Credit Crunched
July 11, 2010 2:51 PM Subscribe
Is my understanding of the credit crunch correct, and do you have any more articles to help me get a better handle on the causes and consequences?
My understanding is as follows:
1) Banks/mortgage lenders worked out that they could make money by lending for mortgages, then selling off the right to repayments to someone else.
2) This encouraged "liars loans", self-certifying mortgages etc.
3) Investment banks bought a ton of the mortgages, and packaged them up into mortgage-backed securities.
4) These had various slices - the top slice would be repaid from the whole before any other slice, then once that was paid off the second slice would be paid off from the whole etc. etc.
5) Ratings agencies were paid on the basis of giving ratings, and generally gave these top slices great AAA ratings because they figured the chance of the whole pool defaulting was low.
6) These got sold off and traded throughout the global financial system.
7) Lots of defaulting
8) Banks suddenly realised that these were a lot less valuable than they had previously thought, so had to write-down their balance sheets.
9) Due to market capitalisation rules, suddenly this meant that banks weren't able to lend
10) Lack of liquidity meant that banks couldn't get inter-bank loans to service their debts
11) Large possibility of default (Lehman Brothers, Northern Rock etc.)
12) Central banks stepped in and bought the bad assets to repair the banks' balance sheets in the hope that they'd start lending to each other.
Is this correct?
Have I missed anything out? Someone told me something about gilts, and banks making money off buying gilts with bailout money or something, but I can't find an article to explain/back that up for me.
Are there any good articles I could read on the causes, effects, consequences etc., and especially the response of central banks and the banks' response to the actions of their central banks?
My understanding is as follows:
1) Banks/mortgage lenders worked out that they could make money by lending for mortgages, then selling off the right to repayments to someone else.
2) This encouraged "liars loans", self-certifying mortgages etc.
3) Investment banks bought a ton of the mortgages, and packaged them up into mortgage-backed securities.
4) These had various slices - the top slice would be repaid from the whole before any other slice, then once that was paid off the second slice would be paid off from the whole etc. etc.
5) Ratings agencies were paid on the basis of giving ratings, and generally gave these top slices great AAA ratings because they figured the chance of the whole pool defaulting was low.
6) These got sold off and traded throughout the global financial system.
7) Lots of defaulting
8) Banks suddenly realised that these were a lot less valuable than they had previously thought, so had to write-down their balance sheets.
9) Due to market capitalisation rules, suddenly this meant that banks weren't able to lend
10) Lack of liquidity meant that banks couldn't get inter-bank loans to service their debts
11) Large possibility of default (Lehman Brothers, Northern Rock etc.)
12) Central banks stepped in and bought the bad assets to repair the banks' balance sheets in the hope that they'd start lending to each other.
Is this correct?
Have I missed anything out? Someone told me something about gilts, and banks making money off buying gilts with bailout money or something, but I can't find an article to explain/back that up for me.
Are there any good articles I could read on the causes, effects, consequences etc., and especially the response of central banks and the banks' response to the actions of their central banks?
Best answer: 8) Banks suddenly realised that these were a lot less valuable than they had previously thought, so had to write-down their balance sheets.
Well, you're missing a step between 5 and 7, or so, and that's the credit default swaps placed against these mortgage derivatives. Basically a CDS pays out in the event of a default. So, for example if I get a car loan, the car company want's my money but if they think I might default they can buy a CDS from some third party provider that will pay them if I stop making payments.
In other words, basically insurance.
But the trick is, anyone could take out these CDSes against any loan. So for example if I told my friend I'd just lost my job, he could take out a credit default swap on my car loan, and when I stop paying it, he'd get a payout, along with anyone else.
A lot of hedgefunds got involved with this, including the so called "Magnitar" trade and the one Goldman sachs is in trouble for. In both of those cases, they actually picked securities they thought were 'extra' risky, created credit derivatives, and sold them. Then hedgefund partners took out CDSes on those loan packages they had just sold. The customers got screwed and the hedgefunds made bank.
So that was the problem with AIG. They had written lots of swaps thinking they'd just collect money and never have to pay. And when the bill came due, they couldn't pay, requiring a bailout for AIG, which went straight to their customers. (Meanwhile, the actual employees kept raking in tons of cash the whole time. AIG stockholders, not the actual employees got screwed)
posted by delmoi at 3:00 PM on July 11, 2010
Well, you're missing a step between 5 and 7, or so, and that's the credit default swaps placed against these mortgage derivatives. Basically a CDS pays out in the event of a default. So, for example if I get a car loan, the car company want's my money but if they think I might default they can buy a CDS from some third party provider that will pay them if I stop making payments.
In other words, basically insurance.
But the trick is, anyone could take out these CDSes against any loan. So for example if I told my friend I'd just lost my job, he could take out a credit default swap on my car loan, and when I stop paying it, he'd get a payout, along with anyone else.
