The Credit Crunch, Financial Crisis, and Stimulus Packages
April 20, 2009
While some pundits have referred to the current economic situation as the Great Depression 2 or some other similar crisis situation, the fact is we still have a long way to go before we get to that point. Nevertheless, we are now in what appears to be the most significant financial crisis since the 1930s. While we may not see soup lines around city blocks anytime in the near future, it is, nonetheless, a very serious situation.
How did the American financial system get to this point? What caused such a tremendous downturn so seemingly quickly? The fact is, each segment of the economy is dependent upon the others. Those who realize this can make smarter decisions when it comes to their money.
Home Mortgages
So how does it all fit together? For those who own a home, at some point in time they had to approach a bank about taking out a mortgage loan. In the past, an approval usually meant the borrower and lender were in a relationship with each other for 20 to 30 years, substantially longer than many marriages. This is no longer true.
Now, as little as minutes after the loan closing, it may be bought by a different company. In many cases, it goes to Fannie Mae or Freddie Mac and is repackaged with other loans in what are known as mortgage-backed securities. These are then sold on the secondary mortgage market.
It is not necessary to understand the minute details of mortgage-backed securities, but it is necessary to know they are groupings of mortgages sold as a package. The companies now at the root of so much of the problems — such as Bear Stearns, Lehman and Merrill Lynch — were heavy investors in the secondary mortgage market and bought up many of these mortgage-backed securities.
So how does this affect an insurance company like AIG? They, along with others like them, were responsible for insuring the mortgages. Fannie Mae and Freddie Mac also insure mortgages.
The Crisis
From 2001 to 2006, the mortgage industry was experiencing a very prosperous time. Interest rates were at all-time lows causing a boom in the housing market and everyone was reaching a state of euphoria. In some ways, it was like the Roaring 20s. But like the Roaring 20s, the bottom fell out. During that half decade, banks made loans to certain individuals, sometimes regardless of the risk, believing that they could always refinance later if things got too difficult. Often, these mortgages were variable rate mortgages with increased payments after a few years.
When those individuals ran into tougher times and could not find the money to make the monthly payments on the mortgage, it defaulted and went into foreclosure. In some ways, this is not a huge problem for the economy has a whole. Foreclosures happen all the time. However, with the housing industry slumping, mortgage holders were not getting back what they had invested. More was owed on the homes than the current market said they were worth.
Therefore, companies who invested heavily in these mortgage-backed securities suffered heavily. It will take a tremendous amount of effort, and probably a fundamental change in the way they do business, before they see any relief.
Mortgage-backed securities are generally considered safe because there are a lot of them. Some may pay off early and some may default, but the vast majority stick to the terms of the loan, making it very profitable for those who hold the securities. While the conventional wisdom says there is safety in numbers, these companies were finding out there could be devastating effects in those numbers if many borrowers started going under at the same time.
The Bailouts
With these companies facing mounting challenges and collapsing at alarming rates, the federal government stepped in and take control, buying bad mortgages and getting these liabilities off the books of these troubled companies. It first spent $700 billion on a Wall Street bailout, then an auto makers’ bailout. The latest bailout, referred to as the Obama stimulus package, is a massive collection of public works projects.
While it is acceptable to debate the wisdom of these bailouts, the alternative may have been much worse. Without these actions, a number of the nation’s most storied financial companies and manufacturers would no longer exist. In itself, that may not be much of a problem. However, the further collapse of these institutions and individual investors would amplify the losses already being experienced. A depression may even develop.
While the government may have had little choice but to act, the spending will likely lead to further difficulties. The budget deficit will increase and oil prices may go higher, as the dollar is further weakened. Of course, in this situation, there may be no good answers.
Contributed by Ken Black
What Have We Learned?
The main lesson I’ve learned from the “Great Recession” is to build a bigger financial cushion. This means putting away more money in an emergency fund and also buying smaller houses, less expensive cars, and less stuff. If you lose your job and have a $1500 a month house payment you’re in much worse shape than if you’re laid off and have a $700 a month house payment.
Another lesson is to try and diversify your sources of income. If your whole family is reliant on one salary and that job goes away then you’re in major trouble. If you can add even a few small extra income sources then at least you still have a little money coming in if your laid off.
All posts by Ben Edwards
“, it goes to Fannie Mae or Freddie Mac and is repackaged with other loans in what are known as mortgage-backed securities”
It goes a little further than that. Wall Street then sliced this mortgage backed securities and created new derivative financial instruments containing based on them – CDOs or collaterised debt obligations. Some of these CDOs were based on mortgage backed securities while some were based on bonds e.g. corporate bonds. There were also CDOs squared i.e. CDOs based on other CDOs. Each CDOs could be based on different mortgage based securities with different percentages of riskier loans. The rating agencies then rated these securities based on complicated mathematical models that even math professors couldn’t understand. At least they couldn’t understand how they got these AAA rating. One assumption used to justify low risk was that the real estate would continue to grow forever at the rate of 7% a year. One doesn’t need to even know math to understand that this is silly.
