Hank and Nancy: The Subprime Crisis, the Run on Lehman and the Shadow Banks, and the Decision to Bail Out Wall Street
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R E V : D E C E M B E R 1 , XXXXXXXXXX
HBS Professor Rafael Di Tella, Professor Alberto Cavallo (MIT Sloan School of Management), and Senior Researcher Aldo Sesia (Case Research &
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R A F A E L D I T E L L A
A L B E R T O C A V A L L O
A L D O S E S I A
Hank and Nancy: The Subprime Crisis, the Run on
Lehman and the Shadow Banks, and the Decision
to Bail Out Wall Street
On the evening of Thursday, September 18, 2008, U.S. Treasury Secretary Henry (Hank) Paulson
(MBA ’70) convened an emergency meeting with Speaker of the U.S. House of Representatives Nancy
Pelosi and other leaders from Congress. Over the prior six months, the Treasury Department and the
U.S. Federal Reserve (the Fed), under the direction of Chairman Ben Bernanke, had been working
overtime to control the fallout of the U.S. housing crash, which had left the financial markets jittery.
Paulson and Bernanke had been fighting the “crisis” on an ad hoc basis, addressing each of the
problems as they arose. Now, however, Paulson wanted to address the crisis with a comprehensive
approach and was about to ask Congress to give the Treasury an unspecified amount of money (the
equest ended up being $700 billion plus) and the authority to purchase large amounts of “toxic assets”
from U.S. banks. According to Paulson, without this the U.S. economy would collapse from the weight
of the risky mortgage-backed securities whose value was in free-fall. “If we don’t do this,” Bernanke
eportedly said, “we may not have an economy on Monday.”1 When asked what would happen if
Congress did not grant the Treasury the authority it sought, Paulson replied: “May God help us all.”2
Events Preceding the Meeting
The Housing Bu
le and Subprime Crisis, 2006–2007
House prices had risen steadily in the U.S. for decades (see Exhibit 1). For many people, buying
properties appeared to be a safe investment with the potential for high returns and low bo
owing
costs, particularly after 2001, when the Fed lowered its federal funds target rate below 2% and house
prices started to increase more than 5% every year (see Exhibit 2).
The housing boom was also the result of a long process of innovations in mortgage-lending
practices. For decades after the Great Depression, mortgages in the U.S. were mostly structured as 30-
year fixed-rate loans. While this protected bo
owers, it created problems for lenders when market
interest rates increased. In particular, in the early 1980s a large number of “savings and loans” (S&L)
For the exclusive use of G. Ca
ena, 2021.
This document is authorized for use only by Graciano Ca
ena in Competition in the Global Economy taught by NOEL MAURER, George Washington University from Jan 2021 to Jul 2021.
XXXXXXXXXXHank and Nancy
2
companies failed as the Fed kept interest rates above 10% in an effort to lower a double-digit annual
inflation rate. The S&L crisis of the 1980s
ought significant losses for the government, which
guaranteed depositors through the Federal Savings and Loan Insurance Corporation (FSLIC) and
eventually through the Federal Deposit Insurance Corporation (FDIC).
The S&L crisis also promoted the process of securitization. With the objective of improving access
to housing while limiting the risks involved with traditional fixed-rate mortgages, government
sponsored enterprises (GSEs) Freddie Mac and Fannie Mae (whose motto was “Our Business is the
American Dream”) started bundling prime mortgages purchased from banks and selling mortgage-
acked securities (MBSs) to investors. The GSEs collected a fee for guaranteeing the interest and
principals of the MBSs, while investors received a claim on all future payments from the underlying
mortgages. In principle, securitization allowed investors to diversify the risk by pooling mortgages
from different locations and risk profiles, while local banks continued to perform the “screening” of
potential bo
owers, analyzing their income and employment information, financial assets and debts,
and bankruptcy history.
The 1990s
ought even more innovations in lending practices. Mortgage interest rates started to be
adjusted by the likelihood of default predicted with computer statistical models that relied on FICO
credit scores (which assigned a number indicating an individual’s credit history). Lenders started to
ely more on mortgage
okers, which identified potential bo
owers and received a commission for
each loan. These commissions typically rose with the interest rate paid for the loan, so
okers often
specialized in “subprime” bo
owers, who had lower credit scores and paid higher interest rates on
their mortgages.
