Can’t Grasp Credit Crisis? Join the Club - Another Rehash

March 26, 2008

The NY Times had this article a couple of weeks ago explaining the Credit Crisis in a simple and easy way to understand. I wanted to blog about at the time, but totally forgot about it till another PF blogger recently blogged about it.

So how is it that a mess concentrated in one part of the mortgage business — subprime loans — has frozen the credit markets, sent stock markets gyrating, caused the collapse of Bear Stearns, left the economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression?

Great question! And if you still can’t understand after reading dozens of articles and blog posts, don’t feel bad. I’m going to add a couple of snippets from the NY Times post and add a couple of comments I think they missed.

It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she’s going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

We all remember those ARM (Adjustable Mortgage Rates), right? The NY Times doesn’t mention that the catalyst for the real state bubble wasn’t really the new type of mortgages, but the low interest rates. After the 2000 dot com bubble burst, the Feds, trying to save the stock market, started lowering rates (sounds familiar?). People were able to get loans with rates as low as 3.56% (1-Year ARM in 2004). Would we be in this current mess had the Feds not lowered rates as much as they did? Food for thought.

Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Good point, but again, it’s a simplistic view. Normally, 5-ARM loans would make perfect sense. Why get a 30 year loan if I know I’ll be moving in 5 years?

But as I mentioned in my previous post, if lenders were responsible and NOT greedy, they would only loan money to people that could actually afford those loans.

And how were lenders making money with these risky loans (lending to people that can’t really afford)?

As mentioned by the NY Times, they repackaged these loans as C.D.O. These packages are then rated by agencies like Moody, Fitch and S&P. Because these rating agencies were using outdated algorithms to rate these C.D.Os, lenders were able to resell these C.D.Os with AAA ratings (the best one out there).

That caused hedge funds, international funds, investment banks and all sort of companies and people wanting to make money to buy these AAA investments with high returns.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people — by “people,” I’m referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

Now we all know they were risky, but at the time, everyone were buying them because of their excellent AAA Ratings (as mentioned above). Not only that, we also had insurance companies insuring these packages. Traditionally, they used to insure only muni bonds, but greed struck them, and they decided to also insure these complex vehicles. And once these subprime mortgages started to default, everyone started realizing that these ratings meant nothing. C.D.Os and their insurers started being downgraded causing banks and financial institutions that owned them to write off billions of dollars.

It was just a huge cluster f**k that a lot of us are still trying to understand.

This toxic combination — the ubiquity of bad investments and their potential to mushroom — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

The conservatism has gone so far that it’s affecting many solid would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Streets fears. A recession could cause credit card loans and other forms of debt, some of which were also based on overexuberance, to start going bad as well.

And that’s how subprime mortgage loans were able to crash the whole global financial system, from 401k plans in America, retirement funds in japan to a Wall Street iconic symbol, like Bear Sterns.

Posted in Finances