The Credit Crisis, In Plain English

On Monday, September 22 Treasury Secretary Henry Paulson made public his $700,000,000,000.00 proposal designed to prop up failing credit markets.  Seven hundred billion is a large enough number that even people who don’t usually take an interest in financial news went “WTF?!?!”  It’s so big, actually, that the mind kind of boggles.  Here are a couple of comparisons that might help to give it some scale:

  • It’s about 40% more money than the Pentagon budget in 2008.
  • It’s about ¼ the entire budget of the United States.
  • This proposal, coupled with the other bailouts we’ve seen in the last two weeks, have raised the national debt-every dollar borrowed by the U.S. since 1776-by about 10% in just two weeks.
  • It’s about $10,000.00 for every household in the United States.

Worst of all, it’s actually sort of necessary.  If you’re one of the majority of Americans wondering what the hell happened, here’s my take on it.  It’s kind of a long chain of events, but the individual steps are actually pretty simple.

1. Starting in December 2002, the central bank of the U.S. (“The Fed”) lowered the interest rate they charge to their best borrowers–big banks–to around 1%. This was done in hopes of stimulating economic growth in the wake of the tech stock bubble and 9/11.

2. It did stimulate growth. Big banks that borrow money from The Fed took advantage of the low interest rates being offered and borrowed heavily. They turned around and re-loaned that money to consumers (at a slight increase) for, among other things, home mortgages.

3. Because there was more money in circulation, more people were able to afford mortgages. More people bought houses. Because more people now had more money to bid on the same number of houses, two things happened:

  • Housing prices increased.
  • House builders increased the rate at which they built houses.

4. This was generally a good thing. In addition to all the people who benefitted directly from the rise in “housing starts” (drywall guys, electricians…) your average homeowner also benefitted from the rise in housing prices. “Hey, honey! Our house is worth $200,000–didn’t we pay like $150,000 only a year ago? Woohoo!”

5. Here’s where the problem starts.  The number of people in the country who could actually afford mortgages was no bigger than it had been before the Fed made it so easy to borrow money. By mid-2004 pretty much all of the qualified borrowers were taken care of.  But the Fed kept interest rates low.  Why?  Well, we can’t know for sure-the meetings of the Fed are held in secret.  But Alan Greenspan, then the Fed Chairman, offers a clue in his book Age of Turbulence:

“In the revised world of growing deficits, the goals were no longer entirely appropriate. [President Bush] continued to pursue his presidential campaigns nonetheless. Most troubling to me was the readiness of both Congress and the administration to abandon fiscal discipline.”

6. Anyway, whether it was politically motivated or just dumb, the Fed kept money on sale. Banks, not wanting to miss out on a good thing, continued to borrow it from The Fed and loan it out to consumers…but to keep a steady stream of borrowers, they had to lower their standards a little.

7. Because these new borrowers weren’t quite as qualified (read: bad-ish credit) as the ones from a few months ago, banks felt justified in giving them a slightly crappier deal than usual. Many banks sold something called the Adjustable Rate Mortgage (ARM) to poorly-qualified consumers. The idea with an ARM is that your mortgage is tied to the prime lending rate, which is in turn tied to the Federal Funds Rate. Every 5 years the ARM adjusts to match the new prime rate.  So, like, when the Federal Funds rate is at the (historically low) level of 1% you might see an ARM at 6%.  If the rate goes up, as it was more or less guaranteed to do, so does your mortgage.  Investment banks love this kind of mortgage because it’s much more profitable than the regular kind, and they gobbled them up as fast as regular banks could write them.

8. Immediately after the 2004 elections, The Fed took its foot off the economic gas pedal and raised the federal funds rate to a more normal level of 5%. As a consequence, ARM rates went up to like 10% and fewer new buyers were able to afford mortgages.

9. By early 2006, all the builders who had started new houses were standing around going “where are all the buyers?” To recover the costs of building (plywood, drywall, salaries) they lowered prices on their brand-new houses.

10. By mid-2006, housing prices had begun to fall. This was a serious problem for all the people who had taken out ARMs.  The five year mark was coming up, and  they were counting on housing prices continuing to rise so they could sell the houses, or use the equity in the homes they bought a couple years ago to qualify for a new mortgage that didn’t suck.

Meanwhile, on Wall Street

Banks (Wachovia, Bank of America…) are basically salesmen of mortgages and car loans. They usually don’t just hold on to mortgages that they’ve made until the 30 year term of the mortgage is up. If you’ve ever bought a house, you probably noticed that the person you send the check to changes 3-4 times in the first year, right? That’s because banks resell mortgages to bigger banks.

These bigger banks take, say, 1000 mortgages and bundle them together and sell them off as (typically) bond issues. A bond issue is basically a promise to pay (say) 5% of interest to whoever buys the bond for 30 years or whatever. The bigger bank is obligated to pay that 5% regardless of what happens.

Normally this works out fine. Historically, only 1% or 2% of people who took out mortgages were unable to make the monthly payments.

HOWEVER

10. Recall that back on main street we had all these empty new houses owned by desperate builders. This drove down prices. Because house prices were lower, all those buyers with the ARMs (a.k.a. “sub-prime mortgages”) were now starting to get desperate. They knew that when their mortgage rate adjusted, their $1500/month house payment was going to turn into a $3000/month house payment. They started selling their houses for whatever they could get.  Housing prices fell further.

