Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Decoding the Bond Market (S1 E2)
Ready to unravel the mysteries of the largest long-term capital market? Join us on an enriching journey as we decode the world of bonds with Edward Finley, a sometime Professor at the University of Virginia and an experienced Wall Street investor. Offering a deep-dive into the intricate workings of the $51 trillion bond market, Edward will shed light on the various types of bonds including Treasuries, corporate, and municipal, providing an invaluable insight into the dynamics of this, the largest long-term capital market.
The episode takes a closer look at the differences between different types of bonds, breaking down their distinctive features. Edward’s expertise also opens up the complex world of collateralized debt obligations (CDOs), providing a clear understanding of the $12 trillion mortgage-backed securities market and their different risk levels. As we navigate through the intricacies of conforming and subprime mortgages, we'll also journey back in time to explore the historical development of mortgages leading up to the great depression.
The discussion culminates by exploring the aftermath of mortgage market innovation, shedding light on how subprime mortgages and adjustable-rate mortgages in the early 2000s played a role in the liquidity crisis that shook the banking system. Get ready to gain a comprehensive understanding of credit default swaps and how they contributed to the impression of these mortgages as less risky than they actually were. With Edward's expert guidance, this episode offers a golden opportunity to expand your knowledge of the bond market and how its evolution has shaped the existing financial landscape. Tune in for an enlightening discussion that promises to deepen your understanding of long-term capital markets.
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Hi, I'm Edward Finley, a Sum Time Professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Speaker 1:Last time, we introduced short-term capital markets and, in particular, we talked about the money market. Today, we're going to introduce long-term capital markets and, in particular, we're going to spend our time focusing on the bond market. First, let's take a big step back and ask ourselves what do we mean when we say long-term capital markets? What we mean is that these are markets that provide long-term capital to households, firms and governments. When we say long-term capital, we mean the kind of capital that household, firms and governments need to make long-term investments. To make capital investments things that are going to be productive of more revenue if you're a firm, things that are long-lasting if you're a government or a household. There are two broad categories of long-term capital markets, that is, places where households, firms and governments can go to get long-term capital the bond market and the equity market. We're going to focus today on the bond market.
Speaker 1:So what's the bond market? Well, the bond market is a place where firms and governments raise long-term capital by issuing debt securities. Debt security is just a fancy word for bonds. Bond owners receive periodic interest during the life of the bond and the principal at maturity. Debt can be raised in public bond markets or in private bond markets. Government bond owners rely on the full faith and credit of the issuer, which we mentioned last time in Treasury bills, while other bond owners have a claim against the assets of the issuer. Sometimes that claim is a general claim it's unsecured we discussed that last time with commercial paper and sometimes their claim is against specific assets, which is called secured.
Speaker 1:By October 2023, it's estimated that the US bond market had about $51 trillion in outstanding issuances. There's about $127 trillion in the bond market globally. Estimates vary, but they are pretty much around $715 billion in the US of private debt outstanding, or about $1.2 trillion globally. So the total bond market is about $51.7 trillion a very, very large market. I'll bring you back to something that we shared last time, which is just the pie chart of US capital markets. That are listening. You can find these charts on the Not Another Investment Podcast website and you'll see that we're focusing now on the long-term capital markets. The money market was a little baby. That was a very small market. Here we're talking about the bigger, of the market's $51 trillion in the US in outstanding bonds.
Speaker 1:The bond market itself can be then broken down in the US into some large main categories. The biggest category of all will be treasuries that's about $21 trillion. Next largest is something called CDOs collateralized debt obligations. We'll talk about what those are in a minute. That market is about $14 trillion. Next largest are corporates, that is, bonds issued by companies. That's about $10.4 trillion. Municipal bonds about $4 trillion. And agencies again will sort of unpack all these ideas slowly about $2 trillion for our total of $51 trillion.
Speaker 1:Let's start with the biggest part of the bond market and that is treasuries, treasury notes, treasury bonds, tips and something called FRNs floating rate notes. We'll talk about all of these In the aggregate. All of these bonds are issued by the national government and they are the source of funding for the long-term debt of the United States. So when you think about the national debt, think treasury notes, treasury bonds, tips and FRNs. This is the long-term financing for the activities of our national government. Floating rate notes, or FRNs, mature in two years. They bear a floating rate of interest and they pay their interest quarterly, four times a year. Treasury notes, in contrast, are in maturities ranging from two to 10 years two, three, five, seven and 10. And they bear fixed rate of interest and they pay their interest semi-annually, that is, once every six months.
