Ignorance is Bliss

23 09 2008

I’m sure a lot of people have been reading about the financial crisis that’s hitting Wall Street in the past few weeks. There’s talk about bankruptcies and bailouts and the worst financial meltdown since the Great Depression. I’m typically pretty good at removing the media hype from a situation like this and finding out the real facts. I’ve been quiet for the past week or so because I’ve really be trying to understand what’s going on and if it’s as severe as the media is hyping it up to be. It’s such a complicated matter, looking at all the causes that got us here, their effects on the economy, the reactions from the government and Wall Street, and the effects of the government actions on the economy, the financial sector, and citizens. As far as I’ve been able to discern in my week of reading, I can say this: it is definitely at least as bad as you’re hearing it is. In fact, it may be worse because the media is too short sighted to talk about how this effects us in a year or five years.

Let me see if I can briefly and clearly describe what happened. (I doubt this is going to be brief)

The whole downturn of the system started about 2 years ago when the housing market started going under. Big lenders were giving out loans to people who were hardly qualified to take them on or pay them back. In the lenders’ eyes, if the people defaulted on their loans, they still have the house as collateral and with the long trend of upward housing prices, they’d at least make back their money, if not turn a profit. The assumption was that housing prices would continue to rise. These risky loans are what you hear about when they talk about “subprime” mortgages. Subprime sounds nicer then “risky.” Eventually, prices of homes did start to come down and these subprime borrowers started to default on the loans in large numbers which caused the banks to begin to fail. I believe that so far we’ve seen 9 major consumer banks go under because of this.

So the question is, why was this money being given out so freely? There are a few reasons. First, the government helped to keep interest rates artificially low, which makes it easier for banks to get money and give it away. Also, the government pushed through regulations on banks that basically said that they need to offer loans to a wider group of people under the “everyone should own a home” initiatives of the early part of this decade. Essentially, the banks couldn’t say no to some people that they would have deemed too risky in the past. Third, there was no fear of lending because of the previously stated perpetual upward trend in the housing market.

The decline of these mortgages caused a domino effect in the financial industry because everyone had their hand in the pot of what seemed to be an endless supply of profits. Little known to most people, mortgages are bought and sold all the time. These troublesome subprime mortgages were cut up and repackaged into what are called securities. Investment banks and Wall Street firms purchase these securities all the time as a part of diversifying their investment strategy. These particular securities that they were buying and selling were very exotic in nature, being a complicated mix of a bunch of different parts of different mortgages. Thus, even the smartest of economists don’t really know what they’re worth. When the subprime market started to go under, all the banks shut down their credit, even to other banks (banks exchange cash all the time). The big investment banks, like Bear Sterns, had a problem in that they had no liquid assets. This means that they had plenty of money, but it was tied up in these exotic securities. When the housing market went under, no one wanted to buy them anymore because no one could figure out what they were worth.

Ok, everyone breathe, we’re getting there.

Next question: How does having your money tied up in these housing securities make an investment company go under? There are credit rating agencies that give grades to banks based on their assets. The two major ones are Moody’s and S&P. When these credit rating agencies downgrade a bank’s credit grade, it requires the bank to post a higher collateral on their debt assets. As an example, if you’re rating was an E, you might have to post $1 on a $100 debt, but if I lower your rating to a D+, you might have to post $5 instead. Because these investment banks had all of their money tied up in these securities that no one wanted to buy, the credit agencies lowered their rating and the banks didn’t have the extra collateral to post to cover the lower rating. This is what got Bear Sterns and AIG (more on them in a sec).

Fannie Mae and Freddie Mac are federally backed mortgage companies. This means that if a loan defaults through one of these companies, the government will back them up and make sure that they get paid. During this time of loose spending, these two companies backed up some $5.4 trillion (yes, trillion with a t) in mortgage debt and, when they couldn’t keep up with the defaults, were taken over by the government.

