An Explanation of the Financial Crisis That Even I Understand

by Redfin Blogger | 10 Comments

For the past two days, I’ve read more economic news than I’ve ever read in my life. Mostly I’m trying to get a better handle on what is going on with our financial system, so I can decide whether I’m for or against the big government bailout. Of course, in the end it really doesn’t matter what I think; Congress is going to do whatever it does, and I’m guessing the rescue bill is going to pass, because the consensus is that although only a handful of reckless folks caused this mess, everyone will be hurt by it.dollar.jpg

Anyway, I came across this New York Times article that references an episode of a Chicago Public Radio show called This American Life that aired back in May. The episode, entitled “A Giant Pool of Money,” is still on the Web, and yesterday I listened to the entire thing. The hosts — Ira Glass, Alex Blumberg and Adam Davidson — present the most comprehensible explanation of the evolution of the housing bubble that I have heard. If, like me, charts and graphs make your eyes water and you really aren’t sure what a mortgage-backed security is, spend an hour and listen to this show. It’s fascinating, forthright, and entertaining, and you’ll come away reasonably learned about how we got into this mess. Here’s my takeaway:

  1. There is a “giant pool of money” out in the world at any given time — from pension funds, insurance companies, 401(k)s, etc. — that money managers must a) safeguard and b) make grow (i.e., invest).
  2. In the early 2000s, interest rates were so low that it was impossible for money managers to make any real money on “safe” investments like bonds or CDs.
  3. Around that time, someone got the bright idea to create “mortgage-backed securities,” created by buying home loans in bulk from lenders and selling them as investment vehicles. The reasoning was that the mortgage-holders, who were paying around 6% interest, would provide a dependable rate of return that was considerably higher than that of bonds or CDs.
  4. This idea really caught on; the demand for mortgage-backed securities went through the roof. The problem was, by 2003 everyone who could get a mortgage pretty much already had one. How would the demand be met? You guessed it: by lowering lending standards.
  5. Lending standards kept devolving as demand for mortgage-backed securities continued unabated. As one lender lowered standards, others followed suit to compete. The bottom was the advent of the so-called “NINA” loan — no income, no assets.
  6. Things started to tank when people stopped making their mortgage payments — in some instances, new homeowners would go immediately into default, not making a single payment. As delinquencies snowballed, lenders finally started to get spooked, and things started to tighten up.

And here we are.

At the end of the episode, which aired nearly five months ago, Blumberg and Davidson conclude that the fallout from this bubble will be “more like the 1970s than the 1930s,” with the economy simply shifting into neutral for awhile. So even though these two men were in front of the curve in seeing that the housing boom was a house of cards, they still underestimated its impact, just like practically everyone else — including our leaders.

When you listen to this report, it seems so patently obvious that the the situation was a disaster in waiting. Yet none of our leaders and money managers saw it coming — or, if they did, they decided to ignore it. I don’t know which is worse.

But if Congress and the Fed didn’t foresee this, how do we know they’re capable of doing the right thing going forward?

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  • Jose

    Let me understand the rationale behind the bailout, I mean the rescue bill. The economy is in a stand still because the banks have tightened their lending practices as a result of no liquidity because they made loans available to people that cannot repay them. More than the 700 billion dollars have disappeared into the pockets of those who engineered the schemes to buy the over rated packages of loans to Wall Street. Now, the tax payers most provide the banks with 700 billion dollars in an effort to allow the banks once more to lower their credit standard and perhaps double the loss. The money already lost will never be recovered. It is necessary to provide the money to boost the economy or is it necessary to provide the money to help those in Wall Street regain their loses?
    I would certainly not trust a friend let alone a stranger to whom I would have loaned 12k 3 years ago who failed to repay that loan as promised and who is now in a worse financial situation but is yet asking for another 12k loan.

  • http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1 A spoonful of sugar…

    Cindy – another easy-to-understand site. :)

  • Jean

    Another factor that great NPR story made clear was that the idiots that thought all this up never once imagined that real estate wouldn’t always increase wildly in value. They used the RE data model from the late 1990s and early 200s to set earnings expectations, even though most analysts would notice that those years were a statistical anomaly in terms of rate of return. It was a bubble. The greedy goons never once adjusted the data model, so they never considered anything but more money coming in.

    And we’re expecting a workable plan from these same goons? Sure, take $2 trillion while you’re at it. Sigh.

  • http://losangeles.redfin.com/blog/author/cindy.allen Cindy Allen

    Thank you for commenting, everyone. You’re right, Jean. Now we have to trust the same idiots who let this mess happen. It’s criminal.

  • Pingback: The Bailout Has to Pass, And It Will | Redfin Orange County Sweet Digs

  • Klutz

    Good synopsis, Cindy…and I love “This American Life”!

