Christopher Papagianis

More to the financial crisis than just subprime

By Christopher Papagianis
July 12, 2012

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

Just as the recession in the early 2000s became linked with the bursting of the tech bubble, for many the financial crisis in 2008 has been synonymous with the blow-up of subprime mortgages.

But there was more to 2008 than that.

Gary Gorton, an economist at Yale, recently published an analysis that shows how well some subprime mortgage-backed securities have performed over the past few years – a very counterintuitive conclusion. Citing one of his graduate students, Gorton explains that AAA/Aaa-rated subprime bonds issued in the peak bubble years (when mortgage underwriting was arguably the weakest in history) were only down 0.17 percent as of 2011. In other words, the highly rated subprime bonds – or toxic assets so associated with the financial crisis – have experienced only minimal losses since the bubble popped.

Of course, that bond statistic ignores the numerous costs borne by the federal government in response to the crisis. For example, the mortgage giants Fannie Mae and Freddie Mac required more than a $150 billion bailout, and the Federal Reserve dropped and held interest rates to historical lows, in part so that millions of homeowners could refinance their mortgages (often into new mortgage products that were also backed by taxpayers through another government program). That is, it’s important to acknowledge that subprime mortgage products have done relatively well partly because of post-crisis government interventions that were costly for taxpayers.

Nevertheless, the subprime bonds’ better-than-expected performance can help us think through the broader role of highly rated securities in the financial crisis. In particular, it helps focus our attention away from the assets themselves (as it now appears that some subprime securities held up surprisingly well) and toward how the assets were financed using leverage and risky holding structures.


Consider the production process for mortgage securities during the crisis. To convert bundles of poorer-quality mortgages into valuable securities, banks made use of waterfall structures in securitization. Any future losses on subprime mortgages would first go to the lower-rated tranches of the securities. The highest-rated tranches – given AAA status – would only lose money in the event of extraordinary mortgage losses, which effectively wiped out the lower-rated tranches. Generally, lower-rated tranches accounted for 20 to 25 percent of the securitization. This meant that if mortgages defaulted and only 50 percent of the value was recovered through foreclosure, then between 40 percent and 50 percent of the mortgages in a pool would have to default for the AAA noteholder to suffer any losses. While defaults and loss severities on subprime loans have been bad, they have not been this extreme in most cases thus far, which is why the highly rated subprime bonds seem to have escaped serious losses so far – declining in value only a small amount, as Gorton suggests.

If the performance of these mortgage pools remains sustainable in the future, then one surprising conclusion post-crisis may be that the securitization waterfall structure will have actually held up surprisingly well. The construction of mortgage-backed securities in most instances will have sufficiently left enough of a buffer in place to protect the highest-rated tranches from serious losses.

Of course, the much bigger problems lay in the quality of that buffer – the lower-rated pieces of subprime mortgage-backed securities. These were generated in many cases almost as a waste by-product of the securitization process. As the housing bubble burst, it was the holders of these assets that suffered massive losses, since they were in the first loss position.

While it was originally difficult to find willing buyers of the lower-rated pieces of subprime mortgage-backed securities, issuers eventually combined and repackaged them into derivative products called collateralized debt obligations. It was these products – including the so-called synthetic variety, which relied on credit default swaps – that proved to be the real problem products. Many of them were held by structured investment vehicles (often sponsored by banks) and constitute one of the reasons financial institutions faced insolvency during the crisis.

Underlying the demand for CDO products was the phenomenon previously discussed: the universal hunger for highly rated financial products. Overwhelming demand for AAA-rated securities induced banks to create new financial instruments that effectively stretched the definitional bounds of what was truly a quality or safe asset. These structured products wound up constituting a large fraction of the losses borne by subprime mortgages.


The problem with securities during the financial crisis wasn’t just how they impacted the asset side of the balance sheet. Rather, the greatest fallout appears to be the result of how these (and other similar) securities were funded through short-term loans on the wholesale market.

Prior to the financial crisis, in the so-called shadow banking system, banks came to use securities – highly rated MBS and asset-backed commercial paper – for the purposes of short-term borrowing and lending. The higher the security was rated, the greater its collateral value, which allowed the bank to secure more funding on better terms.

