Financial Crisis: A Layman’s Understanding

I am trying to make sense of this financial mess. I am highly motivated as my core customers — professionals in real estate, financial and investment services — are all impacted by this mess.

Will the bailout help? After weeks of research I can honestly say I have no idea. And I think there are about 100 people in the world with enough experience to have a good idea. (This, of course, excludes every member of Congress.) The best I can do, I have come to realize, is understand the history and push my Congressman to enact changes so it doesn’t happen again. This whole problem comes down to transparency.

Let’s start with the history. In layman’s terms, here’s what happened:

  1. The housing market was out of control. People who should have never gotten loans did. And banks were offering these folks loans at rates far less than what it would take to pay off the loan (these are the sub-prime ones).
  2. As you know, when a bank lends money it is on the hook (this is the bank’s risk). If the person who borrowed the money can’t repay it, then the bank has to write off the debt. Our government requires that this debt be on the bank’s books, which impacts its bottom line (negatively) and which drives down its stock price (negatively).
  3. To mitigate its risk, the banks started trading that debt to investment banks. It got the debt off the bank’s books in exchange for a bond. It’s an insurance policy (called a credit default swap or CDS): the bank buys insurance against that debt going bad. Someone else gets the debt risk and all the bank has to do is make monthly payments! Good deal! Now the debt is off its books and it is no longer negatively affecting the stock price.
  4. The investment banks that bought up this debt then took it, threw it all in a big pile and chopped it up into pieces. Think of it like making cookies. You take the dough and roll it out and take your shapes and cut up the dough, then mush the remaining dough back into a ball, roll it out and do it again, over and over, until the dough is gone.The investment banks did this so they could cut the debt into strips (called tranches) that had similar potential failure rates. These tranches of debt, called CDOs or Collaterized Debt Obligations, were packaged up as bonds and sold on the market. Everyone in the world bought them.

The problem is it was a giant house of cards. Let’s start at the top (the numbers reference the same bullets from above):

  1. When the housing bubble popped, house prices started to sink. People who took sub-prime mortgages, who were over their head’s before, were really in trouble now. Not only didn’t they have the money to repay the loans but they also realized they couldn’t sell the house either a) quickly or b) at a value above their mortgage. They also couldn’t refinance. They started to default instead.
  2. The banks realize that, if people aren’t repaying their loans then they aren’t covering their debt obligations and are suddenly struggling to keep enough cash in the bank to stay around.
  3. Even though they got insurance on the debt, all this did was move it off their books (out of sight, out of mind) instead of reducing their risk. They still had to make the “insurance” payments and now they couldn’t do that. There was just too much of it. So Bear Sterns, Countrywide, and Fannie Mae and Freddie Mac go down hard. Bear Sterns was supplying CDOs and the others had tons of defaulted sub-prime mortgage debt.One thing you need to know is that banks rely on lending to meet their daily cash obligations. And this is when we really get into trouble because no one knows who will go under next. The financial institutions get uptight, and when financial institutions get uptight, everyone stops lending money to each other. In other words, no one wants to get stuck holding the bag. [See Fear and The US Economy.]
  4. If there is no money coming back into the companies to repay the debt and no one can borrow money to cover their cash needs, then the entire system starts to unravel. Boom! Suddenly AIG fails — they insured a lot of that debt — and Washington Mutual goes under and Lehman Brothers — who was investing in CDOs — fails and Wachovia is gone. And every time another institution fails, it becomes even harder and harder for anyone to borrow money to meet their daily obligations. It’s a vicious cycle.

So our Federal Government (with the Fed) acts as lender of last resort. And that’s what they have been doing, either exchanging great amounts of money to companies for large equity positions (i.e. buying up Fannie and Freddie) or arranging buy out deals with others (i.e., Bear Sterns, AIG) or letting them fail (i.e., Lehman).

