problematic. It does this by enabling smaller investors to purchase shares in a larger asset pool. An example of securitization is a collateralized debt obligation (C.D.O). This is a security that is backed by a pool of loans including credit card debt, bonds, and other assets. These are usually backed by non-mortgage loans and bonds. These are similar in structure to collateralized mortgage obligations (C.M.O) or collateralized bond obligations (C.B.O). They can be structured in order to embody different levels of credit risk associated with different debts. These different types of debt are called tranches. Associated with each is a different maturity and also risk. The C.D.O pays more to tranches with higher levels of risk.

The securitization process is as follows; first a financial institution issues a large number of mortgages, which are secured by claims against the properties whose purchases the mortgage facilitates. The individual mortgages are then bundled into a mortgage pool that serves as collateral for a mortgage-backed security (M.B.S). The M.B.S can be issued by financial firms, including large investment banking firms. It can also be the same bank that originated the mortgages. Mortgage-backed securities are also issued by aggregators such as Fannie Mae and Freddie Mac. The result is a new security backed by the claims against the issuers assets. The security can be sold to participants in the secondary mortgage market. This market, and similar markets for other asset-backed securities including securitized credit card debt, is very large and provides liquidity to the mortgage and other markets. One strategy issuers often employ is to divide the mortgage pool into different segments or tranches to target the risk tolerance of investors. Consumer finance companies must be able to access funds in order to provide credit cards, auto loans, and student loans. With the freezing of the markets for securitization this funding source has been seriously curtailed. Proof of this is that the borrowing costs for credit card issuers rose to as much as five percentage points higher than they were when the credit crisis began.

One example of securitization is the mortgage-backed securities (M.B.S) we are familiar with due to the current financial crisis. The combination of mortgages into one pool of loans facilitates the division of the large pool into smaller pools. These divisions are based on the default risk of each mortgage and are then sold to investors. Individual retail investors are able purchase portions of a mortgage as a type of bond, an investment that in most case is beyond the affordability for many investors and as a result is purchased by large investors and institutions. Treasury Secretary Henry Paulson has said that, “approximately forty percent of U.S. consumer credit is provided through the securitization of credit card receivables, auto loans, student loans, and other similar products.” The problem is that the risk related to these securitized were inaccurately assessed for a variety of reasons, including greed and ignorance, and as a result their true underlying value was significantly lower than the market value. Once the real path of the value of the underlying asset, in the case most prominent in the news in 2008 this was home prices, then the value of the mortgage-backed securities declined significantly.

A derivative is a contract between two or more parties whose value is determined by increases and decreases in the value of the underlying assets. These assets may include commodities, currencies, stocks, bonds, market indexes, and even interest rates. High degrees of leverage are often associated with derivatives. The most common types of derivatives include futures contracts, forward contracts, options and swaps. The fact that derivatives are just contracts means the underlying asset may be anything agreed to by the parties in the contract. One example is as follows. An institutional investor in securitized credit card debt issued by a bank would be exposed to default risk while holding that bond. To hedge this risk, the investor could purchase a credit default swap (see my definition of this below). Similar approaches may be used by investors in stock issued by a foreign company will be exposed to foreign exchange risk, and as a result that investor will want to hedge against that risk. Another example, options can be purchased to hedge against potential losses in the stock market. The New York Times has reported that the derivatives market exceeded $500 trillion by 2008 versus $106 trillion in 2002

A Credit Default Swap (C.D.S) is a swap that is designed to transfer exposure to the credit risk associated with fixed income securities between parties. The buyer of a credit default swap receives credit protection. In exchange the seller of the credit default swap guarantees the credit worthiness of the product. The default risk is transferred from the holder of the fixed income security to the seller of the swap in exchange for periodic payments. This works like an insurance policy in that if the fixed income security defaults then the buyer of a credit swap will receive the par value of the bond from the seller of the swap. Credit default swaps are also used by investors to speculate on the credit quality of a particular asset or entity. For example, the investor who is comfortable with the probability that a borrower or group of borrowers will be able to meet their debt obligations can sell a credit default swap protecting the lender. On the other hand, an investor who is not comfortable with the probability that a borrower or group of borrowers will be able to meet their debt obligations can buy a credit default swap protecting the lender The value of the C.D.S market is significantly greater than the underlying assets of the bonds and loans making it clear that speculation has become the most common use of credit default swaps. It is this that got AIG in so much trouble. They sold a significant number of credit default swaps under the understanding that the collateralized debt obligation they insured would retain their value, but with the collapse of the housing market AIG’s responsibilities greatly exceeded their ability to meet their obligations.

Given these descriptions, what went wrong? The problem was not with the fact that these securities markets exist. The problems were related to greed and poor market evaluation on the part of lenders and borrowers, a lack of regulation and oversight, and a short-term viewpoint that overvalued current gains versus long-term fundamentals. There are numerous stories related to this that one can read, but it is safe to say that greed is a common denominator in many of these stories. That being said, long-term structural economic problems have contributed to the conditions that led to the financial crisis and recession. The economy over the period of 2000-08 performed very poorly in any measurable way, including; median household income; employment; the stock market; private non-residential investment; government budget deficit. The reliance on debt to sustain lifestyles and spending was a major factor that should be considered when identifying the causes of the recession, especially as the banking industry and homeowners lost track of fundamentals and believed that home prices would increase at rates significantly above the inflation rate.

Note; a primary source for the definitions above was Investopedia, a Forbes Digital Company, 2008.

On Friday, November 28, 2008, the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) met and it was the determination of this committee that the economic recession started in December 2007 (see: http://wwwdev.nber.org/cycles/dec2008.html). See this other link for more information related to the recession dating process (see: http://wwwdev.nber.org/cycles/main.html). The committee determined that the U.S. economy had expanded from November 2001 to December 2007 (an expansion that lasted 73 months versus the 120 months for the period of economic growth in the 1990s). I should note that the period of November 2001 to December 2007 was relatively poor in terms of income and employment gains versus prior periods of economic growth.

We often hear that a recession is called if the economy experiences two consecutive quarters of negative results (a decline of real GDP). It is actually more complex than this, and a number of factors are involved. The Business Cycle Dating Committee defines a recession as, “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other factors,” (NBER, 2008). The committee clarifies this further by indicating that, “a recession…is a period of diminishing activity rather than diminished activity,” (NBER, 2008). Given these considerations, the committee considers a group of economic factors in its analysis, especially domestic production and employment rather than just real GDP, and considers it important that the income-side estimate of domestic production was lower in the first quarter of 2008 than the fourth quarter of 2007.

The committee also noted that payroll employment as declined since December 2007. Real GDP and real income have shown both periods of gains and also declines since December 2007. The committee noted that, “real personal income less transfer payments, real manufacturing and wholesale-retail trade sales, industrial production, and employment estimates based on the household survey-all reached peaks between November 2007 and June 2008,” (NBER, 2008). Further interesting details are included in the report related to the data used and their analytical process.

It is interesting to note that as part of my work I have noted that water consumption per account for each group of the water customers of the City of Phoenix has declined since November 2007. This includes our single-family, multifamily, commercial, industrial, and institutional customers. Given that water is a necessity, the primary reasons for this decrease are the economy, water rates, and the weather. Further analysis has shown that the poor economy was the most important factor. I should note that my discussion with economists from other utilities have observed the same negative results during this economy.