A lot of hedgefunds got involved with this, including the so called "Magnitar" trade and the one Goldman sachs is in trouble for. In both of those cases, they actually picked securities they thought were 'extra' risky, created credit derivatives, and sold them. Then hedgefund partners took out CDSes on those loan packages they had just sold. The customers got screwed and the hedgefunds made bank.
So that was the problem with AIG. They had written lots of swaps thinking they'd just collect money and never have to pay. And when the bill came due, they couldn't pay, requiring a bailout for AIG, which went straight to their customers. (Meanwhile, the actual employees kept raking in tons of cash the whole time. AIG stockholders, not the actual employees got screwed)
posted by delmoi at 3:00 PM on July 11, 2010
Best answer: This American Life did a couple of shows, called "The Giant Pool of Money" and "Return to the Giant Pool of Money." They are truly excellent.
posted by decathecting at 3:01 PM on July 11, 2010 [6 favorites]
posted by decathecting at 3:01 PM on July 11, 2010 [6 favorites]
Best answer: The Crisis of Credit Visualized is a fantastic video animation that's the only thing I ever saw that came close to understanding what happened. Starting from the initial conditions to allowed it to happen, the motivations for those subprime mortgages, and all the interactions therein.
Horribly complex, it's amazing how entangled all the elements of the financial industry and what a torturous series of events had to happen to bring all of this about.
Also, tt was a grad student's thesis project - beautifully rendered, well-written. A fantastic example of great design communicating on a useful level.
posted by artificialard at 3:12 PM on July 11, 2010 [1 favorite]
Horribly complex, it's amazing how entangled all the elements of the financial industry and what a torturous series of events had to happen to bring all of this about.
Also, tt was a grad student's thesis project - beautifully rendered, well-written. A fantastic example of great design communicating on a useful level.
posted by artificialard at 3:12 PM on July 11, 2010 [1 favorite]
I am not an expert, but I thought some other aspects were involved also, perhaps someone else will comment to flesh them out or correct me if I am wrong:
- Congress putting political pressure on Fannie Mae and Sallie Mae so that qualifications were not looked at too closely, which contributes to your point #2
- Government regulators not regulating (i.e., Securitization of loans has been common practice since the 1970s but I gather capitalization minimums and tranche ratings were more carefully enforced in the 20th Century)
- Corruption on the part of Wall Street vis conflicts of interest in dealing with their customers
- I remember reading that some idiotic economist (can't find a reference right now) said in 2000 that it didn't matter if people paid back their mortgages since the Bank would just foreclose, and the market for housing is always active and prices always go up, right???
I found an interesting document at the US Treasury Web site that describes how Securitization was supposed to work and (as I said) *did* work for decades.
Personally I think this is a case of stupid politicians taking down the entire country (unless you are a conspiracy theorist in which case you could claim it was a plot and not stupidity, but I think idiocy). I realize there was greed and dishonesty at many touch points, but if you totally subtract government regulation from any area of life how long before it all goes in the crapper?
posted by forthright at 3:53 PM on July 11, 2010
- Congress putting political pressure on Fannie Mae and Sallie Mae so that qualifications were not looked at too closely, which contributes to your point #2
- Government regulators not regulating (i.e., Securitization of loans has been common practice since the 1970s but I gather capitalization minimums and tranche ratings were more carefully enforced in the 20th Century)
- Corruption on the part of Wall Street vis conflicts of interest in dealing with their customers
- I remember reading that some idiotic economist (can't find a reference right now) said in 2000 that it didn't matter if people paid back their mortgages since the Bank would just foreclose, and the market for housing is always active and prices always go up, right???
I found an interesting document at the US Treasury Web site that describes how Securitization was supposed to work and (as I said) *did* work for decades.
Personally I think this is a case of stupid politicians taking down the entire country (unless you are a conspiracy theorist in which case you could claim it was a plot and not stupidity, but I think idiocy). I realize there was greed and dishonesty at many touch points, but if you totally subtract government regulation from any area of life how long before it all goes in the crapper?
posted by forthright at 3:53 PM on July 11, 2010
- Congress putting political pressure on Fannie Mae and Sallie Mae so that qualifications were not looked at too closely, which contributes to your point #2
That's a favorite trope for republicans, but it's not really a big part. Fannie and Freddie didn't get very involved in "Subprime" mortgages, and the only 'pressure' was from Wall Street who wanted another place to sell them too. The demand for these mortgages was coming from wall street, not being pushed by the government.
posted by delmoi at 3:57 PM on July 11, 2010
That's a favorite trope for republicans, but it's not really a big part. Fannie and Freddie didn't get very involved in "Subprime" mortgages, and the only 'pressure' was from Wall Street who wanted another place to sell them too. The demand for these mortgages was coming from wall street, not being pushed by the government.
posted by delmoi at 3:57 PM on July 11, 2010
Best answer: 2nding the This American Life shows. Also, this video has a really good explanation of the problems of capitalism in general (including how it led to the current downturn) and is presented in a really cool whiteboard drawing.
posted by melissasaurus at 4:25 PM on July 11, 2010
posted by melissasaurus at 4:25 PM on July 11, 2010
You might be interested in an EconTalk interview with Arnold Kling, a former economist for Freddie Mac (a rare quasi US govt operation chartered by Congress). There's also a more recent talk since then, but this episode is one of the more unfortunate 'dialog between host and his good friend, theoretically on a topic which we don't really know the answers to' kind of episodes that EconTalk sometimes falls into with recurring guests.
