Quote:
Originally Posted by spence
Certainly, but I was speaking more to US borrowing rates (like 1%) and big outside investors seeking better returns. It's not like people were looking for a way to package mortgage backed securities just so banks could issue more loans...there was a demand that drove the process from both sides.
-spence
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With 1% rates, folks were more inclined to borrow money and plow them into low-returning securities. It's called leverage. To retail investors it's called margin.
Take a $1,000 face value bond with an annual coupon of 3%. That bond throws off $30 of interest per year.
Your return on invested capital, if you plow $1,000 of your own money into that bond, is 3% per annum.
Take the same scenario. But instead of plunking down $1,000 of your own money, you borrow $900 and only put $100 of your own money down.
You are still earning $30 in interest.
You are paying 1% on the $900 you borrowed, or $9.
On a net basis, you are earning $30-9 = $21.
$21 divided by $100 of your own money = 21% return on invested capital. That compares with 3% ROIC if you put $1,000 of your own money up.
This is all hunky dory, as long as rates stay at 1% and that your banker doesn't call in your loan and your investors in your hedge fund (the guys who furnished the $100 of capital you plowed into that $1,000 bond) don't ask for their money back.
From 2001 through 2007, this is exactly what happened, with institutional investors taking advantage of artificially low interest rates.
This caused two undesirable things:
1) a massive increase in borrowing and leverage to amplify returns
2) rampant speculation in all asset classes
When subprime CDO's started to blow up (the underlying loans weren't being repaid), guess what happened?
1) The bond we used as the example above dropped in price
2) Banks started calling their loans in
3) Nervous hedge fund investors started asking for redemptions.
So the "market forces" you refer to, which were all motivated by ridiculously low interest rates, coupled with the spark of bad sub-prime loans, initiated a massive unwinding of leverage.
That $900 you borrowed - you had to pay it back quick, so you sold your $1,000 bond. Unfortunately, due to market conditions, you took a loss on that bond. It dropped to $750 face value.
Two things happened: As a result of the drop in price, the $100 equity financing the $1,000 investment got wiped out. Also, you couldn't pay back the full amount of the $900 you borrowed from a bank. You could only pay back $750.
Repeat this over a skillion times - and you can see why the financial markets tanked. This not only happened with bonds, but with stocks, foreign currencies, and commodity futures and all sorts of instruments (hell, even a few plugs were involved I'm sure). And we haven't even talked about the $1.4 quadrillion (notional amount) of credit default swaps outstanding at the time.
Getting back to my original point: the "market foces" that you refer to that eventually bit us in the ass came about due to lower interest rates (government policy).
NONE of this would have happened if the federal reserve did not bring rates to almost zero % from 2001-2004.