Financial Crisis #1: What happened.

What happened.

Disclaimer:

If any of you econ, finance or otherwise smarter than me folks want to point out where I'm going wrong here... please do. I'm mostly repeating what I saw on a financial show on CNN over the weekend.

So what did happen?

Step 1: Loan
Retail bank or mortgage company makes a (often government subsidized) loan to buy a home. This loan has a below-the-market interest rate and, more importantly, can be made to a very risky borrower because the bank has no intention of administering the loan itself.

Step 2: Convert
The retail bank or mortgage company transfers these loans to the investment portion of their business which packages thousands of these mortgages into securities. These securities are sold like stock to other investors and the general public.

Step 3: Profit

a) The sale of these securities create a market that allows for the price of the security to go up by being traded despite it's actual value being based on "bad" loans. This is the same trading phenomena that allows google stock to be worth 600% more than simple earnings would seem to justify.

b) Most of these securities were sold as "bonds" that matured and were redeemed by the investment bank. These bonds allowed the banks to take capital out of the general public to which it wouldn't otherwise have access. This new capital is invested in stocks, money markets, commodities etc. All of which make profits totally separate from the housing market. This worked particularly well because these mortgage securities paid dividends, were seen as low risk and usually grew about 10% over a two year period. This is all a function of the securities market that functions well above the actual loans that the retail bank originally gave to homeowners.

c) Because mortgages were so much easier to get it drove demand for homes. This demand for homes drove home prices up, and not just for new homes. Everybody's home increased in equity because there was suddenly a way for previously risky borrowers to get a loan. This has the effect of buoying the entire market. Real wealth was created by the increase in home prices that came along with an increase in demand. So when a borrower could not repay their original mortgage she could refinance by taking advantage of the equity built up in their home and get into a second bad mortgage... which they then could not repay... thus requiring another refinance. The investment banks that administered the "bad" loans managed to mitigate their losses based on this increase in home prices as well. Even when they had to foreclose on bad mortgages, the bank could make up some of their losses because the house had increased in value and could be resold for more than the original loan. And, because the bank was willing to write another bad loan there were no shortage of buyers.

Step 4: Saturation
So this magical method of making money worked! As long as home prices increased fast enough the "bad" loans could be packaged and sold as securities without much worry about foreclosure. The problem happened when the market became saturated. Home-ownership was at an all-time high in 2006-7 and frankly the building industry built too many houses for people who weren't moving into them. This over-supply slowed the growth of housing prices thus making foreclosures much more expensive for banks thus making these risky loans far more likely to actually destroy wealth if they were defaulted upon.

Step 5: The Unknown
So the securities upon which these loans were based started to lose their value. Then, worse, they ceased to have a sure value. These securities became so stigmatized in the market that it was impossible to sell these mortgages at all despite the fact that they did have value as represented by the houses they bought. The inability to sell these securities at all made all of the investment previously made in them illiquid. It's not that it was "lost" it was just impossible to free-up and use somewhere else. So, for example, when Citi Group announced a $5,000,000,000 loss it wasn't quite what it appeared. What they were reporting is that they have $5b that they can't liquidate. When securities can't be sold they're counted as being worth zero on the books.

So:
All of this money isn't gone, it's just stuck. Ironically, it was the ability to trade "bad" mortgages that allowed these banks to make them in the first place, now its their inability to trade these mortgages that is keeping them from even liquidating them for a loss! Morgan Stanly recently was able to sell its portfolio to Bank of America... except they had to take 22 cents on the dollar, almost certainly far less than the simple houses those securities represent are worth. Now we've got a huge amount of capital that is tied up in these untouchable securities. It's actually enough money to affect the supply of capital. It's as if all of that money has simply stopped circulating. Thus it cannot be gathered and reinvested. So credit rates go through the roof, there's not as much money to invest in new business or stocks and the economy suffers.

Come back tomorrow for "What the government can do about it."