From those two discussions, it's important to realize this wasn't just lying borrowers and a lack of basic due dilligence from the lenders. Reducing downpayments made it a lot easier for people to take on loans. More loans drives up prices. It's only when the economy goes into a recession that the missing downpayment hurts, and those purchases are sold back onto the market, reversing the rise in price and people start to trigger their non-recourse mortgage clauses.
djgh: "8) Banks suddenly realised that these were a lot less valuable than they had previously thought, so had to write-down their balance sheets.
9) Due to capitalisation rules, suddenly this meant that banks weren't able to lend
10) Lack of liquidity meant that banks couldn't get inter-bank loans to service their debts
11) Large possibility of default (Lehman Brothers, Northern Rock etc.)
12) Central banks stepped in and bought the bad assets to repair the banks' balance sheets in the hope that they'd start lending to each other.
Is this correct?"
The later steps of this argument are harder to pin down accurately. It comes down to a solvency vs liquidity argument. The banks said they were illiquid, that their long term loans were really valuable and will pay out 100 cents on the dollar or close to it, even if the market is trading at 30 cents on the dollar. This was presented as a valid position by news organizations like CNBC, but the market and volatility indexes gave a different consensus. But banks refused to write down those losses, because it would trigger bank capitalization rules and scare investors and basically bring their house of cards crashing down.
So central banks basically have to recapitalize lenders without directly admitting that they're doing so. Every action has a dual purpose. TARP lets them trade their crap dollar for dollar with reliable interest bearing assets that don't suck temporarily. Given time, these assets might pay out enough to recapitalize.
posted by pwnguin at 5:24 PM on July 11, 2010
From those two discussions, it's important to realize this wasn't just lying borrowers and a lack of basic due dilligence from the lenders. Reducing downpayments made it a lot easier for people to take on loans. More loans drives up prices. It's only when the economy goes into a recession that the missing downpayment hurts, and those purchases are sold back onto the market, reversing the rise in price and people start to trigger their non-recourse mortgage clauses.
djgh: "8) Banks suddenly realised that these were a lot less valuable than they had previously thought, so had to write-down their balance sheets.
9) Due to capitalisation rules, suddenly this meant that banks weren't able to lend
10) Lack of liquidity meant that banks couldn't get inter-bank loans to service their debts
11) Large possibility of default (Lehman Brothers, Northern Rock etc.)
12) Central banks stepped in and bought the bad assets to repair the banks' balance sheets in the hope that they'd start lending to each other.
Is this correct?"
The later steps of this argument are harder to pin down accurately. It comes down to a solvency vs liquidity argument. The banks said they were illiquid, that their long term loans were really valuable and will pay out 100 cents on the dollar or close to it, even if the market is trading at 30 cents on the dollar. This was presented as a valid position by news organizations like CNBC, but the market and volatility indexes gave a different consensus. But banks refused to write down those losses, because it would trigger bank capitalization rules and scare investors and basically bring their house of cards crashing down.
So central banks basically have to recapitalize lenders without directly admitting that they're doing so. Every action has a dual purpose. TARP lets them trade their crap dollar for dollar with reliable interest bearing assets that don't suck temporarily. Given time, these assets might pay out enough to recapitalize.
posted by pwnguin at 5:24 PM on July 11, 2010
Best answer: James K. Galbraith had an concise explanatory article at The New Republic just Friday.
And Zerohedge today has a piece called, "The Financial Con Of The Decade Explained So Simply Even A Congressman Will Get It"
posted by T.D. Strange at 6:17 PM on July 11, 2010
And Zerohedge today has a piece called, "The Financial Con Of The Decade Explained So Simply Even A Congressman Will Get It"
posted by T.D. Strange at 6:17 PM on July 11, 2010
There are lots of good books out about this.
ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
Bailout Nation, with New Post-Crisis Update: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy
This Time Is Different: Eight Centuries of Financial Folly
13 Bankers: The Wall Street Takeover and the Next Financial Meltdown
Freefall: America, Free Markets, and the Sinking of the World Economy
posted by procrastination at 7:41 PM on July 11, 2010 [1 favorite]
ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
Bailout Nation, with New Post-Crisis Update: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy
This Time Is Different: Eight Centuries of Financial Folly
13 Bankers: The Wall Street Takeover and the Next Financial Meltdown
Freefall: America, Free Markets, and the Sinking of the World Economy
posted by procrastination at 7:41 PM on July 11, 2010 [1 favorite]
Response by poster: Thank you all, every answer was helpful.
posted by djgh at 9:00 AM on July 16, 2010
posted by djgh at 9:00 AM on July 16, 2010
This thread is closed to new comments.
posted by djgh at 2:54 PM on July 11, 2010