April 16, 2008

Credit Crisis: A Short(ish) Primer

Unless you live under a rock or outside of the United States, you've probably heard the terms "sub-prime","credit crunch", and "recession" used, probably together. Since many of the people reporting on the issue don't understand it, there's a lot of stupid shit that gets said about it. Combine that with the fact that the whole story takes longer than 3 minutes to convey in any meaningful fashion, and the result is that many people don't understand what has really transpired. Now just so you know, I'm not entirely sure that I actually understand all of what has happened, but I'm fairly confident I can hit the high points. Even in the nearly 1000 words that this turned into, I'm still leaving a lot out of the story, so be aware of that if you find glaring holes.

The fist step is to understand what sub-prime actually means in this context. I've got a link to a slide show that explains pretty well how bad loans got turned into securities that were sold to investors. These securities promptly lost much of their value when house prices began to fall over the past year or so. Full disclosure: the slide show would carry a parental advisory if it was a music album being sold at an electronics store. So without further ado: Sub-prime Primer.

For those of you who didn't or couldn't watch the slide show I'll summarize: Mortgage lenders (who didn't make the actual loans) gave out a bunch of bad loans. The banks that actually had to make the bad loans sold them to wall street who turned them into bad securities. Bond insurers insured the bad securities and gave them high credit ratings. House prices fell, the bond insurers couldn't cover all the bad securities, and the investors who bought the bad securities lost money for what the mortgage lenders, banks, and wall street folks did to earn a profit.

It is true that house values don't usually fall like they did, but there is not usually a larger than expected increase in demand for new houses over a short period of time like 2002-2005 when rates were low. This was then followed by a huge increase in homebuilding activity, resulting in an abnormally large supply of new homes. As soon as the new homes were built, interest rates went back up and demand for new houses fell. End result is above average supply and below average demand which leads to a decrease in price. One thing that reporters often fail to mention is that this has not happened uniformly across the country, but it happened enough to matter to the country as a whole.

The next stop is a quick overview of how banks operate. A bank takes in deposits and then loans that money out to others. In order to give out a loan (a mortgage, say), the bank must actually have the money to loan it out. Now, idle cash sitting in the vault doesn't earn the bank anything, and so it invests some of its idle cash in short-term, extremely liquid (which is finance-speak meaning it can be sold for cash quickly and easily), usually very safe securities. Since the securities are very safe, they don't pay much in the way of interest, but it's better than nothing. Now into this situation comes these collateralized mortgage obligations (CMO's). They're supposed to be very safe and they pay a slightly higher rate than the usual options. They're even insured, so they're even safer. At least, that's what they thought.

Once those CMO's started to lose value, the banks began to lose money. This is why banks were making "write downs" to their financial statements. The banks lost all this money, and so they couldn't make any new loans. This is the credit or liquidity crisis that you hear so much about. When banks can't make loans, the economy slows down. Without loans, most people can't buy homes or cars or other large ticket items. Without loans, most businesses cannot get the money to build a new store or factory. In short, the economy slows and a recession happens. And that is where we are now. Compounding the problem is that is if a bank loses enough money, then it cannot make good on peoples’ deposits. This is what happened to Bear Stearns, prompting the Federal Reserve to prompt JPMorganChase to buy them out and prevent a run on the bank.

In their other efforts to combat this, the Fed has lowered interest rates to make it easier for banks to get new capital to loan out and cover deposits. Another move was the “stimulus package” that the government passed to convince people to keep spending until the banks can make more loans. If people didn’t rely so heavily on debt and, I don’t know, maybe saved some of their money, this wouldn’t be an issue. Another main thing you hear about is relief for people that took out mortgages and then couldn’t pay them. Now to be fair, some took the loans without being told or understanding that the payments were going to increase. These are the deceptive lending practices, and I wouldn’t mind seeing these people helped out a bit. However, many people just took out the mortgages as an investment, trying to “flip” the house, or they misled the mortgage lender to get more mortgage then they could afford. I think these people should be left to lose their money, especially the people treating it as an investment.

Where we go from here is a more difficult question, and it will depend on how Congress and the Fed continue to react. Hopefully, they won’t overcorrect and cause more problems down the road.

Posted by chupathingy on April,16, 2008 at 2:56 AM | Comments (1)

How long do you see this playing out? Months? Years? I'm personally glad to see housing prices fall a bit... They were doubling in value roughly every 10 years, that's something like a 7% yearly rate... 'bout time they saw some risk for that return. Hopefully it will make it less difficult/prohibitively expensive for me in a few years when I buy in. I don't imagine that Jon & Jenny share my enthusiasm though...

Comment by: mattg at 9:41 AM, April, 16, 2008

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