    To add to that the thing that really caused the levee to break was something that was included in the Sarbanes-Oxley act in 2002 called “mark to market” accounting rules. This was done because in the Enron/Worldcom era companies were allowed to use their own estimates for their own assets. This was highly abused as the companies inflated the value of what they owned to make their companies look strong on their balance sheets when, as we all know, they were weak. Why does this now cause a problem now?

    The mortgage backed securities you mentioned are of great concern as the housing bubble deflates and foreclosures rise. Since the securities are so complex and nobody seems to know exactly what they own NOBODY wants them and, therefore, there is no market for them. With the Sarbanes-Oxley act this means the securities they own are virtually valueless for accounting purposes. In other words, when you “mark them to market” and there is no market you come back with something that is worthless. However, this isn’t true in the real world where those securities are backed by real estate. Are they worth what they once were? No. Are they more valuable than 10 cents on the dollar? Of course! Much more!

    This chain of events created a “perfect storm”for the banks. As they write these securities down to market (virtually nothing) this kicks in downgrades from the credit agencies (based on their balance sheets) and those downgrades kick in agreements they have to repay money they’ve borrowed to purchase securities (and other things) in the first place. With scared people pulling their money out of the system they simply don’t have the cash to meet those margain calls and, voila, they are bankrupt.

    The “bailout” allows the government to purchase those mortgage backed securities above the current market price BUT almost certainly less than what they will will be worth when the housing market stabilizes. This is why Warren Buffett (not a greedy goon, BTW) thinks this will MAKE money for the government/taxpayers when the dust has cleared. The government scoops up these distressed assets to free the bank to start lending again and then, as hoped, sells them later at a profit on the open market.

    For all its warts the “bailout” is important and in all our best interests. I understand the frustration…but it’s true.

  • http://losangeles.redfin.com/blog/author/cindy.allen Cindy Allen

    Great post, Klutz. You seem to have a good handle on what’s going on. I admire that! I have become convinced that the bailout must happen. I have to comfort myself with the thought that what goes around, comes around, even though I might not get to witness it personally.

  • Jean

    Thanks for your thoughts, Klutz. I was not lumping Warren Buffett with the Wall Street tycoons that got us where we are, but he is under enormous pressure to step in line with this bailout and publicly make big investments that make him appear to endorse whatever the greedy goons are endorsing. The difference of course is that he can afford to lose a lot more than most of us.

    And there is still the question: what if it doesn’t work? What if the gov’t scoops up these assets and can’t sell them later at a profit? Lots of folks couldn’t imagine that they wouldn’t be able to sell their home at a profit, but they’re screwed now. What will happen if this doesn’t work?

  • Jean

    Also, FYI, Bloomberg News reports that former Treasury Secretary Paul O’Neill calls this plan “crazy,” with potentially “awful” consequences.

    Full story here:
    http://www.bloomberg.com/apps/news?pid=20601087&sid=atJMmClVjevU&refer=home

  • Klutz

    Jean, I know you weren’t lumping Mr. Buffett in with the “Greedy goons”. Didn’t mean for it to come across that way…

    The question of what will happen if it doesn’t work…nobody knows! Nobody knows how it won’t work if it doesn’t so nobody knows what will happen if it doesn’t work! I know, right?

    But back to Mr. Buffett who was on Charlie Rose and when asked about the bailout he said:

    “Well, I don’t think it’s perfect, but I don’t know that I could draw one that’s perfect. But I’d rather by approximately right than precisely wrong, and it would be precisely wrong to turn it down.”

    In my opinion he is the smartest man about money on earth and I don’t want to be on the other side from him on this one. I can be rather cynical at times but in this case I think he’s more independent minded and ethical than to be under any real pressure from anybody. He didn’t own internet stocks in 2000 (didn’t understand the business model) when he was asked in 2005 about real estate and why he wasn’t getting involved he said about a house that sold in Newport Beach (and I’m paraphrasing) “when you figure it out your paying about 25 million an acre for land! For that kind of money I’d rather stare at the bathtub!”

    I guess what I’m saying is he’s not a “company man” spewing the party line and he’s putting billions and billions (8 at last count) in the market only because he thinks things are VERY, VERY undervalued. He believes when it’s all said and done he will make one more fortune betting on the recovery of the American economy and even though he doesn’t need it he does care about losing his investment. You’re talking about the second richest man on earth who drove around town in a five year old Lincoln Towncar with the license plate “THRIFTY”…and that was 2006!

    Look I guess I don’t know what will happen (nobody does!) but the new bill has language in about “mark to market” accounting, it has increased FDIC insurance to $250,000 to prevent some runs on banks and its genuinely gotten better. I really do understand the frustration about being asked to be on the hook for others bad decision making but the truth is whether they approve the bailout or not…you and I and everybody else already are. In the end–

    I’m smart enough to know when I’m not the smart guy at the table so I’m gonna go with Warren on this one because I’d rather be “approximately right than precisely wrong.”