Understanding the Financial Crisis

Like everyone else, I am struggling to get my head around exactly what happened to produce our current financial crisis.  That is a precondition of anticipating the longer term consequences.  In a single paragraph, this is what (I surmise) happened. 

Sometime during the 1990s, momentum began to build on Wall Street for securitizing home mortgages in new and exotic ways.  Residential real estate seemed like an attractive business because the yields were decent, the historical default rates were low, risk of loss was mitigated by pooling thousands of mortgages (which were, themselves, divided into parts), and the underlying assets (homes) generally went up in value, sometimes by a lot in major metropolitan areas.   Institutional investors had an insatiable appetite for these debt instruments, which were graded as safe by all the major rating agencies.  Further, respected companies like AIG wrote insurance on these instruments on the theory that they would never have to pay.  All the risk was supposedly hedged by "credits swaps," which are fancy and unregulated contracts between private parties.  So money gushed in.  Because virtually any loan could be sold the next day to Wall Street (who, in turn, could repackage them for a large profits within a short time), banks and other mortgage originators could make money with no risk (zero risk!).   This cycle continued even though the pool of mortgage applicants became weaker and weaker--eventually people with (a) bad credit, (b) no assets, and (c) no job.  This had the predictable effect of driving up the price of real estate to a frothy bubble. 

If we want to get back to good old-fashion, sane capitalism where risk is actually assessed before a lender gives a borrower money (and I do), we need to know what the underlying asset (a home) is really worth. 

Here, the news is not good.  According to this story in the New York Times, the price of real estate could tumble throughout 2009.  Frankly, this is where analogies to the 1930s seem like they have some traction.  When an average person's largest asset turns out to be a terrible investment, they have lost a lot of money in the stock market (any thoughts about privatizing Social Security now?),  and banks are failing left and right, it has a devastating effect on society's ability to pool risk--all the money ends up in the mattress, so to speak.   No surprise, people like my grandparents who lived through the Great Depression tended to be very cautious and risk averse with money.

Frankly, the issue now is not how to regulate Wall Street--the investment banks are gone.  It is how to unwind this mess.  The larger tragedy here is not the loss of money; it is the loss of trust by ordinary people in basic financial and commercial institutions.  They worked hard and played by the rules. Yet many of their homes will be worth less than what they paid for them, and retirement seems beyond reach.   Unregulated capitalism failed.  Like it or not, government is the only entity that can fill the breach. 

These two stories from This American Life, both 1-hour long audios, are the two best resources I have found on these topics:

• The Giant Pool of Money, May 9, 2008
• Another Frightening Show on the Economy, October 3, 2008

Comments

[valtrex online]

hello friend excellent post about Understanding the Financial Crisis thanks for sharing!!

[bedroom furniture]

Each of us is responsible for what we are doing now. Imperfect human are just doing trial and error on how they can give a successful righteous rulership in this world, they are making many changes. They try to find a good leader to rule them just like what we can see; the American people have appointed a new leader. The people have chosen “change” by electing Barack Obama for the next President of the United States. Whether the United States changes for the better or for the worse, there is no doubt that change is in store for our country.

[scooter verzekeringen]

The data presented in this report is interesting and useful,Thanks.

[Lisa P]

After Barack Obama wins presidential election all those people who really like him are very happy full of joy and hope but the truth is, we cannot expect certainty to imperfect humans for an overall good leadership in this crazy world There is a saying that “a man cannot direct the path of his own”, how much more for the sake of other people. All we need is to prove ourselves faithful to the Highest Authority, which has the power to remove the present government system. Each of us is responsible for what we are doing now. Imperfect human are just doing trial and error on how they can give a successful righteous rulership in this world, they are making many changes. They try to find a good leader to rule them just like what we can see; the American people have appointed a new leader. The people have chosen “change” by electing Barack Obama for the next President of the United States. Whether the United States changes for the better or for the worse, there is no doubt that change is in store for our country. It’s clear that Americans believe Obama will bring a positive change to our country. We’ve heard many of the promises he has made to the U.S. from lowering taxes for the middle class to putting a timeline on the war in Iraq and trimming the federal budget “line by line.” However, Obama also supports the elimination of the payday loan industry. He believes that eradicating the payday loan industry will protect low-income and families in general from falling victims to predatory lenders. On higher ground, it will be a violation to our financial freedom if the option to utilize affordable payday loans is wiped out. Threatening our rights to financial freedom is not a great start to creating positive change.