Speaker 1:Treasury bonds are the longest maturities. They have maturities of 20 or 30 years. They also bear a fixed rate of interest and they also pay their interest semi-annually. So you can think of the sort of different types of long-term bonds that the national government issues as really ranging across maturities. Floating rate notes have floating rate interests and they mature in two years. Treasury notes range from two to 10 years. Treasury bonds are 20 or 30 years. So one sort of special case is Treasury inflation, protected securities, or TIPS. These have maturities that are in the range of all of them. They have five, 10, or 30-year ranges of maturities. They bear a fixed rate of interest and they pay interest semi-annually. But, importantly, the interest that they bear and the interest that they pay is adjusted each year for inflation.
Speaker 1:All of these treasuries, whether they're notes, bonds, tips or FRNs, may be issued in increments of $100. So, just like T-bills, the national government wants every citizen to have the opportunity to lend money to the government, but more typically they're issued in denominations of $1,000. You can buy these bonds at auction, that is, directly from the Treasury. Treasury notes with maturities under 10 years so not including the 10 years are auctioned monthly. The 10-year Treasury note and all the Treasury bonds the bonds are the longer ones are auctioned in February, march, august and November, and so four times a year. Frns floating rate notes are auctioned also four times a year, but in a different schedule January, april, july and October. T-bills will be auctioned depending on the maturities the five years are auctioned in April and October, the 10 years in January and July and the 30 years in February.
Speaker 1:All of these treasuries are guaranteed by the full faith and credit of the United States and it's important to point out what that really means. We said it last time about T-bills. I think now is a good moment to talk about what that really means. What it really means is that the United States puts its credit on the line and says that you can trust it to pay you back. We said last time that the full faith and credit of the United States is about as close as you can get to risk-free, but many of you listening might be thinking to yourself how can that be? At the end of the day, if the national government gets into trouble, if we don't have the tax revenue that we need, if we don't raise the taxes properly, if we have all kinds of events that happen, why in the world would we say that the full faith and credit of the United States is as close to risk-free? The short answer to that question is because, unlike any other bond issuer, the national government has the ability to print more money. Why would they ever default on a bond when they could just print more money and pay the bondholders back? That is both empirically what has been the case in the history of US credit, and nobody has suggested anything to the contrary, notwithstanding the articles we read about we reached the debt ceiling and their threats of shutting down the government and so on. At the end of the day, there's very little to suggest that the national government wouldn't just print more money in order to pay bondholders back.
Speaker 1:The payments of interest are, like T-bills, exempt from state and local income tax, and it's interesting to point out why that's true. We mentioned it only briefly in T-bills, but it's true because the provisions of the Constitution make it clear that the national governments and its laws are supreme relative to the states. They take precedent over the laws of the states and it was decided very early on in the country's history that if we allowed the states to tax any revenue paid by the national government, that the states could in fact exert control over the national government. That was thought to be unwise, and so it's a constitutional provision. It's not a law, it's not something Congress can repeal. Any interest paid on national debt is not subject to state or local income tax.
Speaker 1:Bonds, treasury bonds and treasury notes all of these treasuries are priced as a percentage of the par value. So whenever we talk about, or if you see in the newspaper, the price of a treasury, you will see it priced something. Let's say, for example, $96.56. That doesn't mean $96.56. It means 96.56% of the face value of the bond. If the face value of the bond is $1,000, then you have $965.60 is the price.
Speaker 1:The second kind of in the bond market that we're going to talk about are agencies, and I'm going to talk about them here, even though they're smaller, because they are related in some respect to the national government. So what do agency bonds do? What is the long-term idea here. Well, the agency bond market provides long-term funding to federal agencies that, in general, support farms, small businesses and home purchases. Let's take them up in turn and start with the two. There are two main types of agencies. There are government agencies and then there's something called government-sponsored entities, and I'll help make a distinction be a little more clear.
Speaker 1:So, government agency bonds, first of all. Those are actual agencies of the national government. They are created by Congress and their debt is like the debt of the United States and their debt is backed by the full faith and credit of the United States. Income is exempt from state and local income tax and the bonds are used to fund the operations of that particular agency. So, for example, one agency bond are those bonds issued by the Federal Housing Association, the FHA. What do they do? Well, the Federal Housing Association provides mortgage insurance for working-class people that want to apply to a bank to get a mortgage. They provide mortgage insurance. If they default, the FHA will pay the bank what's owed In order to have capital available. For that kind of long-term commitment mortgages are typically 30 years. The FHA issues bonds and that's how they raise that capital.
