Economic Crisis

I had an extended discussion with Steven the other day about the current economic crisis. It helped solidify my knowledge of the causes, but I tend to think a lot better when I write as opposed to just talking out loud. Also, I kind of want a record of my perception of this crisis.

So here goes.

It all began when certain home lending institutions began a new practice: selling mortgages. Their whole business model was based around this. They would give someone a loan to buy a house and then sell the loan to some investor. In effect, that random investor was giving someone a loan and paying the lending institution a finder's fee as the middle man. This means that these lending institutions were lending out other people's money. Once they had sold the loan, they didn't care if it was paid back or not. They still got their finder's fee regardless. So of course, it was in their best interests to find lots and lots of people and collect more and more finder's fees. The lending institutions found people who had never been offered loans before (usually for good reason) and gave them the opportunity to buy a house that they really couldn't afford. Of course, these people jumped at the chance. Huge sections of the population who had been kept away from the "American Dream" all of a sudden found it attainable. There were all kinds of creative payment plans cooked up so that people thought they might actually be able to pay their loans back. Most people were pretty willing to be convinced. It didn't matter if they had a plan where their payments increased over time or a plan that prevented them from saving a dime; they figured their salaries might increase or the value of their home would go up and somehow it would all work out. It doesn't matter if the lending companies thought it would work out as long as they could convince people to accept the loans, which generally wasn't very difficult.

It's not hard to imagine how these bad mortgages were created. I might have made the same mistake in their place if I thought I could actually have a house after being denied one for so long. The part that gets tricky is how these loans were sold. I mentioned before that lending companies were using other people's money to sell these loans, but I conveniently glossed over how they convinced people to buy mortgages that were so incredibly likely to be defaulted. The simple answer is that no one knew who the loans were being given out to. They didn't realize that everyone from the minimum wage earners to migrant workers had been offered loans. The total picture is a bit more complicated than that though. Very few investors are willing to buy something they know so little about. However, many also aren't willing to research their stocks in extremely great depth. That's why stock rating systems were devised. The ratings measure how safe or low risk a stock is. So now the lending companies were faced with the task of making their investments appear safe so that they could get more money to loan and then get more finder's fees. How do you make such and incredibly risky investment appear like a conservative, safe way to store your money? One way was to insure the mortgages. If the person who received the loan defaulted, then the insurance company would pay. Of course, insurance companies make you pay very high rates if they think their insuring something risky, so the lending companies were again left with the problem of making their stocks appear safe. Then some horrible genius came up with the idea of tranching. They divided up all the mortgages into groups called tranches. Often there would be about 20 tranches or more. Let's look at an example of a lending company with 20 tranches. The first tranche would be the first 5% of the mortgages to default on their loans. If even 5% defaulted, you would get no money at all. It was definitely a risky investment. The next tranche would pay out full returns unless more than 5% of the total mortgages defaulted. So if 5% of all the mortgages defaulted, you would be fine. If 6% defaulted, you would take some losses. If 10% or more defaulted, you would get nothing. Again, a risky investment considering that foreclosure rates were about 20% historically. But now imagine that you're in the 15th tranche. More than 70% of all the loans this company gave out would have to default before you'd even have to think about it. Even lower tranches than that looked pretty appealing. Imagine how safe and secure the 20th tranche must have looked. Everyone would have to default before you'd have to worry about a thing. Thus, stock rating companies were deceived and most of the crappy loans earned the safest rating, AAA. People gladly paid big bucks to buy something unbelievably secure with high rates of return that was also insured. You could put your life savings into something that secure and then not have to worry about money at all. Little did they know that the people who could afford loans were usually going to banks, not these lending institutions. People who could actually afford loans are a harder sell. People who never had a chance at a house will jump at the opportunity. You can move people through much more quickly and collect more finder's fees if you give loans to people who have never had money before. The 15th tranche wasn't safe. Even the 20th tranche didn't deserve a AAA rating. Almost every one of those crappy loans ended up defaulting. Nearly all the investors lost all of their money. But how could they lose everything? The investments were rated as being so safe, and weren't those loans insured? Unfortunately for the insurance companies, they were. The insurance companies were some of the first to go under (remember AIG?).