The onset of the financial crisis led to large-scale downgrades of many of the securities that were used as collateral. Even though a lot of these securities did not end up experiencing large credit losses over time (per Gorton), they did suffer huge declines in market value (at least initially).

Many mortgage securities were used in relationships of overnight lending referred to as repo – between banks and other financial institutions. The downgrading of mortgage-backed securities led to greater margin calls, leading to trading losses and finally some fire-asset sales. In short, these assets could no longer support the loans secured against them; their collateral value fell and, effectively, there was a “run” on major aspects of the financial system as lenders demanded their money back. The resulting losses – from the collapse of trading arrangements, not of the underlying securities – wound up bankrupting major financial participants like Bear Sterns and Lehman Brothers.

Recent research by Northwestern economist Arvind Krishnamurthy and colleagues has found that similar problems with asset-backed commercial paper were actually far greater in scope. The resulting collapse of credit in other areas of the financial sector, such as money market mutual funds, subsequently fueled the recession.

The lesson is that it wasn’t just the product that was the issue – fragile financing mechanisms were really the key driver in the financial crisis. If financial intermediaries had held their asset positions with less leverage or with longer-duration borrowings, they would have been able to ride out market gyrations. Instead, reliance on debt and short-term holdings forced banks into costly sales and drove widespread insolvency.

The mix of leverage and the shared interdependence on extremely short-term wholesale funding markets (comprising both repos and commercial paper) turned what were initially relatively small losses into tens of trillions in lost output globally.

In many respects, the pre-crisis shadow banking system resembled the pre-Depression-era banking system, which was also prone to fragility and frequent crises. The problem back in the 1930s was partially addressed through the use of deposit insurance, which limited the potential for bank runs (though with the cost of boosting moral hazard).


Regulators today face two options in dealing with this complex financial system. One option would be to further encourage financial complexity but offer sufficient insurance (along the lines of the FDIC deposit guarantee) to financial institutions. However, this would expose taxpayers to future losses that could rise into the trillions, meaning the guarantee itself might not be sufficient to prevent a crisis to begin with. Additionally, it would further fuel moral hazard.

Another option would be to recognize the systemic fragility and work to combat the underlying sources. The first of these is the widespread reliance on “safe assets,” which itself is partially a regulator-driven phenomenon. As we’ve seen, regulators’ preferences for seemingly safe assets incentivizes market participants to create and transform risky assets into new products that can be passed off as safe. Additionally, no asset is truly safe from losses to begin with, and doubling down on that fiction simply raises the stakes when default finally happens.

The second core reform should be to restructure the liability system of systemically important financial institutions. Maturity mismatch, to the extent it happens, should take place in traditionally regulated commercial banking institutions. Firms should be free to pursue real financial innovation, so long as their actions do not result in demands for bailouts or contagious financial losses for others.

A review of this narrative suggests a rather stark picture of the reality of the modern financial system. Rather than the financial crisis being a one-off result of a historically anomalous housing boom, it increasingly appears that the central problem was a financial system so levered and dependent on near-term financing that relatively small losses could spark big problems. Absent reform, look for this pattern to return.

8 comments so far | RSS Comments RSS

All of this would be moot if the sub-prime mortgages had not been thrust on the banks by the CRA. Banks would not have had to bundle the loans up, or create the resulting CDOs, if the loans had not been made under threat of retaliation by the US Government. So I disagree with the main thrust of the article – it was the sub-prime loans that instigated the crisis.

Posted by stevedebi | Report as abusive

Thank you for stating the obvious. It is only because of Wall Street money bribing US congress members to prevent restoring and enforcing regulations, that reform has not been implemented since the financial crash. Such casino type gambling on derivatives rather than investments in actual assets is what caused the Great Depression as well as the Great Recession, and will cause the next global implosion if regulations and democracy are not restored. If America has sold its soul and lost the will to do so, then the world will have to look to stronger and less corrupt democracies to restore integrity to financial markets.