And now the bailout, in essence, to buy up large amounts of debt that no one else is willing to buy. If the government does it right, there could be trillions of dollars in it for US taxpayers since we are presumably buying this debt for pennies on the dollars. And if they do it wrong, we get more failed companies and/or rich bankers/soaked US taxpayers. Take your pick. In the 1990s, the government played this game successfully by buying up lots of Savings and Loan debt for $.50-$.60 on the dollar and then selling it off a decade later. Will it work this time? I have no clue.

But what I do know is that the underlying problem is really one of transparency. As I have said before, transparency is the key to an efficient market and it is the government’s job to ensure that transparency. Everyone has to play by the same rules. If I can’t see what rules everyone is playing by then the whole system is in trouble. Things like carving up debt into new debt (i.e., this mess) and hiding debt off the books (i.e., Enron and Worldcom in the tech bubble) are two such examples.

Our government has abdicated their oversight roll, the roll of making sure that the market is transparent. It’s time for Congress to do its job and ensure transparency.

This reminds me of the definition of insanity: doing the same thing over and over the exact same way and expecting the outcome to be different. Congress could have dealt with transparency issues in 2001-2 but failed to do it. If they don’t deal with it now, we will be having this same conversation about something else in 6-8 years.

2 thoughts on “Financial Crisis: A Layman’s Understanding

  1. Elia,
    Good summary. I would add, however, that we should not overlook the impact of legislation—from the 70’s, I believe, coercing banks to provide loans to otherwise untrustworthy borrowers for mortgages with the aid of Fannie and Freddie—and the deregulation of appropriate credit verification by the lenders. These two main contributors have joined with the easing of bankruptcy laws over the years and the inanity of government leaders ( like VP Cheney ) promoting “toxic” behavior with stated opinions endorsing a “debt doesn’t matter” philosophy. That “toxic” behavior has been adopted by far too many Americans of all races and creeds in every socioeconomic level. They took shelter under the umbrella of false confidence that somehow they should not worry about or feel ashamed when they walk away from debts owed. This corrosive and selfish attitude aligned itself with greed on Wall Street and provided the Category 5 hurricane force of this financial Perfect Storm. It has been a long time building. It is a calamity created by Democrats and Republicans. A one-time gimmick bailout may grease the current lending stalemate but it will not diffuse this behavioral problem. It will require strong national and local leadership and attitude modification across a very wide swath of the American population. How do you awaken those who believe that it is their American right to demand assumed entitlements ( i.e. our money promised to them by politicians spending our tax dollars ) but not the responsibilities they have to our country and especially to those they are taking the money from to pay back what they borrow? If there is a high probability that you cannot pay back a loan unless “blue skies” stay in place forever, you should not take the money. Debt does matter. People ( and governments ) want and deserve to be paid back what borrowers agreed to pay.

  2. I agree with you completely, Ken. A couple of collaborative points:

    1) I drew the line in the sand somewhere to explain this. Yes, we could trace back to the formation of Freddie and Fannie as being ‘market modifiers’. Both of those organizations were put in place to increase home-ownership. Because they are forced to buy loans, good or bad, below a certain threshold, people who the market would consider inadequate for home ownership can now get loans. So banks take risks — think 0% down, for instance — with loans because they know they can dump them on Fannie Mae.

    We could also trace this to 9/11. In its wake, the economy contracted (recession) and the Fed dropped short-term rates to try and combat the problem. Short-term rates, the ones the Fed controls, dropped way below long-term rates. What did this cause? A lot of short-term borrowing, like all the sub-primes loans. Governor Palin, in the VP debate Thursday night, kept criticizing Senator Biden for looking backward. The only way to fix this mess is to understand how we got there first. History, as Senator Biden said, is prologue.

    3) I have been thinking about this post since I wrote it and wanted to add a comment regarding regulation. To me, oversight and regulation are two completely different things that, throughout US history, have been tied together. The run of deregulation over the past two decades has thrown the baby out with the bath water. Yes, deregulation is fine but we can’t stop watching the companies that used to be regulated. The SEC provides oversight. FASB, the accounting standards board, provides oversight. We need oversight to ensure that companies are transparent in regards to the businesses so everyone can work from a level playing field.

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