AIG is the world’s largest insurance company. Their situation was a little different. They offered an insurance plan to the people that were buying all of the wacky mortgage securities. (It’s called a credit default swap if you care). In essence, this insurance said that if there was a default on the mortgage, AIG would make sure that the investor didn’t lose money. AIG got a premium every month for this guarantee, kind of like what you do for your car, but in obviously larger payments. When the defaults got crazy, AIG couldn’t keep up with the payments to people who lost money and went under. Think of it like if you were Geico and all of sudden, every one of your customers got into a major accident in the same day. You’d be hard pressed to come up with enough cash to pay out all of those claims. AIG has been given an $85 billion line of credit from the government to keep afloat in exchange for an 80% ownership stake in the company. So, in essence, the government owns the two largest mortgage companies and most of the largest insurance company in the world because of the whole mess. Talk about socialism.

As you can see, it’s a long, complicated mess that took me over a thousand words to briefly write about. I’m sure I’ve oversimplified things a lot to get it down to a thousand.

The big question that I’m sure a lot of people care about is: How does this effect me? The best answer that I’ve been able to gather so far is that it’s impossible to be sure right now. In the short term, it’ll be really hard to get a loan. With the shock to the financial system, banks are a little wary of giving away any money to anyone but the most reliable borrowers. If you want to buy a house, you’ll probably have to go back to the old days of having good credit and 20% down. (Fortunately, with housing prices readjusting down, 20% isn’t near as high as it used to be).

As a taxpayer, it’s a big waiting game right now. The bailout of Fannie Mae and Freddie Mac has the potential to be profitable in the long run since that debt could turn a profit in the same way it does for a mortgage company. The same goes for the money that we used as a bailout for AIG. There is, still, a huge sum of money that no one knows about because the major bailout package still isn’t through Congress. The bad part of this that in order to cover all of these bailouts, the government will need to print money. We didn’t have any money before the bailouts and now we’re looking at a ton of money that we need to come up with that we don’t have. This money printing causes inflation which will probably lead to higher prices for middle America and the poor.

From everything I’ve read, we haven’t seen the bottom of this yet. I guess it’s time for all of us to tighten up our spending and actually get back to saving and waiting for the mess to blow over in a few years. This knowledge definitely makes me fear the next few years. I guess what they say about ignorance is true. Knowing what’s really going on is the opposite of bliss.

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One response

25 09 2008
Tim Martin

You kinda got most of it right.

Fannie and Freddie are GSEs (government sponsored entities). The government doesn’t back their mortgages though (they back FHA Mortgages). Fannie/Freddie basically just get away with stuff other public companies can’t (monopolies, etc).

Think of it this way… mortgage companies don’t have a vault of money to lend. They do a bunch of mortgages and then package them to sell to the secondard market. Fannie and Freddie are just the biggest buyers in the secondary market. So, if mortgage company A does 1000 conventional fixed mortgages, they package them and sell them (that’s the securitized mortgages). This gets them money to then originate more mortgages. That’s why Fannie and freddie (they buy over half of the mortgages in the secondary market) couldn’t be allowed to fail. It would cripple the entire industry and no one could get a mortgage. In addition to Fannie and freddie, many investment banks had these securities on their books.

The big problem the investment banks had was that these securitized mortgages (securitization is generally good thing as we see above) became illiquid. People who normally would buy or trade securities were unwilling too once they realized that subprime was foreclosuring and property was going down and other stuff was hitting the fan. They were not sure how to value the securities (basically, they didn’t know what they were worth so they didn’t buy them at all).

Think of it as if everyone today decided that the way we’ve been coming up wit the price of stocks was all wrong but they weren’t sure what the right way was either. So, everyone stops buying stock all together. Now, everyone who owns stock is basically stuck with it, has no idea what it’s worth, and can’t sell it if they want to.

Mortgage companies and investment firms (bear sterns, etc) assumed that these securities would always be liquid… meaning, that if times did ever get tough, they could always sell them, even if it was at a loss. Problem is, most had millions tied up in these securities and now they can’t sell them. Because they can’t sell them, they run low on cash. Since they are low on cash and stuck in an illiquid position, no one will lend them money (credit crunch).
Ultimately, they go broke and get sold for pennies on the dollar or go bankrupt unless the government intervenes.

That’s my simple 1000 word explanation. I could talk about this stuff all day

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