This is how the downward spiral began, but the spiral has much, much farther to go. A few investors losing their savings is certainly tragic for them, but it doesn't destroy a whole economy. Even a major insurance company going out of business isn't more than a ripple in the whole US economy. There are several other factors that set the stage for the huge downfall that ensued. Again, it begin with the lending companies that sold mortgages. Here, the focus shouldn't be on who they sold the loans to, but rather on how many people ended up with loans. From out of nowhere, the demand for houses went through the roof. Many people who had previously never had the opportunity to enter the home buying market were now seriously shopping. Here is a classic case of supply and demand influencing cost. Even with companies building houses as fast as they could, there was no way anyone could match the rate at which lending companies were giving out loans. Demand was increasing far faster than it ever had before. You would think people would get suspicious when their home values began to grow exponentially, but most people just saw it as a great windfall. Real estate agents were certainly enjoying the boom and housing developers didn't have time to consider why housing prices were soaring when other housing developers were getting filthy rich with their newly constructed houses that were being sold as fast as they could be built. As a result of the soaring prices, loans for houses needed to get larger and larger for people to be able to afford one. Even people who could normally afford a house were faced with extremely daunting loans that even they would be hard pressed to pay back. People who tried waiting for housing prices to come down again often panicked as the prices kept going up and up. "Priced out" was a common phrase back then. If you didn't stretch your means and buy a house now, the prices would soar and soar until you no longer had the option even to stretch. To avoid being priced out, people rushed to their banks (and also to those lending institutions) clamoring for loans that they could less and less afford. Even without the lending institutions giving loans to people certain to default, the foreclosure rate would have still skyrocketed because of the unreasonably high cost of housing and the large number of people making sacrifices to buy a house while they could. Now even banks that didn't sell away their mortgages (and so actually screened their loans to increase the chances of being paid back) would be faced with more losses than usual.

As you can see, an enormous problem was already looming on the horizon, but another new lending policy made the problem even worse: the home equity loan. Because of the rising prices of housing, there was now a huge section of the population that looked rich on paper but didn't have a dime in cash. They had spent every penny on buying their house and paying back their enormous mortgage, and now they had nothing with which to buy a car or start a business. Even though they had no liquid assets, many families had a house that was worth much more than when they bought it. It was probably frustrating to have that much net worth and be unable to buy some of the necessary things to live and have a family. So in comes another horrible genius. Why not turn their non liquid assets (in almost all cases, their homes) into cash and then make a profit off of the transaction? People were now able to trade in their mortgage that they had stretched to pay for earlier for an even bigger one plus some cash upfront. If someone wanted to start a business, but didn't have the cash to do so, this was an excellent opportunity. With a brand new successful business, they could afford a larger mortgage. What they really needed was the cash upfront, and now their house could give it to them. Banks liked the deal because they made a lot of money in the process. People liked the deal because they could go from living like paupers in an expensive home to living like they were used to and having the opportunities they would have had if houses had been available that they could have afforded.

And it wasn't just banks and individuals who benefited from home equity loans. The whole economy surged because now people who had never had access to money not only had a house, but a lot of cash from the house's equity that they could now spend. For a few years, the economy experienced an almost unprecedented surge. More people were able to spend than ever before. Most companies tried expanding to meet the growing demand for products and experienced record profits. For a short time, the American dream was attainable and everyone was able to be middle class, even on minimum wage salaries.

The the first foreclosures started to happen.

At first, a few of the most obviously bad loans foreclosing was not a problem. Only the first tranches were affected, and pretty much everyone knew the first tranche was not a good deal anyway. Then more and more tranches were left with no returns. People who had felt very secure were left with nothing. The price of all of these "secure" stocks plummeted. No one was willing to invest in the lending companies or their tranched loans anymore. With no more influx of other people's money, the lending institutions were forced to slow down their loans and eventually halt them entirely. Countrywide and many other companies specializing in quick turnover of home loans began to cease operations. The insurance companies began to crash along with them. Housing prices suffered a commensurate crash since all of a sudden, the supply of available houses was much higher than it had been before. Investors also began to suffer. Individual investors lost whatever they had put into purchasing those loans, but individuals weren't the only investors in the lending companies. Some banks, such as Bear Sterns, were also investors. Bear Sterns was one of the first actual banks to suffer devastating losses. The government didn't want to see the 4th largest bank in the US to go under because they feared that the people would lose trust in the economy and cause it to tank. They did what they could the bandage the situation, but there were many other problems on the horizon that they couldn't foresee.

