Dear Mom, Here’s What Crashed the Economy (Part II)

In case you missed the first post in this series, you can link to it here. You should read it. My mom says so. My goal is to answer my […]

In case you missed the first post in this series, you can link to it here. You should read it. My mom says so.

My goal is to answer my mom’s simple question: Why did the economy crash? She was asking me because she had read two newspaper articles that had completely different views as to why this very bad thing happened: Five Good Reasons Why Wall Street Breeds Protesters (USA Today), and Wall Street’s Gullible Occupiers (Wall Street Journal).

In a nutshell, these two opposing views are:

1. Wall Street greed, lax regulatory oversight, and excessive executive compensation fueled a global debt glut that finally imploded; and:

2. Federal housing policies forced Wall Street financiers to provide high risk mortgages to unworthy borrowers, ultimately leading to an unstable housing market that finally collapsed and brought the economy down with it.

In my first post, I explained some of the background for these opposing views, and I also spent a substantial amount of time discussing why view #2 appears to be (a) freakishly out of touch with reality, (b) so freakishly out of touch with reality that even people who normally want to blame the government for everything can’t agree with it, and in spite of (a) and (b), freakishly popular.

To add vinegar to gall, I don’t think view #1 really does justice to the issues either.

OK, So What Really Caused the Financial Crisis?

Believe it or not, I agree with the Republicans. Well, kind of. I agree with the three Republicans who wrote their dissent to the Financial Crisis Inquiry Commission and scooped the majority report by releasing theirs the day before.

Well, I almost agree with the three Republicans who released their dissent the day before. I also pretty much agree with the Democrats. In fact, when you look at the FCIC report and the main Republic dissent, they pretty much agree with each other. What I have to admit is that the Wall Street Journal editorial they published on January 27, 2011 contains the clearest summary I’ve ever read on why the economy collapsed. I’m going to use their top ten list and do a bit of translating for my mom and all the other intellectually curious moms out there. And so to begin:

1. Excess Liquidity: After the collapse of the dot.com bubble and the aftermath of 9/11, there were many investors around the globe sitting on lots of cash. They had pulled money out of the stock market like gangbusters and tucked it away in nice safe mattresses like US Treasury bonds, where the principal sat safe but yielded very little interest. Where oh where could these investors place their money that would be safe and still produce better returns?

2. Rising Home Prices: One place that lots of folks put their money in down markets real estate. Why? Because real estate (so the historical trend told us) never goes down in value. That was especially true for the good old US of A. And lo and behold with all those investors piling into the US housing market real estate prices started going up and up and up. What’s more, interest rates for borrowing were very, very low (thanks to monetary policy set by former Fed Chairman Alan Greenspan), so more folks could afford mortgages, and many people with mortgages were re-financing into lower rate mortgages.

3. Growth in Non-Traditional Mortgages: But there just weren’t enough “prime mortgages” to meet demand. Prime mortgages are home loans given to people with sound credit whose loans could then be “securitized” by (at least early on in the housing bubble) Fannie Mae and Freddie Mac. (More on securitization in a moment.) So mortgage lenders started looking at borrowers whose credit was not so good, so called “subprime borrowers.” Investors, it turned out, were willing to invest in subprime mortgages too.

4. Declines in Credit Quality: OK, now for that “securitization thing.” This is a big one. In the 1990s some very clever people on Wall Street figured out how to take, say, a few thousand mortgages and bundle them all together into a single security — kind of like a mutual fund, but made up entirely of mortgages from around the country. These new securitized mortgages offered some real advantages:

a) Securitization provided liquidity: Instead of making a mortgage loan to someone and waiting for 30 years while they slowly paid back, as a lender I could sell the mortgage to someone else, then use the money I just got paid and make a new mortgage loan to another new borrower. Therefore, I could make earn money by making loans, instead of earning money by collecting loans. This is much faster and more lucrative.

b) Securitization diversified risk: If I put thousands of mortgages together, I spread the risk around a lot more. This meant that using historical averages I could actually calculate the risk of not getting repaid. It turns out that based on those historical averages the overall risk to the whole portfolio is very low. I might lose 2 percent or so, but I could adjust my prices on making and selling mortgages to cover that loss. As long as my assumptions about the level of risk were accurate, then the product would actually spread risk around nicely.

Unfortunately, securitization has a dark side. As a mortgage lender, I’m now passing along the long-term risk to whoever buys that mortgage from me. Should I care? I mean, I’m making a tidy little commission on all these loans I’m selling, so maybe it’s ok if I just make a slightly riskier loan. After all, if investors buy it, then that’s their problem. And here’s where the race to the bottom begins. Investors are snapping up mortgage securities by the mouthful (even the subprime stuff), and they think they are getting what has historically been a very safe investment, but is no longer safe. In the meantime, however, there’s so much demand for these investments that the mortgage lenders are making these loans to homeowners with worse and worse credit, then passing that risk along. Yes, some homeowners were gaming the system to buy investment properties and to flip real estate for profit. And yes some homeowners were being wheedled and cajoled into taking on way more mortgage than they could afford. But really the mortgage lending industry went hog wild and pretty much made loans to anyone with a pulse, and investors swallowed it hook, line and stinker. It all got very, very ugly.