Posted by Greenspan2 | Report as abusive

Had this crisis merely been caused by subprime loans, then subprime borrowers would have lost their homes, which would have been reabsorbed into the market with negligible damage to the economy. The derivatives took a minimal risk and raised it to the power of near infinity which someone mistook for meaning no risk. The power of exponents is by definition, exponential.

Posted by Greenspan2 | Report as abusive

Missing from this analysis is what drove the demand for such products. It was the U.S. trade deficit. All dollars spent on imports must return to the U.S., since the U.S. is the only place where they are legal tender. (Sure, they can be spent on oil – from Saudia Arabia, for example – but then the Saudis are stuck with the dollars and must find a way to reinvest them back in the U.S.) Dollars can be reinvested in the U.S. in only a few ways:
- direct investment, as in factories and real estate. However, direct investment has seen a net outflow of money for decades. That is, more money leaves the U.S. to be invested overseas than is returned to be invested here. That drives the need for even more of the two remaining options.
- investment in private stocks and bonds. Included in this category are the credit default swaps discussed in this article.
- government debt, or U.S. treasuries.

The federal government was a willing accomplice in driving the purchase of credit default swaps as a means of funneling money directly back into the U.S. economy, driving a housing boom that masked the the consequences of our idiotic trade policy. Once that bubble burst, the only option left for foreign nations flush with U.S. trade cash is the purchase of U.S. debt, and the only option for the federal government is to issue it, and plow the money back into the economy through deficit spending.

The real root cause of the ongoing financial crisis is the U.S. trade deficit.

Pete Murphy
Author, “Five Short Blasts”

Posted by Pete_Murphy | Report as abusive

First of all, it should be clear that deposit institutions were dealing in speculative assets. A dependence on regulators to make that somehow work will fail sooner or later – either regulators will be told to look the other way or the folks being regulated will learn to dress up the paper while the underlying substance is truly rotten. Both of these occurred in the period 2001-2007. A return to a strict separation of deposit institutions from speculative investment banking, that is reinstatement of Glass-Steagall which worked for decades, is needed but Congress has failed to do the obvious.

Second, where have all the real bankers gone? A real banker is a cornerstone of the local community. He knows the people, the real estate, and the businesses of the community. He combines this knowledge with good judgement to make local loans to businesses and people and to do good mortgages. A real banker lives in the community for decades and takes responsibility for his loans over the lifetime of the loans rather than passing them along like a hot potato. Jamie Dimon and his ilk on Wall Street are the antithesis of real bankers. So are the thousands of real estate agents and mortgage brokers who filled out forms with false statements knowing exactly what was needed to sell the loan off and then encouraged buyers to sign them.

Posted by QuietThinker | Report as abusive

What is the purpose of the article?

Posted by ALLSOLUTIONS | Report as abusive

So, banks abrogated their fiduciary responsibilities and CREATED high risk intermediary transactions.

Posted by TIREDINPHILLY | Report as abusive

I think the article has an obvious purpose and that is to add clarity to the debate and deliberations on a proper regulatory response. There are people in the Federal agencies and the FRB that are genuinely interested in protecting the country from another, and likely worse, replay of 2007/08. Their job has been made gratuitously difficult by ideological delusion, partisan obtuseness, and flat out corruption in the Congress, focused in their Financial Crisis Inquiry Commission and played out in the confused and malleable constructs of Dodd-Frank.

The guilty parties are still doing all they can to dilute regulation and divert public attention to the Community Reinvestment Act (CRA). Sadly, one of the commenters here has fallen prey to their siren song that the banks who took the risks and virtually collapsed are fine — it’s really all those poor people who caused this mess. I have downloaded at least a dozen serious papers that have shown the CRA to have had negligible involvement in the debt and banking crisis, so the “scientific” assessments are out there if the effort were made to read them.

The comment by Pete Murphy adds a useful layer of depth to this analysis, but if he ever returns to this discussion, I’d very much like him to explain how he concludes that the “federal government was a willing accomplice in driving the purchase of credit default swaps.” I thought that the opaque OTC trading, the speculation beyond hedging, and the impenetrable complexity of some instruments all point to purely private sector initiative here.

Posted by cowboy_abq1 | Report as abusive

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