Read more on this topic:http://personalmoneystore.com/moneyblog/2008/11/06/obama-to-bring-change-how-will-payday-loans-change/

[biglaw partner]

I think this is almost totally wrong, like describing measles as caused by high fever and red spots on the skin. Europe has just as much of a financial crisis as the United States, notwithstanding that the single family mortgage market and the securitization market are totally different there (to the extent they exist at all).

What has happened is a global repricing of risk. Credit spreads had been narrowing for five to ten years, and capital flooded the global financial system. Suddenly, that trend reversed. In the past few years, one sector after another has been buffeted as, in each case, a minor tremor provoked violent capital flight. Subprime mortgages, CMBS, CP, developing country loans, etc., have all been hit.

[Jennifer Martin]

Bill,

Both of the American Life programs are really good. News Hour has a couple of helpful programs as well. Explaining the basics is really tough to do in a short soundbite. My post on Explaing the Financial Crisis to Students takes a stab at it: http://ucclaw.blogspot.com/2008/10/explaining-financial-crisis-to-students.html. The trouble with the valuations of the underlying homes surely was part of it. Greenspan mentioned the other day that there really wasn't incentive for companies bundling the mortgage backed securities to make proper valuations because they did not retain any ownership. Perhaps partial retention will be a new rule of the road?

[Payday Loan Advocate]

America’s collective brow is furrowed over the current economic crisis that careless mortgage lending has brought on. But did you know that Americans are not the only people who are impacted on a daily basis by plummeting dollars and good sense? The International Herald Tribune shows us that the worldwide credit crunch is very real in Europe, too. Small businesses like Dominique Boudier’s printing company, outside of Paris, depend upon credit with its suppliers in order to function, and her creditors are cutting back their offerings by half. This is by mandate of the suppliers’ credit insurance companies. Considering a typical 60-day lag time in which clients pay, Boudier’s business needs added cash flow to make up for this major shortfall. As her own bank’s hands are tied, she fears the worst. Her bank, like many others across Europe, began to put their money to sleep with the European Central Bank instead of investing it back into other banks and the economy as a whole. When banks began to fail and liquidity was disrupted, credit began to dry up. Much like America’s Federal Reserve Bank, the European Central Bank uses a mechanism based on the ability to create as much fiat money as required. Fiat-money currency, which is effectively credit money, loses value once government refuses to further guarantee its value. During this world credit crunch, we see this in high inflation rates. Many believe stronger private banking systems that make responsible decisions can solve this problem. Until that happens, payday advance loans will inevitably be easier to come by for consumers who need immediate short-term help and cannot wait on a faltering central banking system.

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[Maggie Knowles]

"The larger tragedy here is not the loss of money; it is the loss of trust by ordinary people in basic financial and commercial institutions."
~~~~~~~~~~~~~~~~~~
And the loss of trust of all the foreign investors too. Investors rely on agencies like Fitch, Moody's, and S&P to determine investment risk. I heard a panel of men from the credit rating agencies testify at the House Committee on Oversight and Government Reform hearing this morning on CSPAN. They were using the words "fraud", "criminal", "extortion", and "racket". I imagine that foreign investors feel like the U.S. conned them out of their money, and that they are pretty pissed off about it (I am.)

for more info:
http://dealbook.blogs.nytimes.com/2008/10/22/rating-agencies-draw-fire-capitol-hill/?ref=business
or
http://tinyurl.com/5kf8k9