Saturday, September 27, 2008

The How's & Why's of the Financial Crisis

There's a fantastic story on NPR about the process that caused the current credit crisis. I highly recommend reading the entire transcript, or you can go to this website and click on the "Full Episode" link to listen to the piece online.

In a nutshell, here's how it goes:

1. The "Global Pool of Money" essentially doubled from 2000 to 2006. Global investors were looking for safe ways to make a reasonable profit on investing this money. Since the US government was keeping interest rates low on treasury bonds, these investors started looking for other places to invest that money.

Adam Davidson: How does the world get twice as much money to invest? Lots of things happened, but the main headline is all sorts of poor countries became kind of rich making TVs and selling us oil: China, India, Abu Dhabi, Saudi Arabia. Made a lot of money and banked it. China, for example, has over a trillion dollars in its central bank, and there are office buildings in Beijing filled with math geniuses-- real math geniuses-- looking for a place to invest it. And the world was not ready for all this money. There's twice as much money looking for investments, but there are not twice as many good investments. So, that global army of investment managers was hungrier and twitchier than ever before. They all wanted the same thing: A nice low risk investment that paid some return...

Think how attractive a mortgage loan is to that 70 trillion dollar pool of money. Remember, they're desperate to get any kind of interest return. They want to beat that miserable 1 percent interest Greenspan is offering them. And here are these homeowners, they're paying 5, 7, 9 percent to borrow money from some bank. So what if the global pool could get in on that action?

2. Banks and mortgage brokers discovered that they could bundle mortgages together and sell them as securities.

Adam Davidson: There are problems. Individual mortgages are too big a hassle for the global pool of money. They don't want to get mixed up with actual people and their catastrophic health problems or debilitating divorces, and all the reasons which might stop them from paying their mortgages. So what Mike [Francis] and his peers on Wall Street did, was to figure out how to give the global pool of money all the benefits of a mortgage-– basically higher yield-- without the hassle or the risk.

So picture the whole chain. You have Clarence. He gets a mortgage from a broker. The broker sells the mortgage to a small bank, the small bank sells the mortgage to a guy like Mike at a big investment firm on Wall Street. Then Mike takes a few thousand mortgages he’s bought this way, he puts them in one big pile. Now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next thirty years, the life of a mortgage. And he then sells shares of that monthly income to investors. Those shares are called mortgage backed securities. And the 70 trillion dollar global pool of money loved them.

3. The demand for these mortgage backed securities became huge, and brokers got creative in finding ways to supply Wall Street with new mortgages.

Alex Blumberg: So Wall Street had to find more people to take out mortgages. Which meant lending to people who never would’ve qualified before. And so Mike noticed that every month, the guidelines were getting a little looser. Something called a stated income, verified asset loan came out, which meant you didn't have to provide paycheck stubs and W-2 forms, as they had in the past. You could simply state your income, as long as you showed that you had money in the bank.

Mike Garner: The next guideline lower is just stated income, stated assets. Then you state what you make and state what’s in your bank account. They call and make sure you work where you say you work. Then an accountant has to say for your field it is possible to make what you said you make. But they don’t say what you make, just say it’s possible that they could make that...

Then the next one came along, and it was no income, verified assets. So you don't have to tell the people what you do for a living. You don’t have to tell the people what you do for work. All you have to do is state you have a certain amount of money in your bank account. And then, the next one, is just no income, no asset. You don't have to state anything. You just have to have a credit score and a pulse.

Alex Blumberg: Actually that pulse thing-- Also optional. Like the case in Ohio where 23 dead people were approved for mortgages.

4. The mathematical models for the mortgage-backed securities said that they were safe, but the models were based on historical data, from previous decades when banks didn't give mortgages to people who couldn't afford them.

Adam Davidson: As we now know, they were using the wrong data. They looked at the recent history of mortgages and saw that foreclosure rate is generally below 2 percent. So they figured, absolute worst-case scenario, the foreclosure rate may go to 8 or 10 or 12 percent. But the problem with is there were all these new kinds of mortgages, given out to people who never would have gotten them before. So the historical data was irrelevant. Some mortgage pools, today, are expected to go beyond 50 percent foreclosure rates.

Alex Blumberg: To be fair, they knew there were risks. But investors have a system to assess those risks. They’re these special companies. Credit rating agencies. Moody’s, Standard & Poor’s, Fitch. Their job, their main job, is to assess risk for Wall Street and the global pool of money. They rate every kind of bond according to its risk. Triple A is the safest, then there’s double A, single A, all the way down to single B and below. And that’s all most investors look at-- the letter grade. They trust the credit rating agencies. And these agencies blessed most of these mortgage-backed securities. Gave them AAA ratings, which means they were considered as safe as a US government bond. This was the magic of this whole system. You could take a pool of thousands of risky mortgages, and create a security that was called money-good, as safe as any investment out there. At least that's what people thought. But now we know those agencies relied on the wrong data. That same historic data that had nothing to do with these new kinds of mortgages.

