Current Crisis for Dummies
Ali Mir, Professor of Business at Wayne Paterson and acclaimed lyricist for films like “Dor,” has produced a quick guide to the financial mess we are in:
If you don’t understand the financial crisis on Wall Street, don’t fret. No one does, least of all the experts. What we do know is that it is an unholy mess, which is about to get worse. Here’s my quick FAQ for those who don’t wish to wade through dense treatises on collateralized debt obligations, asset backed commercial papers, and blah-blah-blah. It’s hardly comprehensive, but it can serve as a starting point for engaging with the issues surrounding the greatest financial debacle since the Great Depression. Let me know if any of this doesn’t make sense. AM.
Do the roots of this crisis lie in the housing bubble?
The roots are all over the place (in the absence of regulation and oversight, for instance), but for the sake of simplicity, let’s say yes. After 2001, the Fed kept its interest rates low in order to increase liquidity and encourage spending. Financial institutions offered easy credit to those who wanted to borrow money to buy a house. Many who did not qualify for loans at regular market rates – the subprime borrowers – were persuaded to take out mortgages despite the fact that their income level, ability to make a down payment, and credit history made them high-risk debtors.
Why did so many borrowers take out mortgages?
As the number of buyers increased, the values of homes started going up. And as the values of homes started going up, the number of buyers increased. Everyone wanted to jump on the gravy train. In 2005 and 2006, 40% of homes sold in the U.S. were purchased as either investment or vacation homes. Financial institutions offered subprime borrowers “teaser rates” which were scheduled to go up after a period of time (these were the so-called ARMs – adjustable rate mortgages). Existing homeowners assumed that the value of their principal asset – their home – had increased (when they noticed, for example, what their neighbors’ home was selling for) and refinanced their mortgages, spending the borrowed money.
Why did the financial institutions lend so much money to these “subprime” borrowers? Weren’t they worried about defaults?
Not really. For one, most mortgage brokers do not lend money of their own; they merely collect commissions. Besides, the system is geared towards increasing revenues and profits in the short run. Bonuses are linked to current performance. But more importantly, many of these institutions were not planning to take much of a risk. Because of a lax regulatory system, these loans were allowed to be “securitized”. In other words, the rights to these mortgage payments along with the accompanying credit risks were sold to third-parties.
So the risk passed on to the third parties then?
In some cases, yes. But for the most part, these third parties cut up these securities, mixed them up, repackaged them, and sold them down the line in the form of Mortgage Backed Securities (MBS) or Collateralized Debt Obligations (CDO). There was little, if any, regulatory oversight. At each step, the parties in this chain collected profits, and believed they were handing off the risk.
What was the role of AIG?
AIG offered insurance to those who bought MBSs and CDOs in exchange for a fee. Credit rating agencies such as Moody’s and Standard and Poor’s gave a high grade to these securities, thus reducing the amount of collateral that AIG was required to post in order to demonstrate that it had the ability to make payments in case there were defaults.
I am not sure I understand.
Assume that you bought $1 million worth of securities. You are worried that the assets behind these securities are not a sure bet. So you hedge by buying $1 million insurance from AIG. If there is a default on the payment, AIG pays you your $1 million. These are the so-called “credit-default swaps”. Pay attention to that term. We will hear a lot about it in the near future. There is currently a $62 trillion (yes, that’s a trillion) market for these swaps which is absolutely unregulated.
How much is a trillion anyway? Apart from being a really large sum of money?
As figures keep getting tossed around, one begins to suffer from number fatigue. How does one make sense of these large values? Here’s one way to imagine a trillion dollars. Let’s say you have a magic machine that spits out a $100 bill every second, all day and all night long. In the first minute, you’d have $6,000. In the first hour, $360,000. In the first 24-hour day, you will possess more than $8.6 million. A year later, you’ll have a little more than $3.15 billion. In other words, it will take you and your machine more than 317 years to produce a trillion dollars.
So, back to our story. Wasn’t everyone making money?
