Thursday, October 16, 2008

Understanding the Financial Crisis

[By Bill Henderson, cross-posted on ELS Blog]

Like everyone else, I am struggling to get my head around exactly what happened to produce our current financial crisis.  That is a precondition of anticipating the longer term consequences.  In a single paragraph, this is what (I surmise) happened. 

Sometime during the 1990s, momentum began to build on Wall Street for securitizing home mortgages in new and exotic ways.  Residential real estate seemed like an attractive business because the yields were decent, the historical default rates were low, risk of loss was mitigated by pooling thousands of mortgages (which were, themselves, divided into parts), and the underlying assets (homes) generally went up in value, sometimes by a lot in major metropolitan areas. Institutional investors had an insatiable appetite for these debt instruments, which were graded as safe by all the major rating agencies.  Further, respected companies like AIG wrote insurance on these instruments on the theory that they would never have to pay.  All the risk was supposedly hedged by "credits swaps," which are fancy and unregulated contracts between private parties.  So money gushed in. Because virtually any loan could be sold the next day to Wall Street (who, in turn, could repackage them for a large profits within a short time), banks and other mortgage originators could make money with no risk (zero risk!).   This cycle continued even though the pool of mortgage applicants became weaker and weaker--eventually people with (a) bad credit, (b) no assets, and (c) no job.  This had the predictable effect of driving up the price of real estate to a frothy bubble. 

If we want to get back to good old-fashion, sane capitalism where risk is actually assessed before a lender gives a borrower money (and I do), we need to know what the underlying asset (a home) is really worth. 

Here, the news is not good.  According to this story in the New York Times, the price of real estate could tumble throughout 2009.  Frankly, this is where analogies to the 1930s seem like they have some traction.  When an average person's largest asset turns out to be a terrible investment, they have lost a lot of money in the stock market (any opinions on privatizing Social Security now?), and banks are failing left and right, it has a devastating effect on society's ability to pool risk--all the money ends up in the mattress, so to speak.   No surprise, people like my grandparents who lived through the Great Depression tended to be very cautious and risk averse with money.

Frankly, the issue now is not how to regulate Wall Street--the investment banks are gone.  It is how to unwind this mess.  The larger tragedy here is not the loss of money; it is the loss of trust by ordinary people in basic financial and commercial institutions.  They worked hard and played by the rules. Yet many of their homes will be worth less than what they paid for them, and retirement seems beyond reach.   Unregulated capitalism failed.  Like it or not, government is the only entity that can fill the breach. 

These two stories from This American Life, both 1-hour long audios, are the two best resources I have found on these topics:

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Here's one more attempt to Understanding the Financial Crisis. We tried to come up with an explanation for high school kids but it turns out, the majority of people watching this are adults.



Posted by: Jordan | Oct 17, 2008 6:40:12 AM

To really understand one would have to realize that when the Federal Reserve System was sneaked into operation in 1913 and we were forced onto a fiat money system we were doomed.

Posted by: c | Oct 18, 2008 3:09:48 AM

To really understand one would have to realize that when the Federal Reserve System was sneaked into operation in 1913 and we were forced onto a fiat money system we were doomed.

Posted by: c | Oct 18, 2008 3:10:12 AM

There is one more aspect that is crucial in understanding the crisis and that is the role of debt (leveraging). Much of the purchase of the financial instruments created through securitization and funneled through to special purpose vehicles was effected without significant outlays of cash but through intensive borrowing. The beauty of derivatives compared to stocks and shares is that contracts can be bought without having to provide the full purchase price hence the precipitous peaks and valleys in profits and losses. The unwinding of the debt is of horrendous proportions. And one must wonder if it can ever be accomplished.

Posted by: John Flood | Oct 20, 2008 3:03:00 PM

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