Speaker 1:Another government agency that raises long-term capital to support its functions. The Small Business Administration, or sometimes called SBA. The Small Business Administration guarantees small business loans. Same idea, and the last example I'll give you something called the Government National Mortgage Association, which, on Wall Street, goes by its funny nickname Ginny May Ginny May, I suppose, because the acronym GNMA, if you pronounced it, might sound like Ginny May. Well, what does the Ginny May, or what does the Government National Mortgage Association, do with long-term financing? What do they need it for? They guarantee mortgage-backed securities that are issued by participating banks, and we're going to talk about mortgage-backed securities in a bit, so for the moment, don't worry if you don't know what that means, just suffice it to say that these are government agencies. They issue bonds in order to support their long-term commitments in guaranteeing or ensuring. I gave you examples of mortgages and small business loans, but there are many, many other examples. Their bonds are the obligation of the United States. They bear the full faith and credit of the United States. Their interest is exempt from state and local income tax.
Speaker 1:Okay, the next category, though, is called government-sponsored entities. Now, the government-sponsored entities are a little bit of a hybrid. They're created by Congress, they have national mandates, and they have programs that they support by issuing bonds. But they are not actual agencies of the national government and their debt is not actually issued by the national government and so, as a result, their bonds are not backed by the full faith and credit of the United States, but instead they're backed by a kind of what's sometimes called an implicit guarantee. Since Congress created these entities, even though they're not agencies, it has long been thought that Congress wouldn't allow the entities to go bankrupt. But they are not really subject to the support of the national government, and we'll talk in a little bit about our case study when we talk about the bond market as a direct implication in that category. So the bonds issued by these entities, we call them entities, even though this is part of the broad category agencies. So we have actual agencies and then we have government-sponsored entities.
Speaker 1:These entities issue bonds for their long-term purposes. They are not backed by the full faith and credit of the United States. Their interest might or might not be exempt from state and local tax that's not clear but generally what they have in common is that they issue long-term debt in order to buy mostly mortgages, and they hold those mortgages in what's called a retained portfolio. Some cases, government-sponsored entities have programs that they run, but mostly it's to buy mortgages, and so they use the financing from these bonds to buy mortgages. Here's a bunch of them.
Speaker 1:I'll give you some quick examples. The federal national mortgage agency, fannie Mae they buy conforming mortgages from commercial banks. Conforming just means that the terms match Fannie Mae's requirements. The federal home loan mortgage corporation, freddie Mac they buy conforming mortgages, but they buy them from savings and loans. Most of those bonds bonds issued by Fannie Mae, bonds issued by Freddie Mac bears interest that is not tax exempt. Federal home loan banks they issue bonds in order to lend money to regional banks that use mortgages on their books as collateral. So there are lots and lots of regional banks in the US that lend money to people in order to buy a home, and the banks then borrow money from the federal home loan bank in order to put more capital back on their books so that they can go out and make more mortgage loans. The interest on the federal home loan bank bonds is, in fact, tax-exempt at the state and local level. The federal farm credit bank funding corporation there's a mouthful. They buy loans, mortgages made to farmers. And then the one example I'll give you. That's just interesting because it's not about buying mortgages, though that's the general gist of government-sponsored entity bonds is the Tennessee Valley Authority. Tennessee Valley Authority maintains and operates a power company in the Tennessee Valley, and so they issue bonds in order to maintain the dam and the hydroelectric facilities that they use in running their operations.
Speaker 1:In terms of all agency bonds, there are a few things that they have in common. First, the initial increment that an investor can buy in those bonds is $10,000 of face value. Thereafter they can buy in increments of $5,000. All of these bonds pay interest, can be fixed or floating, and they pay their interest every six months. The maturity on these agency bonds ranges from one to 40 years.
Speaker 1:The government agency bonds the actual agency bonds have very little credit risk because they're issued with the full faith and credit of the United States, but they're a little less liquid than treasuries, meaning liquid. There's not nearly as many buyers and sellers in their market as there is in the treasury market and so, as a result, their yields are sometimes a little higher than treasuries because of that liquidity risk. Gse bonds government-sponsored entity bonds have credit risk because there is no full faith and credit of the United States. There is just the implicit backing. They are also less liquid and it makes their yields higher yet than the agency bonds. So agencies is the first category where we see raising long-term capital in support of households. The national government supports its programs through Treasury notes, treasury bonds and tips and FRNs. The agencies are raising long-term capital to support farms, small businesses and home purchases so really, households at the end of the day.