With the price of homes dropping drastically, home equity loans began to look like a very bad idea. They increased the projected earnings of the banks tremendously and caused their stocks to go through the roof, much to the glee of stockholders. However, the banks were suddenly realizing that those projected earnings weren't going to happen. Housing prices began dropping back down to sane levels and banks realized that they had given people money for something that was no longer worth what they had paid. For many people, their mortgage was now actually higher than the value of their house. Normally, when someone defaults on their mortgage, the banks take a loss, but it is usually in expected profits. They will also often sell a house for less than it is worth because they would rather have cash. If someone has a $500,000 house and still owe $200,000 on it when they find they are unable to continue paying their mortgage, the bank sells the house (let's say for $450,000), keeps the $200,000 plus interest that they are owed, and then gives the rest to the poor defaulted family who often quickly use it up paying the bills they've accrued that caused them to go bankrupt in the first place. That was the old model before home equity loans. It's not great for the banks, but they survive. But now imagine a house that was worth $500,000. Pretend this family also had a $200,000 mortgage, but they needed some cash, so they got a home equity loan raising their mortgage to $400,000. Now imagine if housing prices dropped drastically. This family's $500,000 home could be worth as low as $300,000, perhaps lower in some areas. Some people in this situation chose to default on purpose because they didn't like the idea of paying a mortgage worth more than the cost of their home. By declaring bankruptcy, they would have a bad credit rating for a while, but they could start over fresh without an overwhelming debt that they got from buying an overpriced house. That situation did happen, but I believe that most people continued to struggle to make ends meet and pay exorbitant rates for their house which was steadily decreasing in value. However, when a family couldn't pay any more (perhaps there was a death in the family or a source of income dried up), the bank was unable to recoup their losses. They might be able to sell the house, or they might not. With more houses than there were buyers, a lot of banks couldn't turn over their foreclosed houses, even at a loss. Even if they did manage to sell the house, say for $250,000, that only pays for $250,000 of the now $400,000 mortgage. The bank doesn't get back what it lent and the family gets nothing. And if the family gets nothing, none of their bill collectors get anything either. Credit cards, which had been freely given out during the boom, were now creating losses for companies everywhere.

While companies did receive a blow from the families defaulting on their debts, the real blow came when the home equity loans stopped. The cash from those home equity loans had been stimulating the marketplace significantly and many companies had expanded in response to that. When that cash flow suddenly dried up, companies were suddenly left with an excess of employees and a lack of profits. Hard times hit on Wall Street and one of the first responses was layoffs. So many families were struggling to make ends meet to pay for their expensive houses and they couldn't afford to have a major breadwinner unemployed for long. Many families were stretched so thin they were living paycheck to paycheck. When they got laid off, they were forced to default, which made the situation even worse. It made housing prices drop just a little more since there was a larger supply and less demand. Banks took even more losses from failure to sell houses. Creditors had to erase the profits they had made on paper when they lent these families money. And most importantly, people who used to be shopping and consuming no longer had any money with which to do so, which reduced company profits even more. This, of course, meant more layoffs and the cycle continued.

Everything I've described above affected a large number of people, but many members of the general populace hadn't realized yet how dire the situation was. The general public started to really notice how bad things had gotten when banks started to go under. At first, everyone thought the Bear Sterns bailout was bizarre and unusual. Then other banks started to go under as well. Banks were some of the first institutions hit and they lost the most. Some people started to panic. A few made runs on the banks withdrawing all their cash above $100,000 (the maximum amount the government had insured at that time), which made the banks' situations even worse. Banks that didn't own any crappy mortgages and that had made fewer home equity loans started buying up all the floundering banks that had. Fortunately for people who had their money in banks, very few banks went under. Most were simply bought at a fraction of their real value. If they hadn't been, the situation would have been much, much worse than it is today.

Not many normal banks declared bankruptcy (the same cannot be said of investment banks), but they had all been dealt a serious blow. Very few banks were willing to give out loans anymore, even to families that would normally be able to pay them back. Even middle class families that should have been safe investments were defaulting because they had paid too much for their houses. As more and more people began to be laid off, even someone with a good salary was no guarantee. As banks became more and more reluctant with their loans, housing prices continued to fall. Now when layoffs happened, banks hurt even more. And layoffs were becoming more and more common. The unemployment level was rising steadily. As more people got laid off, fewer people were left to buy products, which lead more companies to lay off their employees. Even people who weren't laid off began to curtail their spending. Everyone realized that their jobs were not safe and they would need as much savings as they could if they wanted to keep their houses. At this point, even people who were relatively safe or who had never applied for a home equity loan started tightening their belts and reconsidering expected purchases. Now the crisis began really touching people who weren't even in the housing market. People who had never had anything to do with bad mortgages and had lived within their means found that they could no longer get credit. Credit card rates increased across the board. People were losing jobs right and left, and even families with savings couldn't afford the loss of income for long. With fewer and fewer companies hiring and more and more layoffs, the number of people unable and unwilling to spend just kept increasing. Then even large companies started going bankrupt (Circuit City, Mervyn's, etc.) and more jobs were lost. Anyone who took out their home equity loan to start a business was faced with a hostile market. More foreclosures ensued.

At this point, the cycle has gone on long enough that the entire country developed a recession mindset. Most people don't feel comfortable spending money, and rightly so. Secure jobs are in high demand. As more secure jobs start flooding the marketplace (from the stimulus package, for instance), the economy will improve slightly, but it will take a while for people to feel comfortable spending again, and the economy won't change until that happens.

Whew! That was long! I'm glad I wrote it down though. It's hard to keep track of it all without seeing it. It's easy to forget how complicated this all is. I think I may also have some parts wrong, but not many. This is the gist of it and I am satisfied. I hope I didn't miss anything.