5. Poor Regulatory and Rating Agency Oversight: By now, it should be abundantly clear that everyone is pissed off at the ratings agencies (Standard and Poors, Moody’s, and Fitch), who presumably had the job of checking to see if these investments were of high enough quality. The ratings agencies clearly failed in their obligation to accurately understand, assess and communicate the risks involved in mortgage securitizations. Many investors also failed to understand the risks of what they were buying (ironically, very similar to many of the homeowners who failed to understand the mortgages they were sold), and relied on the ratings agencies faulty opinions instead of conducting their own research. Ratings agencies, it turns out, were being paid by the mortgage lenders to provide their ratings — a very nasty conflict of interest. Meanwhile, various federal regulatory agencies (the Federal Reserve, the Office of Thrift Supervision, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission) were caught up in turf battles, hampered by poor coordination, understaffed, and generally unable to keep up with the explosive growth in the banking and finance sectors. No one was really watching the shop.

6. Long Term Debt Funded by Short Term Borrowing: Now, what most folks don’t know is that many investors were buying mortgage securities using very short-term debt. How short-term? Well, it needed to be paid back the next day. That’s right. The next day. But, you ask, if you are holding a security and you plan to hold it for a long time — at least a couple of years — how do you pay back the money that you borrowed the day before? Well, you borrow the money again the next day. And so it went. As long as the mortgage securities were worth what folks thought they were worth, then this cycle of borrowing and repaying using overnight funds went unbroken. The sh*t hit the fan when suddenly it appeared that the mortgage securities might NOT be worth what folks thought. Remember in 2006 when we started hearing about rising mortgage defaults? Well, those low historical averages of homeowners failing to pay weren’t holding. It’s obvious now why this was so: they themselves were very over-leveraged. They had borrowed more money than they could afford, and they couldn’t sell the house to repay what they owed either. As default rates shot up, those securities looked like they were worth a lot less, and suddenly people had to pay back money that was due tomorrow. Ouch! But why didn’t the banks just pay back the loans with the money they had stashed away for a rainy day? Good question, Mom! It turns out they hadn’t stashed away very much money compared to how much they were borrowing. In some cases, they had only $1 on hand for every $30 they owed. This, as you can imagine, was a problem.

7. Contagion: OK, here’s another tricky issue. Remember those mortgage securities? Well, some investors said they would feel so much safer if someone would provide some insurance — just in case somehow things went really bad. Luckily, there were people (like AIG) that said, sure, we’ll insure you: if that mortgage security doesn’t pay you back, then we will. But it wasn’t called insurance. It was called a “credit default swap.” But never mind that. What you really need to know is that Person A said to Person B, you pay me a little premium, and if anything ever goes wrong then I’ll cover you. But then Person C comes along and says to Person A, hey, can you make a bet with me? I want to bet that mortgage security is going to go fall apart. Person A says, you’re crazy, it’s a very safe investment — I’ll take that bet. Person C pays Person A a little premium and essentially gets the same insurance that Person B did, even though Person C doesn’t actually own any of the investment. Weird, right? It’s like betting that your neighbor’s house is going to catch fire and getting your neighbor’s insurance company to write you a policy on your neighbor’s house. Then the house does catch fire. Now the insurance company has to bail out your neighbor, but they also have to pay you because you were right. These little side bets amounted to about, oh, $60 trillion dollars in 2007. That’s a lot right? Yes, it’s five times the size of the entire US mortgage market. Oh, and one more problem, all these bets were never disclosed. They weren’t listed on anyone’s balance sheet, or traded openly on any exchange. They were secret contracts between two parties, and they would come back to haunt everyone.

8. Common Shock: By the time things started to really fall apart, you’ve got homeowners who can’t pay their mortgages, mortgage lenders who can’t earn more fees, investors who can’t pay back their lenders, and insurance providers who can’t pay back their claims. In short, no one can pay anyone back, and a crisis that started out being about homes is now about markets. We could have absorbed a collapse of the housing market. It would have sucked, but we could have done it. What we couldn’t absorb was the collapse of the financial market.

9. Rapid Succession of Failures: Worse yet, it got really hard to tell who owed what to whom, and how much they owed. It was like a giant game of hearts, and people couldn’t tell who was holding the Queen of Spades. So what did people do? They stopped. Everything. All at once. The markets just froze up completely, like a heart attack, and weakened parties began dying: Lehman Brothers, Countrywide, AIG, Merrill Lynch, IndyMac. Others went on life support: Fannie Mae and Freddie Mac, Citibank.

10. Panic: And yes, if many others had failed, then all the others could have failed, like a plague. World financial markets would have crashed so deeply that almost no one would be left standing, and the economies of the planet would have ground to a complete halt. It was that serious.

So, crash. Boom. Bang. It was, to paraphrase, nasty, brutish. and long. It’s still nasty, brutish, and long, and now we’ve got Europe to worry about (another blog post, Mom).

But for all of you who have to argue with some Neanderthal who says we should have let the banks fail and the free markets would have corrected themselves, try these talking points:

  • Homeowners who borrowed too much didn’t bring down the economy. Banks who borrowed too much did.

  • The free market is not rational. It does not price risk well. What it does price well is the opportunity to make tons of cash in the shortest time possible, and then get the hell out of Dodge. Those who get this are rewarded. Those who do not are punished. Horribly.

Wait, There’s More!

In Part III of this blog I will discuss my favorite ideas about what to do next to help us clean up this mess. Mom sends her love!

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