Speaker 1:The next bond market that I'd like to spend a little bit of time thinking about is the municipal bond market. That's about $4 trillion, so that's a fairly large-size bond market. What does the municipal bond market do? Well, they provide long-term funding for the operation of state and local governments and their instrumentalities. These bonds are almost always exempt from federal income tax. That's not constitutional, though, and it really can be changed by an act of Congress, but for the moment, they're almost always exempt from federal income tax, and these bonds are typically exempt from its own state income tax. So if you live in Virginia and you pay Virginia income tax and you buy a Virginia municipal bond, you won't have to pay any Virginia tax on that bond's income.
Speaker 1:That $4 trillion bond market, where municipalities raise money for their operations and their instrumentalities, operations can really be broken down into two basic types. First, there's general obligation bonds. That represents about 40% of the municipal bond market, so it's not the majority by any stretch. These bonds are backed by the full faith and credit of the state that's issuing the bonds. Now, because most states are not permitted by their own constitutions to run annual deficits, you shouldn't think of general obligation bonds being like treasuries. But for the states, treasuries are really funding the national debt. That's what they're doing.
Speaker 1:But general obligation municipal bonds are not funding debts of the states, because the states are typically not permitted to run deficits. It's not that they're funding the debt in the sense of spending more than they're taking in his revenue. Instead, these bonds are issued to finance long-term government initiatives Think roads, bridges, think pension obligations to state employees. The maturities on general obligation munis can be pretty short. If they're just funding, say, cash flow needs, that would sound a little like the money market. These are called tax anticipation notes, but they're most typically long-term to fund large capital investments of the state, usually maturities ranging up to 30 years. Each state's finances makes these bonds very in credit risk because, unlike the national government, the states can't print more money to pay their debts, there is a real difference in the credit quality of some states versus others. Unfortunately, for those listeners who live in a state like Illinois, their municipal bonds are rather risky. The finances of the state of Illinois are not in the best shape, where other states like California or New York have municipal bonds, where their finances are rather secure and so the bonds aren't perceived as being particularly risky. All right, that's general obligation bonds about 40% of the municipal bond market.
Speaker 1:The lion's share of the municipal bond market are bonds that are called revenue bonds. What are revenue bonds? These are bonds that are issued by states in order to fund a particular project. These bonds are guaranteed by the revenue stream associated with the project. That makes them really different than general obligation bonds, which is just the state's promise to pay and where the financial health of the state really tells us how risky those bonds are. What are some examples of why you would issue revenue bonds? You're building a new airport, you're upgrading your state's premium hospital, you're building new toll roads, you run ports. All of these dormitories at colleges and public colleges and universities, all of these long-term capital projects require a lot of money to build in the first place. It would seem silly to pay for them out of current state revenue just because they will benefit citizens of that state for decades to come. It makes sense to finance them over a long period of time. Revenue bonds are the prime way in which to do that. Since the state doesn't guarantee the bonds and since there are many fewer issuances, it makes these bonds a little bit more risky than the most premium general obligation bonds. Therefore, they often pay higher interest rates.
Speaker 1:We'll turn our attention now to the next biggest, after collateralized debt, obligations and treasuries, and we'll look at the corporate bond market here. I won't have much to say about it because it's pretty straightforward. Corporate bonds are what? Well, this is how companies, businesses, finance innovations, new products and longer-term projects, building new factories, entering new geographies. They need long-term funding to deliver on those long-term projects.
Speaker 1:Corporate bonds can be secured and provide specific collateral. Those secured bonds are considered less risky If anything were to happen to the company. There are assets of the company that are set aside to satisfy these bondholders. These are secured bonds. Unsecured bonds also have a funny bit of nomenclature. You might sometimes hear them referred to as debentures Debenchers just a fancy word for unsecured corporate bond. These are general obligations of the firm and therefore they are not as risky as owning shares of the firm, but they are nearly as risky because they get paid ahead of only equity owners in the case of a default.