Gradually, lending standards were relaxed and the share of subprime mortgages rose from 9.5% of
all mortgages in 1996 to 23.5% ($600 billion) in XXXXXXXXXXSubprime mortgages were often structured to
have a relatively high fixed rate for two years, and then an adjustable rate for another 28 years (2/28s
mortgages). Debtors had pre-payment penalties in the first two years, but could refinance afterwards.
Other bo
owers were offered similarly structured “adjustable rate mortgages” (ARMs). Brokers often
ecommended these loans to debtors on the basis that they could use the first two years to raise their
FICO scores and obtain a better rate by re-financing at the end of that period. This also benefited lenders
and
okers, who collected refinancing fees.
By the early 2000s, the variety of mortgages being offered to bo
owers was unprecedented.
Examples included second mortgages that covered the down payment of the first mortgage; “option
ARMs,” which allowed bo
owers to decide how much down payment they wished to pay up front;
and “ninja” (no income, no job, no assets) loans that required little proof of income or collateral assets.
The mortgage lending boom was also fueled by a dramatic rise in securitization. A large number of
financial institutions were buying prime and subprime mortgages from the original lenders, bundling
them together into MBSs, and selling them in “tranches” to investors. These MBSs were often re-
packaged and mixed with other assets, such as credit card debt and student loans, to form collateralized
debt obligations (CDOs). The complexity of these securities increased over the years, and it was
common for CDOs to be bundled into other CDOs. To reassure investors, their issuers hired companies
such as Moody’s, Standard and Poor’s (S&P), and Fitch to provide ratings that were supposed to reflect
the quality of the underlying assets. In addition, companies such as American International Group
(AIG) sold credit default swaps (CDSs) that provided insurance for many of these bundled securities.
In 2005 housing prices rose by an unprecedented 11.2% per year and mentions of a “housing
u
le” became common in major U.S. newspapers (see Exhibit 3). However, foreclosures and
For the exclusive use of G. Ca
ena, 2021.
This document is authorized for use only by Graciano Ca
ena in Competition in the Global Economy taught by NOEL MAURER, George Washington University from Jan 2021 to Jul 2021.
Hank and Nancy XXXXXXXXXX
3
delinquency rates were still relatively low by historical standards during 2006 and early 2007.
Bernanke, speaking to Congress in March 2007, stated:
At this juncture, however, the impact on the
oader economy and financial markets
of the problems in the subprime market seems likely to be contained. In particular,
mortgages to prime bo
owers and fixed-rate mortgages to all classes of bo
owers
continue to perform well, with low rates of delinquency.4
Eventually, the troubling state of the mortgage market became clear in the summer of 2007, during
the so-called “subprime crisis” (see Exhibit 4). On March 8, New Century, the second largest subprime
lender in the U.S., announced that it was facing “constrained funding capacity” and closed its lending
facilities. By April 2 it had declared bankruptcy. In June, Bear Stearns, the fifth largest investment bank
in the U.S., suspended redemptions from two of its funds that were heavily exposed to subprime MBSs.
In August, Countrywide Financial, the largest mortgage lender in the U.S., obtained an emergency loan
from four banks in what appeared to be a na
ow escape from bankruptcy.
The crisis quickly spread to financial companies in other countries who had also invested heavily
in U.S. MBSs. In August, the German bank IKB was rescued by its government, and France’s largest
listed bank, BNP Paribas, froze three of its funds, stating that “[t]he complete evaporation of liquidity
in certain market segments of the U.S. securitization market has made it impossible to value certain
assets fairly, regardless of their quality or credit rating.”5
Trying to remain optimistic, the same day that BNP Paribas made its announcement, the Fed
decided to keep its federal funds target unchanged at 5.75% after a scheduled Federal Open Market
Committee (FOMC) meeting.6 Two days later, President George W. Bush held a press conference and
argued, “[. . .] the fundamentals of our economy are strong. [. . .] People are working. Small businesses
are flourishing. [. . .] I’m told there is enough liquidity in the system [. . .].7
In the weeks that followed, a growing number of mortgage lenders and investors faced financial
trouble. For example, Ameriquest, another large subprime lender, shut down and sold most of its