The Financial Crisis

So we are back from Europe (yes, I know, it has almost been two months since then but sometimes it takes me a little bit to get started back up). I hope that by blogging about the crisis ward members' questions can be answered. If you find this information useful, please let me know and I will keep blogging as events unfold.

Also, as a disclaimer, I am not going to claim I understand what is going on. But I will relay the information I do have and convey it as accurately as I can.

WHAT PRECIPITATED THE CRISIS

There are many things that probably contributed to the crisis in one way or another, but I will focus on the housing bubble. For the past few years we have heard of the uptick in sub-prime mortgages (think home buyers with a FICO score of around 650 or less). Banks would turn around and sell certificates to third parties, which were secured by the mortgage.

For example, let's say that a prospective home buyer agrees to mortgage the property to the bank and the bank gives the buyer $250,000 to help purchase the home. The bank would usually receive the funds paid on the mortgage each month. But the bank turns around and gives a third party the equivalent of the right to those monthly funds in exchange for immediate payment, which the bank can then use to make more loans. Lehman Brothers' part in this (as well as Bear Stearns', Goldman Sachs', Merrill Lynch's, and Morgan Stanley's) was to borrow at a low interest rate and then invest in these securities, receiving a higher return. Note that there are quite a few steps being left out in the name of simplicity (e.g., packaging of various types of mortgages, the role of rating agencies, resecuritization).

These investors could protect themselves from default on the underlying mortgage by purchasing a credit default swap ("CDS"). A CDS is a form of insurance. In exchange for payments to an insurer (think, AIG), the insurer agrees to protect the buyer from default.

O.K., I have now listed some of the major players (the Federal Reserve and the Government (e.g., Fannie Mae/ Freddie Mac) played a huge part but I will save that discussion, except for what I mention incidentally, for another day. As long as people kept paying on their mortgage everything would be fine. Even in the case of default, as long as the value of the property kept going up, the bank could foreclose on the property, sell it for more than the value of the mortgage, and thus the benefits to the bank and the investors would continue.

Here's the rub (O.K., there is probably a plethora of reasons but I am a simple person and I will stick with one): As a result of a changing economic environment, interest rates began to go up. Home owners with an adjustable rate mortgage all of a sudden saw their mortgage payments increasing and began to fall behind and default. Banks foreclosed on properties and tried to sell them. At the same time, developers had built more homes than needed and thus since there were more homes on the market than demand, prices began to come down! Uh-oh.

With lower prices on homes, even more home buyers began to walk. Think of it like this. I own a home and still owe $150,000 on it. It used to be worth $180,000 but it is now worth $120,000. Do I keep paying on a home that is worth less than the mortgage (remember, the bank only can presumably only foreclose on the home and can't go after any of my other assets)? I hope I would because I agreed to pay it but that is not a good reason for many. Although their credit score will take a hit, saving tens of thousands of dollars by walking away is very enticing.

As a result, even more houses are on the market. AIG can't keep up with all of the payments on the defaults and almost goes under. Investment firms, especially those who were heavily leveraged (meaning they had borrowed money to invest in these loans and thus needed the proceeds to pay off their own obligations), all of a sudden held the rights to receive payments that they might never receive. Lehman Brothers goes bankrupt (I guess they were allowed to go bankrupt), the government bails out AIG, etc., etc.

WHY HELP THOSE BIG BUSINESSES

So first of all, let me say who I think is at fault. The Government is at fault (we didn't get to discuss the push of policy through Fannie Mae/ Freddie Mac, but catch me in the hall, I would love to chat about it), probably the Fed, "Wall Street," and, do I dare say it (no politician would), "Main Street." Yes, we are at fault too, at least those of us who took out second mortgages on a home thinking prices would keep going up, or buying a home when we barely had money after paying the mortgage each month to pay for anything else (what were we thinking??? Third car, flat screen, I don't know).

In any case, the damage is not just limited to banks and investment banks because when they hurt, there is a commonly used phrase: a run on the bank. All of a sudden banks are trying to hoard cash to make sure they have enough to pay its customers (in case you did not know, if you give a bank $1,000, it can usually turn around and give $900 of that to other people to buy a home, purchase business equipment, etc. and thus if a bank's customers all came running to the bank for their money, that bank would have big problems (the customers might not in the short-term b/c of FDIC insurance)).

BUT businesses fund much of their operations through debt. Thus if they can't get money loaned to them through financial institutions (e.g., a bank), then the companies cancel plans to expand, causing loss of jobs (also, big companies have lines of credit, which are being used extensively now, resulting in smaller companies not having as many options for credit).

With businesses not conducting business, at least not conducting it as usual, the economy contracts and thus all suffer, not just those on "Wall Street."

A QUICK NOTE ON THE BAIL-OUT PLAN

Governments around the world have been trying to encourage banks to loan money to each other and businesses to get the world economy back on its feet. I won't discuss what each measure is, but one point I will discuss is what are the effects on us as taxpayers?

Well, let's ignore any pork spending by the government and let's focus on the $700B for banks. In theory, the government is making an investment (O.K. arguably any government expenditure is an investment (e.g., investing in education will spur future growth) but many of us see various expenditures as a waste). The government is not taking taxpayer money (or foreign investment through the issue of T-Bills) and throwing it away (remember, I began by saying "in theory"). Instead the government has the ability to buy bank assets that nobody wants right now that may be worth something in the future (but for an interesting case, take a look at what the Mexican government did during the peso crisis in the 90's and how taxpayers got hurt). Further, the government can invest in the banks and thus receive interest each year and repayment of its investment in the future (if you have been following the news, the government now owns preferred stock in some banks, with a dividends rate increasing in a few years . .. why does it increase? The increase encourage the bank to repurchase the shares before the cost of having them outstanding becomes higher).

So we as taxpayers might come out better off than if the government had not done what it did.

The stock market is still crazy and recession is on the horizon (if not already here?). And so like everyone else, I will watch and see what tomorrow brings.