Speaker 1:Let's turn our attention now to this very complicated sounding thing called collateralized debt obligations. Let's just understand what we're talking about really. What we're talking about with collateralized debt obligations is something very similar to what we discussed when we talked about money market funds. If you imagine the bond market as providing long-term capital for the different purposes that we described, you'll recall that one of those purposes, particularly in the agency's space and in the government-sponsored entity space, is to support Americans who want to buy and own their own home. It's thought that that's not only a very good thing from a social policy point of view, but it's also a very good thing from an economic point of view, and the national government wants to make it much more likely that people can own their own home. Financial markets respond to that, just as they did with money market funds. Financial markets created a new security to bring more capital, to make more capital available for mortgages Not just mortgages, by the way, I should add.
Speaker 1:You'll see in a minute many other kinds of lending to families and to individuals, but it's really primarily focused there. Collateralized debt obligations very, very fancy words to describe a vehicle in which to bring more capital into those areas that we think are worth investing more money in. We create special vehicles to aggregate investor capital and to bring more to it. Again, if you're watching this on YouTube, I just put a slide up on the screen to show a little bit of a schematic for collateralized debt obligations. If you're listening on your podcast, please, the slides are available on the website but you'll see that essentially you have lots and lots of mortgages.
Speaker 1:Let's say we're talking about mortgages, but we could be talking about student loans, we could be talking about auto loans, any kind of retail debt Lots and lots of people who borrow. Each one of them might be risky in his or her own way, but it's thought that if we buy all of those loans and bring them together in a single pool and we then organize that pool by the riskiest loans to the least risky loans, we can then sell interests in that pool of loans to investors. And some investors may only want the least risky pool of loans and so they might buy what's called the triple A tranche of that vehicle and they'll earn a certain rate of interest, and that rate of interest will probably be the lowest rate for all of the loans in that pool. There might be other investors who want the riskiest loans in that pool, very happy to take that risk. Why? Because it's not the risk of one borrower, it's the risk of lots of borrowers, and so therefore, the likelihood that everyone will default is very low, and these investors feel they can earn a very significant rate of return so long as defaults remain in the zone that they expect them to be in. And so this is a short and simple version of how to think about collateralized debt obligations, or what's typically how they're typically referred to as CDOs. All right, so collateralized debt obligations.
Speaker 1:Let's talk about the first category of collateralized debt obligations, and that's mortgage backed securities. Of the total in collateralized debt obligations, mortgage backed securities alone is $12 trillion. So here a special purpose vehicle is created by the sponsor to buy mortgages. The mortgages are organized into tranches based on the expected risk of the tranches. Those risks vary based on the creditworthiness of the type of mortgage that's there, and investors purchase securities in the special purpose vehicle to reflect the kind of risk that they want to take. That's, generally speaking, the situation.
Speaker 1:Of the $12.2 trillion in mortgage backed securities, the vast majority are in what's called agency sponsored mortgage backed securities. You'll remember we talked just a minute ago about agencies. Agencies go out and they issue bonds in order to either guarantee or usually guarantee or ensure mortgages for people here. These agency sponsored mortgage backed securities are bonds issued not by the agency but by the pool of mortgages, and they provide long term funding. These bonds provide long term funding for the agencies who are going to go out and acquire these mortgages and resell them to the investing public. They are almost typically conforming mortgages. That means these are mortgages underwritten pursuant to Fannie Mae or Freddie Mac's standards. They represent the less risky tranche of all mortgages. They're usually guaranteed by the agency or the government sponsored entity. Most of the conforming mortgages that find their way into mortgage backed securities are written by commercial banks, not savings banks Subprime mortgages and that will be something we'll talk about in our case study in a bit.
Speaker 1:Subprime mortgages doesn't mean trash mortgages or trash borrowers not by any stretch. Subprime just means these are mortgages that don't meet Fannie Mae or Freddie Mac's underwriting standards. They are indeed riskier. They're usually not guaranteed by the agency or government sponsored entity. But they can be insured and we'll talk a little bit about that later and subprime mortgages will typically occupy the bottom tranche of one of these mortgage backed securities. So the vast majority of mortgage backed securities are going to be agency sponsored mortgage backed securities. Those same agencies that do this work themselves all the time.
Speaker 1:A much smaller part of the mortgage backed security bond market are called non-agency sponsored mortgage backed securities. These are private issuers that originate loans. They sometimes purchase these loans and bundle them. They're sold as private label securities. It's a much smaller part of the market and it almost exclusively operates in the subprime space. They're buying mortgages that don't meet Fannie Mae or Freddie Mac's standards. Again, that doesn't mean they're junk. It just means that they are riskier than the conforming mortgages that live up to Fannie and Freddie standards. We also should understand that it's not collateralized debt.