Another derivative instrument that was invented to justify AAA rating were Credit Default Swaps (CDS). CDS are like the insurance i.e. you buy a CDO and if you are worried about defaults, you could buy insurance for it – a CDS. In some cases, The contract with a CDS issuer stipulated that you’d get some money every time a CDO you bought lost value. But unlike regular insurance a) CDS weren’t regulated, so the insurer didn’t have to satisfy any capital requirements to sell a CDS b) CDS just referenced a CDO, they weren’t tied to it. I.e. you could buy a CDS referencing a particular CDO even if you don’t own a CDO. In fact many people could buy a CDS referencing the same CDO. It was a little like 10 people being able to buy insurance on your house. This way if your house burns, or even loses its value on the market, the buyer of this “insurance” will get paid, but this person will not be the one losing a house. This made CDS perfect vehicle for speculation or even short raids: if you believe real estate will go down you can buy a lot of CDS to make money; if you want stocks of a particular bank to go down, you buy a lot of CDS for CDOs held by this bank. Just the act of buying a lot of CDS will drive the value of CDOs held by the bank down and cause this bank to experience losses. (if it is known that a 100 of people bought insurance on your house, the value of your house will probably drop) A total amount of sold CDS greatly exceeded the number of CDOs held by banks demonstrating that CDS were used for speculation rather than insurance.
All banks are required to maintain a certain minimum ratio between the amount of money they can lend and the amount of capital they have. Normally this ratio is around 1/10. Simple bank operations involve taking our deposits, putting about 10% in reserve, lending 90% and making money on the spread. In 1999 the government repealed the Glass-Steagal act that separated lending business from investment. This was what allowed banks to invest in CDOs to begin with. But the value of CDOs a bank had counted against the bank’s capital requirements. The question was – how to estimate this value e.g. using a model, using potential cash flows while holding this papers for maturity i.e. until the loans are repaid. In 2007, SEC decided to value these securities based on the mark-to-market rule i.e. based on the amount of money you could get for these CDOs on the open market. But… as the values of CDOs started to drop, banks had to right off the losses and to put more money in reserve leaving less money for lending. Every quarter banks had to report paper losses in CDOs market value as real losses. This caused banks to sell the CDOs driving the value of CDOs even lower. Even CDOs that were based on investment grade corporate bonds lost their value. This amplified the losses exponentially since the losses in the value of CDOs greatly exceeded the actual losses in mortgages.
To make matters even worse, in 2004 the SEC in its infinite wisdom agreed to exempt 5 major investment banks – Lehman Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley and Meryl Lynch from leveraging limits i.e. they could keep even less money in reserve and invest more and more money the borrow (including our deposit money) into CDOs. As a result, companies like Lehman Brothers and Bear Stearns were leveraged 30 or 40 to 1. I.e. for every $1 they had in reserve, $30 or $40 were given out as loans. As loan losses mounted, the value of CDOs dropped – in part because of real losses, in part because other banks were selling them and nobody wanted them any more, and in part because of short sellers’ speculating on Credit Default Swaps, companies like Lehman didn’t have enough money in reserve to do business.
After Lehman went out of business, AIG had to pay for a lot of Credit Default Swaps that insured CDOs sold by Lehman. Not only didn’t they have enough money, their credit rating was cut which means they had to have additional collateral on its debt and had difficulties getting more loans… Here goes AIG.
All these companies having problems put money market funds in jeopardy. Since money market mutual funds aren’t insured as banks’ money market account, they can lose value. Some of these funds were invested in CDOs. The panic “run on banks” started with more and more people withdrawing money from the money market funds. But money market funds are vital for business – a lot of businesses keep money in these funds (as well as some of the retirement money and our 401Ks). So the threat to money market funds was a huge problem. Additionally, people with large deposits in banks started withdrawing money from banks.
Normally when a bank doesn’t have money at hand to pay depositors, it borrows from another bank, then repays from payments it gets on loans. But since a) banks needed more money in reserve had less money to lend b) no bank knew what another bank might have on its balance sheet, so banks were afraid to lose money c) by now there were simply fewer large banks, the lending stopped.All lending – to other banks, to businesses, etc. Shipping companies for example, that normally don’t get paid until they deliver the goods, couldn’t get short term loans to pay their crew so that the goods could get delivered, even good solid shipping companies with stellar rating. This is what made this problem so serious – with no lending even to good businesses, with the potential losses in money market funds which are vital for business, without intervention the whole financial system could have collapsed. We may dislike the bailouts, but without them the situation may well have been much worse.
This is in summary. I might have missed a few details or the order, but this is basically what happened.
this is exactly what I try to express… that through the ongoing recession that the more important necessities should be prioritized among anything else…
Detailed analysis. I have found lots of article with similar subject but now found one that have detailed information. Best of luck
Sherin
The Money Maniac
For housing, I would strongly caution many from taking the plunge and buying a home who would otherwise take on a mortgage. Often people, even those who struggle with debt, feel like they are missing the boat by passing on home ownership. But for those with income insecurity, there is no greater way of hurting personal finances than taking on a mortgage that they can barely swing. It is a risky move, and the truth is a family can plan all of their finances, including retirement for the parental units, without ever having actually owned a home! Does anyone else think housing should be treated more like an expense and less like an investment?