Until a certain point in time. But as usually happens with a bubble, the quid came calling for the quo. Subprime borrowers defaulted on their loans when the higher ARM rates kicked in. Foreclosures increased, putting a pressure on the now heavily inflated home prices. Excess inventory created by builders and speculators during the boom started to mount. As prices began to deflate, owners found it increasingly difficult to refinance their homes. The MBSs were not so attractive any more.
So institutions that owned MBSs were in trouble?
Exactly. Bear Sterns was the first to crash. The Feds had to step in and facilitate its “sale” to JP Morgan at the cost of $29 billion to the taxpayers.
And why did AIG stumble?
Credit rating agencies woke up to the fact that they had assigned AAA ratings to relatively worthless securities, so they downgraded the credit of AIG, requiring it to post additional collateral. Since AIG didn’t have the billions it would have taken to do this, it had to be rescued if it was to be prevented from declaring bankruptcy.
Why would that have been such a terrible thing?
If AIG went under, all those who had hedged their bets would have suddenly found themselves in a heap of trouble. They would have most likely gone belly-up too.
So AIG was too important to allow it to fail?
That is the narrative being bandied about. But the bailout wasn’t about AIG. It was done in order to save its “counterparties”, the ones who had bought insurance.
Who were these counterparties?
We are not sure. But most of them (around three-quarters) were probably European banks.
Why wasn’t Lehman bailed out?
We don’t know. Perhaps it was the luck of the draw. It came second in line (after Bear Sterns) and maybe the government wanted to play it tough. Or perhaps its counterparties were not important enough to rescue.
What was the story with Freddie and Fannie?
Mae ‘n Mac owned or guaranteed many of the MBSs and several mortgages that were subsequently bought by foreign banks (China was a big player), who assumed that these government sponsored enterprises (GSEs) would not be allowed to fail. Since foreign funding (those trade surpluses China has with the U.S.) are essential to making up budget (and trade) deficits, the government had to step in and rescue the GSEs, lest foreign capital wander off elsewhere.
Now what?
The U.S. government is planning to bail out the financial institutions whose reckless greed produced the mess in the first place.
What if it doesn’t?
Financial institutions devastated by this crisis have very little capital to lend. Without the credit that they provide, the economy will suffer. How much is unclear, but the impact is likely to be quite severe.
What does the administration want?
The Treasury secretary is asking for unfettered access to $700 billion in order to buy any asset from any institution at any price he thinks is right. Further, the Secretary says that his decisions will be “non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” The government plans to buy up the MBSs at a price it determines (critics worry that lobbyists of the financial institutions will play a role in this), thus freeing the institutions to infuse credit into the markets.
Who will foot the bill?
Ordinary citizens – the taxpayers – who will see a skyrocketing deficit, and most likely, shrinking investments in public goods, dwindling retirement accounts, and greater inflation.
Is there any alternative?
If it doesn’t want to think outside the box (and it is clear that it doesn’t), the least the government should do, in my opinion, is to demand an ownership stake in the companies it bails out. That way, if they recover, the bailout money can be returned to the treasury. The current plan only rewards those who drove the economy into the ground, and who made a lot of money during the good times.
So one final question. Was the crisis primarily caused by irresponsible borrowers who took on loans that they did not have the ability to repay?
No. It’s true that defaults on mortgage payments, especially in the subprime segment triggered this crisis-in-waiting. It is also true that borrowers, both prime and subprime, failed to read the fine print, took out larger loans than they could afford to repay, and got carried away by the thought of buying property that was supposed to keep increasing in value. But the subprime loans were pushed by an unscrupulous industry, which preyed on a population that did not have the wherewithal to figure out the swindle before it was too late. A lot of educated, middle-class Americans lost out too, but the subprime crisis represents the greatest transfer of wealth from the poor to the rich in recent times, and the greatest loss of wealth for communities of color in the post Civil War period.
Thanks for this. One additional question (and possible answer): Why the panic all of a sudden? Is it because A LOT of those sub-prime mortgages will balloon in October?