Speaker 1:Obligations are not just mortgage backed securities. That's 12.2 trillion, of which most is agency sponsored mortgage backed securities. There's also 1.6 trillion in what's called asset backed securities, or sometimes ABS, mbs for mortgage backed, abs for asset backed. What are asset backed securities? They're the same as mortgage backed securities, it's just that the loans that they're securitizing aren't mortgages. They're other stuff that people take out loans to buy. For example, of the $1.6 trillion in the asset backed securities market auto loans $220 billion. Credit cards $54 billion. Equipment loans $80 billion. Student loans $146 billion. These are the kinds of things that we're talking about when we talk about asset backed securities.
Speaker 1:It's important to understand that we're talking about the bond market here. Clearly, the national government issues bonds to fund its long-term debt. Corporations issue bonds to fund their long-term projects. Municipalities issue bonds in order to fund their activities in supporting the people of their state. Agencies issue bonds in order to undertake their work in guaranteeing or ensuring loans to small businesses and to homeowners. Government-sponsored entities issue bonds in order to do the same, to either buy mortgages that they hold on their own books. When we get to the notion of collateralized debt obligations, the bonds that we're talking about and this is important to understand the bonds that we're talking about are the interests in the special purpose vehicle. What you're buying when you buy an interest in the special purpose vehicle looks just like a bond. You provide a certain amount of capital for it, it pays interest periodically and it has a maturity date in which you'll be repaid. Even though what's underneath all of those special purpose vehicles are different kinds of loans, you shouldn't confuse those loans with bonds, because they're different. We're talking only about the notion of those who invest in the special purpose vehicles in order to buy bunches of these loans.
Speaker 1:Why, why in the world, do we have in the bond market? It's pretty easy to understand why we have treasuries. Pretty easy to understand why we have corporates. Pretty easy to understand why we have municipals. Why do we have agency bonds? Why do we have government-sponsored entity bonds? Why do we have collateralized debt obligations? The answer is that it's thought that we can provide more long-term capital to households, small businesses, farmers and by providing more capital. Back to our earlier discussion. You don't need to have studied economics or finance to understand that if there's more capital available for the same number of demanders, the price of that capital will go down. It's thought to be beneficial that it's good for people to go to college, it's good for people to own their home or their car, it's good for all of the kind of steady purposes that you can think of. So securitization, just like the money market funds, made it possible to bring more capital, long-term capital, to these. What we're thought of as salutary purposes. Okay, so the innovation of collateralized debt obligations brings much more long-term capital to the bond market. That's great.
Speaker 1:Now we're going to take a moment and take note of a case study. Here we're going to talk about the second portion of the global financial crisis, which I'll call the credit crisis. So let's talk about that. All right, what happened? Well, prior to the Great Depression, mortgages were very short-term.
Speaker 1:They were just three to five years. So if you wanted to buy a home prior to the Great Depression, you could do that, but you would have to pay it back in three to five years. Moreover, there was no amortization. Amortization is just a big word to describe that you periodically pay some of the principle. So here, the mortgages were very short, no amortization. You paid interest every year until the year of maturity and then, at the year of maturity, you paid all the principle back. These payments were typically made with loan-to-value ratios of 60%. What's a loan-to-value ratio? It's pretty easy to understand. If you own a home, the loan-to-value ratio tells you how much you had to put down. So if you had to put 20% down, the value of the house is 100%. So the loan-to-value ratio is 80%, the loan is 80%. You put in 20%. Loan-to-value ratios before the Great Depression were 60%, so that's just another way of saying before the Great Depression, you had to have 40% of the purchase price before you could buy your house. As you might imagine, that meant that there weren't a whole lot of people taking out mortgages. They existed and people did it, but you had to be in pretty good shape to borrow money to buy a house.
Speaker 1:Prior to the Great Depression, during the banking crisis of the 1930s, what happened? Well, it's a big topic, the Great Depression but just sort of cutting it to its very narrow as quick, homeowners in trouble called in these loans, called in these mortgages. These mortgages were subject to being called. You would just get a phone call from the bank saying hi, I know you don't have to pay me back for another three years, but I'm calling my loan, you need to pay me back today. Homeowners are unable to come up with all the money to pay the bank back today. So they had one choice, and only one choice they had to sell the home. Well, that happened all across the country and so, for the first time ever, housing prices everywhere went down at once because people everywhere were selling their house. And so what did that do? It put downward pressure on housing prices everywhere. As housing prices went down, banks started calling other homeowners up to say you have to pay me back because your house is now underwater. It's worth less than the loan I made to you, so you got to pay me back. That, in turn, triggered defaults, more house sales, and what happened? Well, we had a quick devolution in the value of houses, and that, in turn, created a crisis in mortgages.