11. By 2007, a lot of the people-builders and homeowners alike–couldn’t sell their houses for anything like what they owed on them and couldn’t afford their new monthly payments. These people defaulted on their loans, and banks began to foreclose. The foreclosures were, in turn, sold for whatever the banks could get for them which usually wasn’t much. Prices dropped further.

Meanwhile, back on Wall Street
Fannie Mae and Freddie Mac are two of the biggest financial institutions in the world. Together they hold 5 trillion dollars in assets. Just to give that number some scale, the annual budget of the entire U.S. government is about half that.  Fannie and Freddie were the biggest players in the repackage-mortgages-into-bonds game. They owed a whole lot of overseas governments monthly payments on the bonds they had previously sold. Problem was:

  • By now, enough homeowners had defaulted on their mortgages that Fannie and Freddie didn’t have enough cash coming in to meet their monthly obligations on the bonds they had already sold
  • If they didn’t pay their bills, no one would ever buy from them again.

That last part was the real problem. If Fannie and Freddie couldn’t sell the mortgages they bought to overseas investors, they wouldn’t have enough cash to continue to buy up loans from Wachovia and Bank of America. If that happened, Wachovia and Bank of America wouldn’t be able to keep issuing mortgages. If that happened, housing prices would go down even more.

Which Brings Us To 2008
By mid-2008, Washington realized it had a very, very VERY serious problem on its hands. No kidding or exaggeration, this crisis is huge.  It affects everybody in the U.S. and most of the people in the world.
1. If Fannie and Freddie defaulted on their obligations, no one would ever buy from them again.  Consequently, they wouldn’t be able to buy up mortgages from regular banks.  Consequently, the regular banks wouldn’t be able to make more loans to anybody.  If that happened, the only people that would be able to buy houses would be the ones who could pay cash for them.  That would freeze the already wounded housing market, and drive prices down much further.  Knowing this, the Fed loaned them ~$36 billion so they could continue to make their monthly payments. That hurt the Fed a lot.

2. The $1 trillion dollar insurance company AIG had invested heavily in Fannie and Freddie and was badly wounded when they fell. Consequently, AIG was also unable to meet their monthly payments. The Fed loaned them $85 billion. That was absolutely agonizing, and completely unprecedented.

3. On Sept. 17, 2008, worldwide credit markets seized up briefly. No one could borrow money.  This wasn’t an immediate problem for the average person, but big companies rely on short-term loans to keep their doors open, the lights on, and employees failed.  If they couldn’t borrow money, many (most?) of them would be forced to shut their doors. The Fed realized that they were in absolutely desperate straits. It was now obvious that the entire U.S. economy would seize up if something very, very big wasn’t done very, very soon.

4. Right now, the Fed and Congress are working out a deal to borrow $700,000,000,000.00 from overseas companies which they hope to use to mitigate the credit crisis.

The Bailout

Yes, it’s more than slightly ironic that the Bush administration is now proposing the largest government intervention in the economy since FDR’s New Deal.  (Instead of socialized medicine, we’ve now got socialized banking, ha-ha.)  The fact that they’ve done so should provide some indication of just how serious the situation is.     Basically the idea is:

  • 1. To buy the crappy mortgages directly from the banks.
  • 2. Hold on to them until the housing market rebounds and they’re worth something again
  • 3. Start selling them off when it’s profitable to do so.

At the moment, the homeowners would not receive anything directly.  However, I think it’s safe to say that the Fed won’t be foreclosing as aggressively as the banks would, so in that sense some people would benefit directly.  The rest of us will benefit by not having to live through another Great Depression.  So, why not just pass the thing and be done with it?  Partly because there are still a lot of details to be worked out-the proposal Paulson handed in was only three pages long-and partly politics.  Currently, the substantive issues they’re discussing include:

  • Oversight. As written, the bill gives one man-the Treasury Secretary-sole control over what is done with the money and specifically makes his decisions exempt from oversight by either congress or the courts. That’s not likely to be in the final version.
  • Ownership stake. The financial companies now holding the bad paper stand to benefit greatly from this bailout. As written, the money would be just a gift from the American taxpayer. Some have suggested that maybe the companies should throw in some stock to make up for that.
  • Executive compensation. The executive of the companies who bought up all the mortgages in the first place stand to make a lot of money when the taxpayer makes their mistakes go away. Some have suggested that they shouldn’t be rewarded too much for being key players in the biggest financial debacle of modern times.
  • Votes. Though the bill is probably necessary, it is hugely unpopular with the voting public. Because Democrats make up the majority, they’re in the awkward position of needing to pass a hugely unpopular bill to save the nation from an economic collapse created by the opposing party. Similarly, a lot of Republicans are in the awkward position of having to support the biggest single increase in the size of government ever. The votes of Senators McCain and Obama on this issue are also likely to be scrutinized.

And what is John McCain’s opinion about this crisis?

Our economy, I think, still, the fundamentals of our economy are strong

Which, I guess is understandable since:

I am not an expert on Wall Street.  I am not an expert on this stuff.

Anyway, buckle your seat belts.  The ride is about to get bumpy.

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5 Comments

Filed under Economy

5 responses to “The Credit Crisis, In Plain English

  1. Just wanted to say HI. I found your blog a few days ago on Technorati and have been reading it over the past few days.

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  5. Kumaran

    You have some excellent write ups!! Thanks

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