Comment by Jeff Moses — September 25, 2008 @ 12:11 pm
It seems sudden, but the crisis has been in the making for the last year at least. It was evident that these firms that are now in trouble were finding it increasingly difficult to raise money to cover the losses on their subprime loans. Remember that they were all very leveraged – they were mostly playing with borrowed money – and therefore any loss was highly amplified (as had been the profits during the good times). Frannie and Freddie were about to default on their loans, Lehman could not find anyone willing to lend money to it, and AIG’s credit rating was downgraded by the rating agencies forcing it to put up more money as collateral (against the now-higher-risk securities it was insuring). So, while the details of each of these stories are different, the basic cause was the lack of financing. Once Mortgage Backed Securities began to hemorrhage, no one wanted to buy them (yes, the anticipated defaults down the road – in October and beyond – contributed to it). And as the crisis enveloped one firm, the market value of these securites spiralled downwards rapidly till they became – as they are being called now – illiquid assets. The sudden-ness you mention is a result of this. The MBS bubble has burst.
Comment by Ali Mir — September 25, 2008 @ 1:26 pm
Thanks to Ali mir for this–it’s really well explained. I wonder if you’d be kind enough to explain a bit more about what kind of regulation/regulating body would have been necessary. For instance, Europe hasn’t seen a similar crisis: do the EU countries have a regulator to look into housing loans? I’m trying to understand whose fault this is, ultimately: should Congress have created a regulatory body when the housing boom was underway, or was it the Federal Reserve’s area? Thanks.
Comment by Aravind — September 27, 2008 @ 5:45 am
Aravind,
It would take too much space to explain it this sufficient detail, so I will just offer a few basics. If you have further questions, I can try to address them. I have written a bit more about this here: http://outlookindia.com/full.asp?fodname=20080926&fname=ali&sid=1
That piece might give you an idea of the casino capitalism that was rampant during the deregulated phase, and explain a few basic things that’ll allow the following to make more sense.
There were several regulatory “lapses” during the period that led up to the crisis. Institutions such as Fannie Mae and Freddie Mac had been set up to buy mortgages from lending institution, thus freeing up more capital for more lending to more homeowners. In an increasingly deregulated environment, they were allowed to cut, mix, and repackage these mortgages as abstract securities, and to resell them, thus creating a largely unregulated market for fancy and risky derivatives (see below for a better explanation of this process). Lenders of subprime loans were pretty much unregulated too, since many of them weren’t even banks, but merely mortgage companies that made the loans, and then sold the mortgages to players on Wall Street. And players there were a-plenty, including a whole host of new ones called hedge funds and private equity firms, who were left alone to do as they pleased. Also, the Clinton administration (in 1999) repealed the Glass-Steagall Act that separated comercial banks and investment banks, allowing bankers to underwrite securities and sell them to investors.
But there were two MAJOR deregulatory forces that had more to do with this crisis than any other. One was the fact that investment banks were allowed to leverage their capital heavily. So for instance, for every $1 it held in capital, Morgan Stanley had $30 in debt. This allowed the financial institutions to bet heavily with borrowed money. Which was great as long as the going was good, but it magnified the losses massively when the downturn came along.
The second problem was a strange one. The government chose to look the other way on several issues of conflict of interest. Remember Enron? It had hired Arthur Anderson to audit its books, even while it retained the same company for huge consulting projects. The Sarbanes-Oxley Act fixed that but only after a major debacle, which claimed several prominent organizations. In the case of the current crisis, the securites that were created out of the mortgages (see below for an explanation I have cut-and-pasted from my other piece) became desirable only because credit rating agencies like Moody’s and Standard & Poor’s gave them AAA ratings. Why did they do that? Well, financial institutions that want to sell their securites hire the rating agencies for a large fee to help them convert their mortgages into securities that can be sold in the market. Shouldn’t the rating agency be an independent – maybe a government-run – organization that doesn’t have a dog in the fight?
Should the Congress have created a regulatory body when the boom was underway? Perhaps. But there was enough leeway even within the system for regulators to act in a way that might have prevented the worst of these excesses. But the administration wasn’t exactly a public-minded one, was it?