Speaker 1:So what would the optimal solution have been? The optimal solution would have been to have longer dated mortgages where they were amortized, you pay a little bit back each year, and that there was a kind of national standard as to who could borrow and how much they had to put down. But how? How would you do such a thing after the Great Depression? Well, the answer was the government created one of the first of the agencies we mentioned a minute ago the Federal Housing Authority and the Federal National Mortgage Association, the FHA and FANNY May. And those agencies were created to do what? To make mortgages longer term, with amortization and higher levels of loan to value, or, to put it another way, lower down payment costs. How'd they do it.
Speaker 1:Well, the FHA said to banks hey, listen, we will provide insurance for any mortgages you make, provided they live up to our standards, meaning 30 year terms, amortization and only, let's say, 20 or 30% down. Well, if you're a bank, that's pretty attractive because I can loan money and get FHA insurance on the loan that I just made and then go make more loans because I don't have to reserve nearly as much against the risk of that mortgage as I would if I just made it on my own. And so the mechanism for doing that creating the FHA mortgage insurance encourage banks to lend, and to lend at that standard. Likewise, fanny May was created to purchase conforming mortgages from banks. Here it was even more attractive. Fanny May said to banks hey, the FHA will guarantee the mortgage gets paid. But I'll tell you what I'll buy the mortgage from you, and now you can take that money and go make more mortgages. And for banks, that's pretty attractive to be able to recycle capital like that and make lots of mortgages.
Speaker 1:Well, what did all of that do? What did FHA and FANNY May and some other activities do? Well, prior to 1970, it led to a market where a local bank would extend a mortgage, typically for 30 years, that was amortizing and was not especially large, and so we had a standard that we thought would avoid the problem that occurred in the 1930s, when mortgages were being called by banks and people lost their homes. Starting in the 1990s, the combination of a really robust market for securitized debt. So we saw the money market funds happening in the 1970s and the 1980s. They start securitizing student loans, credit card debt, auto loans, and there's really a lot of investor appetite for this.
Speaker 1:And so, by the 1990s, this robust market for securitized debt and the government's encouragement of Freddie Mac and FANNY May to increasingly buy lower quality loans so that we could get more people into their own homes, led to a large increase in loans with very legitimate very little legitimate underwriting because, unlike conforming loans, these loans, which came to be known as subprime loans, were not guaranteed. You know, adjustable rate mortgages were not conforming loans and they could have very aggressive teaser rates to attract a potential homeowner for one to three years, but that that mortgage would reset its rate much higher in after the teaser period was done. So that by 2006, only 20% of mortgages issued in the US were subprime, but the majority of subprime borrowers had borrowed the entire purchase price of the home, that is to say, they put no money down. 90% of subprime loans had teaser rates that were very low for a little while, and then we're going to reset much higher in fewer than three years. And why was that okay? Well, it was okay because they were securitizing all of these mortgages in mortgage backed securities and investors were persuaded that since I have a very large tranche of loans the only risk is if the home prices everywhere in the country went down at the same time. And so they had quantitative models which evaluated these risks of the lower quality subprime tranches and they assumed all kinds of drops in housing prices. But they never, ever modeled a drop in housing prices across the entire country that resulted from an increase in adjustable rate mortgage rates or that resulted from a homeowner having no equity in their home. They put zero down and when the house price went down, they just walked away. They didn't model these unanticipated events.
Speaker 1:Credit default swaps also compounded that error a little. Credit default swaps are sort of beyond the scope of this podcast. They're sort of an interesting idea, but to fundamentally think about them is to think of credit default swaps as a kind of insurance as a kind of insurance that you could buy, and so I could buy a very risky tranche of a mortgage-backed security pool, and I could likewise buy a credit default swap, which was just a promise to pay me if that tranche defaulted and I didn't get my money back. Credit default swaps were out there, compounding then this error in what it would take for there to be a problem in these tranches, by allowing rating agencies to enhance the credit quality of lower tranches, make them seem less risky than they really were. And despite the fact that the credit default swap counter parties were insurers, there was no one regulating them like insurance companies, and so there was no one really looking to see whether the issuers of credit default swaps could make good on their promise to ensure these securities.
