Thursday, May 10, 2012

Financial Crisis Simplified


For years, deposits into your savings account gained about 1%. The bank then made mortgage loans at say, 7% to anxious homeowners.  The banks made 6%, which was referred to as the “spread.”  The bank is loaning $144,000 in exchange for a future monthly stream of payments of close to $1,000 per month for a 30-year, fixed-rate mortgage. The lower the interest rate a homebuyer gets, the higher the price the bank is actually paying for the income stream.

A few homebuyers would lose their home to foreclosure, and that loss was factored in. However, it was rather rare, because homebuyers had to bring a whopping 20% of the purchase price in cash, along with fees, to the closing. (On an $180,000 home, that’s $36,000 plus closing costs).  They were unlikely to walk away from all that, and if they sold for less than market value, they lost only some of their own down payment. It was a pretty stable system.

So what changed?

Lenders made riskier loans to less than creditworthy folks, for one. These are “subprime loans.” Borrowers were even allowed to borrow the 20% down that used to be required in cash! In other words, they buyer walked into a home with “no money down.”

Remember that your local bank often resells your mortgage product (called “paper”) to investment banks.  Your local bank receives the loaned amount back, plus a few fees that make it a profitable deal, and they then do more. Now the out of town bank owns your mortgage and you have to send payment to them, instead of your local bank.

The investment bank will now “securitize” your mortgage. It will be bundled with thousands of other mortgages. It will be rated, based mostly on the credit of the buyers. Your little American dream home is now part of a pool of 10,000 mortgages, with about $10 million in payments coming in from borrowers every month. Investors can buy the right to a part of that pool. The more solid the credit of the borrowers, the more they are worth.

Shares of some pools are treated differently. A “collateralized debt obligation” is a securitization where some slices have priority. They are entitled to the very first payments that come in each month, and hence are the safest. Some slices of the pool only get the last of the monthly payments, so those are the risky ones. These were cheaper, but paid much higher interest, when they paid at all.

If an investment bank paid $2 million for a slice of a pool, it happily lists that as an asset and waits on the money to roll in from you and your credit-worthy neighbors. But things go badly. The investment bank has used many millions of its own money (“capital”) and borrowed much from others to invest.  To borrow, they usually sold “bonds,” which are just IOU’s with a bit of interest to be paid at some future point. These millions bought slices of mortgage pools with the income stream at 7% and it only paid out, say 1%, on their bonds. This was just a larger version of the old saving account plan mentioned in the first paragraph, and proved quite profitable.

But by 2008, housing prices and securitized subprime mortgages plummeted. Others in the same pool started selling these slices at fire sale prices. Maybe it was at only 25% of the value. Thus, the bank’s $2 million “asset” was now only worth about $500,000! The loss of 75% is called a “write down.” These, in sufficient numbers, can really affect the health of the investment bank, because it is listed just like money out the door for nothing.

Remember the bank runs in the movie, It’s a Wonderful Life? The FDIC insures all deposit accounts to prevent such panic. Other banks can also help a bank out if they are now short on assets to borrow against to pay its depositors.  But following 2008, all banks wanted to simply hold onto its cash in case it became the target of a bank run, or the other bank ultimately fails. A self-fulfilling prophecy resulted:  banks wouldn’t lend, therefore banks had no credit, and were subject to a modern day bank run. Some banks did fail, just not as many as some feared.

Companies like AIG that insured so many bonds on what is called “credit default swaps” were famously deemed “too big to fail.” While it is generally agreed that saving the banking system was required, as usual, the government acted in a wasteful and unwise way in doing it. The “bail outs” were often paid at 100% of value, which is unheard of in a fire sale.  Of course--it was not their money--it was ours.

Unfortunately, with foreclosures still sadly occurring at high rates, appraisals are bottomed out and people cannot sale or refinance their house.  Ultimately, the housing bubble popped and will probably re-inflate rather slowly. It was a return to those original rules of lending that has helped the market start the recovery.