The Current Economic Crisis

18 October 2008

Because I used to work on Wall Street, some people I know are under the (incorrect) impression that I'm an expert in all things financial, and they have been asking me if I can explain how we got into our current state of financial collapse. So, I thought I would write a short summary of my understanding of how rampant greed around the practice of sub-prime lending led to a full-scale financial crisis.

First, let's set the scene: the sub-prime lending market. Here's a brief summary of how it worked:

  • For at least the past ten years, many banks and mortgage companies in the U.S. have been aggressively seeking out people who were not financially ready to buy homes (bad credit history, no savings for down payments, insufficient income to afford a house, etc.), and giving them mortgages. These borrowers had to pay high interest rates for their "sub-prime" mortgages, to offset the increased risk that they would default on them.
  • Many of the borrowers were not very knowledgeable about money, and they often did not understand the implications of their mortgages. Some borrowers had low payments for the first couple of years, which they didn't realize would go up dramatically after that. Other borrowers weren't able to calculate the full cost of owning a home (including fire insurance, real estate taxes, association dues, and water and sewer bills that a renter typically would not pay), and they couldn't even afford the initial payments.
  • Many mortgage agents and brokers did not educate the borrowers or fairly assess their ability to afford the mortgages -- they either were under no legal obligation to do so, or the laws were not enforced.
  • Most mortgage agents and brokers are paid commissions (at least to some extent), so they had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
  • The lending companies sold the mortgages rather than holding them. Once they had traded a mortgage contract for cash, they had no more risk, and could go out and lend the same money again to another borrower. Because they were able to transfer the risk away and lock in their profits, they also had a financial incentive to make as many deals as possible, and no penalty if the borrower eventually defaulted.
  • The companies that purchased the mortgages re-packaged them into very complex "mortgage-backed securities", and sold them to investors (mostly banks); the companies that originally bought the mortgages therefore also transferred away all risk of default and locked in profits, and again had an incentive to do as much of this as possible.
  • Since the Reagan era, we have had less and less regulation of our financial market (under the philosophy that a capitalist market can regulate itself more efficiently). One of the ways in which the financial market is supposed to regulate itself is that we have two big investment rating agencies (Moody's and Standard & Poor's), which rate the risk of financial assets. In this case, they failed: the investment rating agencies gave the mortgage-backed securities "investment-grade" ratings. This allowed companies that bought them to count them fully as assets on their books, rather than having to discount them according to the actual level of risk they carried.
  • The traders and strategists within the purchasing banks (often people like me: ex-physicists who went to work on Wall Street), who were in the best position to understand the long-term risks of mortgage-backed securities, also had a large personal incentive to do these deals. They were basically gambling using someone else's money: they made huge bonuses in the short term because the deals they did looked great on paper, and the most drastic down-side risk they faced is the possibility that they could lose their job some years in the future if the value of the mortgage-backed securities they had bought went too far down.
  • Because of all of the sub-prime borrowers entering the housing market, there was a strong demand for houses, which contributed to housing prices rising at a rate that far exceeded inflation. This led to additional demand from housing speculators, who could buy a house, hold it for a short time, and sell it again ("flipping"), which drove housing prices even higher.
  • So, everything worked smoothly for many years, with many people making a lot of money off the sub-prime mortgage market: even if someone defaulted on a mortgage (and the market expected a certain fraction of these borrowers to default), the principal could be recovered by investors because the house had increased in value. At the same time, many analysts warned that when the time came that the economy wasn't so strong, the sub-prime mortgage could easily collapse.
  • But because they were making money in the short term, banks ignored the underlying problems, and mortgage-backed securities became large fractions of many large banks' assets.

In order to understand our current crisis, you also need some background on the workings of other (non-financial) businesses in our current economy:

  • Much of the world economy currently depends heavily on credit. Medium to large companies do not generally operate by using the proceeds of their current and prior operations to fund their current expenditures. Instead, they fund their current expenditures by borrowing against their future profits. The businesses borrow by issuing bonds for longer-term capital needs, and by obtaining bank loans for their short-term needs. The banks get money to loan by borrowing from larger banks.
  • This whole system depends on trust. The banks lend money to companies based on their belief that the companies will be able to generate income in the short term and pay the money back. Banks lend money to other banks based on their trust in the borrowing bank's assets and loan portfolios.
  • The current economy is also focused on the short term. Nearly every publicly-traded company focuses on quarterly profits rather than long-term prospects -- the reasons being that their stockholders (who hold stock on average for days rather than years) demand it, and their upper management's compensation is based on it.
  • The current economy is also based on an underlying assumption that the economy as a whole will always grow, that the world will always increase its consumption. But consumption cannot grow forever -- it's not environmentally sustainable.

Now that we have set the scene, we are ready to understand the crisis:

  • A few months back, the delicate balance in the average sub-prime borrower's finances tipped (due to rising interest rates, rising oil and food prices, layoffs, etc.), and more sub-prime borrowers started defaulting on their mortgages than had previously been the case.
  • Once this started, the houses these borrowers had owned started flooding the market, and housing prices started dropping quickly. This meant that the holders of the mortgage-backed securities not only held more defaulted mortgages, but the houses that formed the loans' collateral were worth significantly less than the principal of the mortgages.
  • The defaults and housing price drops meant that suddenly no one trusted the value of sub-prime mortgage-backed securities, which had become a very large portion of the total holdings of many banks. This led to a problem where the banks wouldn't loan each other money, even in the short term, since they didn't trust the financial stability of the other banks.
  • When the banks couldn't borrow from other banks, they couldn't make loans to businesses, and the businesses didn't have the money to fund their current operations (payroll, raw materials, etc.), and went into a state of crisis.

So that's the story: short-term profits and risk transfers fueled sub-prime lending, and it got so big that when it collapsed, it took the confidence in the banking industry with it; without trust, no loans were made and our credit-based economy entered a state of crisis. This is why the U.S. government bailout is aimed at getting capital back to banks, and buying their untrusted mortgage-backed securities: so that the banks can once again loan money to businesses, and the businesses can get back to normal operations.

But I am not convinced this will solve the problem, since the underlying issues will not be changing:

  • Economy focused on the short term
  • Economy based on the availability of short-term credit, provided by banks
  • Little oversight on the operations of banks and the investment rating agencies
  • Economic assumptions of continual growth, which is environmentally unsustainable
  • Coming crises in food and energy (see my previous blog articles) that no one is planning for

It will be very interesting to see if our next President and Congress will do anything to address these issues. So far, I haven't seen much evidence that they plan to...