Hope this helps,
Ali
An explanation about the securities racket:
Securitization is a fancy word for the creation of fictitious products called “securities” (which are themselves based on actual assets that are expected to generate income). This is how the game was played: the get-rich-quick Wall Street crowd peddled these subprime loans that they knew very well were predatory, created a bunch of abstract securities by using the mortgage as collateral, packaged them with fancy labels called MBSs-CDOs-CMOs, persuaded credit rating agencies to attach AAA labels to some of the securities, sold these to investors, exploited accounting loopholes to create shell companies called Special Purpose Vehicles (SPVs) in the Cayman Islands and other tax havens, and transferred the junk securities to the balance sheet of the SPVs. So by the time they were done, they had taken crappy mortgages and converted them partly into AAA securities, partly into lower rated ones, and partly into trash that was no longer on their own books (these are the various “tranches” we keep hearing about).
Comment by Ali Mir — September 28, 2008 @ 12:18 am
Great article. Thanks so much. This was incredibly, extremely helpful.
Comment by Sandra L. — September 28, 2008 @ 9:52 pm
Excellent article, genuninely helpful. I have listened to the politicians and Wall Street for the past few days and simply became more confused. Genuinelly appreciate your time given on this.
Comment by Alexander - Melbourne, Australia — September 30, 2008 @ 3:11 pm
thanks again for this! aravind.
Comment by aravind — October 3, 2008 @ 7:33 am
Great article, easy to understood
Comment by wa2nlinux — October 9, 2008 @ 11:44 am
Wow! This article is really helpful and now I have a better understanding on the whole situation - thanks and keep up the great work!
Comment by kiwigal1 — October 10, 2008 @ 3:59 am
My Friend, Thank you very much for the enlightenment! Somehow, I know the roots of this Global Financial Crisis!
Comment by Philip Ian — October 22, 2008 @ 1:44 am
global crisis…huhu
Comment by Parantar — November 4, 2008 @ 2:37 am
hi ali
Exaclty how do mortgage backed secrutities work and how are they any different from CDO’s?From what i can piece together is that MBS’s are basically the right to the cash flow from a mortgage??So mortgage lenders would lend to person A. They would then sell that mortgage to some 3rd party. The 3rd part would sell the right to the mortage payments to so different investors after getting it rated by an agency,correct?
In the extract above it refers to “junk securities” and “shell companies’.What are those exactly?Sorry for so many questions =D.
Thanx for your time,
james
Comment by James — November 17, 2008 @ 11:27 am
And what can we as the screwed taxpayer do to voice our outrage, get the change we need to stay protected, hold our representatives responsible to not further enrich the robber barons who knowingly stole from us? Why would I go to jail for stealing food if I needed it, and they are not only free, but they will remain free to continue doing what they do flying around in their Lear jets, taking $40,000 vacations, while receiving bail out money from my 401k, my future higher interest rates, inflation and taxes? When does the short-term memory of average Americans become enough of a long-term rage to finally not only shame white collar crime, but make the criminals accountable? When will we stop wanting to be like the rich, admiring the rich, watching the rich on t.v. and in magazines, forgiving the rich by believing crackpot notions like regulations and laws are bad because the rich tell us that we should never hinder them and their institutions the right to make limitless money at the majority’s expense? When will we see that when CEOs of multi-nationals get jobs as elected or appointed officials in government, it’s not just a conflict of interest, it’s a special interest!
What! What! What! can be done to bring real accountability to them and stop this expectation that we have to pay for their party when we’re not even invited?
Asia Real, Ventura California
Comment by asia leone — November 24, 2008 @ 7:18 pm
thankz Mr. Ali Mir.. it’s a helpful article.. esp. today in a world crisis..
Comment by watzabatza — January 24, 2009 @ 11:22 pm
There’s no doubt that reckless greed exists and is instrumental in this mess. But why give the feds a pass on our money system and the bankrupt idea of credit expansion through government intervention? All anyone has heard about the past 20 years is “ownership society” through extending credit to low income (high risk) people. The chickens are home to roost and you only blame business? It doesn’t seem contradictory for the feds to spur the economy through inflation and tax incentives and then skirt the blame when a bubble bursts?
Comment by eric — February 11, 2009 @ 6:12 pm
If people aren’t able to pay their debt, they should only be allowed secured credit cards. Pay $1000 for a $1000 limit, and when they don’t pay, it comes out of what they put down for the card. It’s safe all around.
Comment by Ashton — August 14, 2009 @ 7:12 pm