Speaker 1:So what happened? Starting around 2006 and 2007, there were increasing numbers of defaults in the lower quality tranches, and the losses to those tranches started to become significant, and so investors in those tranches panicked. Is this sounding familiar Like the money market fund problem? Investors panicked and they sought to sell all mortgage backed securities, not just the riskiest tranches. The consequence is that if no one wants to buy mortgage backed securities, then you have Fannie and Freddie that themselves own very high quality mortgage backed securities not subprime but no one wants to own them and therefore their securities are highly illiquid, and that caused Fannie and Freddie to seek federal receivership. This in turn led many brokerage firms and banks who owned a lot of the very low quality tranches to struggle.
Speaker 1:How does it work when a bank puts together one of these mortgage backed security tranches? Well, they put them all together and they're selling them in. The high quality tranches sell pretty quickly. It's rather easy to sell them. The medium tranches take a little longer, but they get sold pretty fast. The riskiest tranches will sell, but they're not going to sell right away, and so the banks would hold those risky tranches on their books as inventory. They're going to sell them. It's just going to take a little while.
Speaker 1:Well, if no one wants to own any mortgage backed securities at all and you're a bank that has a high quality tranches, you're a bank that has a bunch of these very low quality tranches on your book, you're going to have a really hard time finding a market to sell them into, and the consequence was Bear Stearns had to be forced into a sale of itself to JP Morgan. Bank of America was forced to acquire Merrill Lynch, and taking us back to our story from the money market, lehman Brothers couldn't get federal assistance and declared bankruptcy, triggering a catastrophic liquidity crisis that ultimately transmitted to the whole world. The uncertainty of the value of mortgage backed securities caused a credit crisis. So, suddenly, if the banks that are holding these very, very low quality tranches and you're lucky not to be Bear Stearns or Morgan or Merrill Lynch or Lehman Brothers, for that matter it means, however, you really need to shore up your balance sheet, because you've got these securities that you know you'll be able to sell someday. They're not worth zero, but you are going to have trouble selling them in the early stage, and so the uncertainty of the value of those caused banks to start protecting their balance sheets.
Speaker 1:What does that mean? That's fancy speak for saying the banks stop lending. And if the banks stop lending now, you have a big economic problem because, as we've discussed earlier, it is an important role in our economy that credit plays. Businesses grow by credit, households fund their expenses by credit, and if credit becomes difficult or impossible to get, can cause a very, very serious problem. So what was the?
Speaker 1:So that's the consequence of this innovation, this innovation in the mortgage market provided some really salutary benefits. More people could own their home, more capital was available for that use, more capital meant that the costs of that lending were lower, that more people could afford to do it, and it was all together very, very salutary. But, like a lot of innovation and financial markets, what we saw are the unintended consequences of the innovation, the ways in which a panic in this case a panic around the lowest tranches of mortgage backed securities could infect all mortgage backed securities. But the problem didn't stop there, because of the nature of how those securities were sold held on the balance sheets of banks until they were sold created a credit crisis and banks stopped lending money. So how did we get ourselves out of it? What are the things that we did to try to help make sure that this doesn't happen again?
Speaker 1:The Dodd-Frank Reform Act had included within it several reforms in order to make sure that, if ever we were to encounter a problem like this again, it would be less likely that we would experience something like the credit crisis in 2008. Three things, basically. First, banks were limited in their ability to trade in these risky securities with depositors assets, so that changed things quite a lot, because when everybody wanted to own them, some banks held them as inventory to sell, to sell, but other banks actually traded in them because they were going to make money on them. The Dodd-Frank Reform Act prohibited banks from using depositor assets to do that. Second, bond rating agencies were now going to be supervised by something called the Office of Credit Ratings within the Securities and Exchange Commission. The big problem was that the lowest tranches were being highly rated because of these credit default swaps, but very few people were understanding whether the credit default swap counterparty was really able to make good, and so the bond rating agencies now come under the supervision of the SEC to make sure there's more uniformity and more objectivity.
Speaker 1:Third, there are risk limitations imposed on credit default swaps. So we still have credit default swaps, they're still out there, lots and lots of counterparties issued them, but now we have a set of regulations and a set of risk limitations so that we can make sure that those who are issuing them and it's a very good thing to have in the bond market, but for those issuing them that they can make good on them when and if the time comes. So that's it for the bond market. I'm going to leave it there and when we come back to see each other or hear each other. Next time we'll talk about the second part of the long term securities market. We're going to talk about the equity market. Thanks for listening.
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