Think back to senior year of high school. You get home from school and flip the television to MTV. You rock through 45 seconds of TRL with Nickleback, and then a middle-aged bald guy breaks into the middle of “Hero”: Citing risky endowment investments gone wrong, Columbia, the University of Pennsylvania, Brown, Dartmouth and Cornell shutter their doors for good.
You’re 17 years old, you’re captain of Model UN, you’ve got a 16.487 GPA and boyish good looks. But before you’ve even sent your college admissions essay to Old Blue, your chances of getting into an elite school have plunged.
Thankfully, this scenario is only fictional. But let’s change some names. Swap out Dartmouth, input Bear Stearns. Replace Columbia with Lehman Brothers. Suddenly, your 17-year-old self’s unimaginable nightmare is your 22-year-old self’s cold reality.
The answer lies, at least in part, in a dark corner of Wall Street that few understand but many live in: the mortgage-backed security market.
Basically, a mortgage-backed security is a collection of mortgages that a bank pools together to manage risk.
Banks use historical data and market demographics to predict both how often homeowners will default and how much the bank stands to lose if they do. When models predict high levels of defaults and consequently large potential losses, investors demand higher interest payments on the bonds. The pool is broken into pieces and bought by individual investors as bonds.
Rating agencies such as Fitch and Moody’s eagerly slapped their most coveted AAA ratings on these bonds, essentially deeming them as safe to invest in as U.S. Treasuries. Investment banks loaded up their personal accounts with them.
More Americans got homes for less money, lenders reduced their risks without sacrificing returns and banks made a boatload of money. All seemed well.
And then, faster than you could say credit derivative swap, the market collapsed.
Bear Stearns disappeared in a matter of days. Last week, Lehman Brothers and Merrill Lynch closed up shop too, leaving just two of the five major independent broker-dealers standing — Goldman Sachs and Morgan Stanley. (At least as of press time.)
Let’s go back to the pricing of mortgage bonds. For decades, default rates and recovery rates were predictable, and statisticians priced mortgage-backed securities assuming these rates would continue in the same manner.
But default rates did not stay the course. Interest rates rose, and borrowers struggled to make mortgage payments. Then they defaulted. Banks seized assets and flooded the market with foreclosed properties, creating a massive oversupply of homes. As home prices fell, fewer and fewer homeowners could pay their mortgages, setting the cycle back into motion.
A couple of decades ago, commercial banks would have been hit with these losses. But this time around, the mortgages were piled into the safes of investment banks like Bear and Lehman, who buckled under the weight of debt barely worth the paper on which it it was printed. Stock prices plummeted, employees lost their jobs and banks everyone thought were “too big to fail” crumbled.
With a job market now frozen like the markets for the securities that spurred this mess, Yalies looking into finance are feeling the crunch. And, with American International Group Inc. near failure, oil prices less predictable than lottery balls and a U.S. Securities and Exchange Commission so desperate that it banned short selling the horizon is looking bleak.
But, in the long run, the market will come back — as it always does — and so, too, will the jobs. Your life is not over, even if it feels like it, and perhaps most important, you are not alone.
As for the meantime? Well, there’s always grad school.