5. And as if the mortgage-backed securities weren't risky enough, someone found a way to integrate even more risk into them by creating something called a Collateralized Debt Obligation.

Alex Blumberg: Let’s translate some of that. A mortgage-backed security, you remember, is a pool of thousands of different mortgages. These are all put together and divided into different slices. Jim [Finkel] used the word tranche. Tranche is just French for slice. Some of these slices are risky, some are not. OK, a CDO is a pool of those tranches. A pool of pools. And Jim and most companies like his weren’t buying the top-rated tranches-- the safest ones, the AAAs. They were buying the lower-rated stuff. The high-risk stuff. Jim’s company was buying tranches that came from Glen Pizzolorusso’s company. The guy who hung out at nightclubs with B-list celebrities. The guy who said he was selling mortgages to people who didn’t have a pot to piss in.

Adam Davidson: There's another term the industry uses, no joke, they call these lower-rated tranches toxic waste. They're so high-risk, they're toxic.

Alex Blumberg: So, a CDO is sort of a financial alchemy. Jim takes that toxic stuff, these low-rated, high-risk tranches, puts them all together. Re-tranches them, and presto: He has a CDO whose top tranche is rated AAA, rock-solid, good as money. If this seems too good to be true to you, you're in good company. Guys like billionaire investor Warren Buffet said the very logic was ridiculous. But back in 2005, 2006, the global pool of money couldn't get enough of these things. And the CDO industry was facing the same pressures everyone else was at every other step of this chain-- to loosen their standards; to make CDOs out of lower and lower rated pools.

6. From 2003 to 2006, more people were qualifying for bigger mortgages, and the increased demand for housing drove prices up, creating a bubble.

Alex Blumberg: The problem was that even though housing prices were going through the roof, people weren't making any more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the more tenuous the whole thing became. No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they couldn't possibly afford, no matter what the mortgage machine tried, the people just couldn't swing it. By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times. And mortgage lenders noticed something that they'd almost never seen before. People would close on a house, sign all the mortgage papers, and then default on their very first payment. No loss of a job, no medical emergency, they were underwater before they even started. And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped.

7. And now that the bubble has burst, no one wants to take a risk on any mortgage-backed securities.

Alex Blumberg: Tonko Gast estimates that most of AAA rated mortgage-backed CDO's that the industry created since 2006, are now worth less than half their value. Some are worth close to zero. But remember to all the investment managers in the global pool of money who bought them, AAA meant safe as government bonds. AAA was called a cash equivalent, money in the bank. It's as if the global pool of money put trillions of dollars in a savings account, came back one year later, and found out that half was gone. Put another way, it's as if the global pool of money thought it was putting trillions of dollars in a savings account, but really, half of it was going into a furnace. The money is gone, burned up, never to come back. And that's what's led to the new term you've been hearing.

Adam Davidson: Maybe you've noticed that the press and others don't call it a sub-prime housing crisis as much anymore. They call it a credit crisis. The global pool of money still has no idea how much money they lost. How much went into the furnace. And because of that, they’ve totally changed their thinking. They used to be obsessed just with getting some profit, trying to make a slightly higher interest rate return. Now the global pool of money has the exact opposite obsession. It wants no risk whatsoever. It just wants safety. Suddenly, those US government treasury bonds-- still near historic lows of 1 and 2 percent-- are beautifully attractive. Because they're safe. They won't blow up like sub-prime CDOs did. The global pool of money is avoiding anything with even the slightest hint of risk and that affects everybody, no matter who you are. It's harder to borrow money to buy a house, or build a factory, or bring your country boldly into the 21st century...

This freezing of credit all around the world is something new, the world has never seen anything on this scale. When the crisis hit, last August, central bankers and finance economists couldn't figure out how bad things might get. There was this question people would ask: will things get like the 1930s or the 1970s? There was real fear that, just like in the '30s, hundreds of banks would collapse, there would be massive unemployment, there was talk of a new Great Depression.

So that's how we wound up here...

(Thanks to E!! for pointing me to Culture11, where I found the link to the NPR story.)


Realty Rider said...
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Elizabeth (E!!) Crum said...

Thanks for the link-up! Hope to see you around on Culture11 or wherever.