This is the first of a three-parter dealing with the current financial crisis. Part I deals with the causes and origins of the crisis. Part II addresses the issue of what, if anything, us lowly consumers should be doing with our money. Part III will focus on longer-term issues of investing and reforms.
Lehman Brothers is gone. Morgan Stanley may be bought by a Chinese concern. Merrill Lynch has been taken over. Bear Stearns — bought. AIG is the subject of a massive bailout. Freddie Mac and Fannie Mae are in conservatorship. IndyMac was shut down. Overseas, the crisis has taken its toll on Northern Rock and other banks (most recently the Halifax Bank of Scotland). Now it is clear that we are in the midst of a truly global economic crisis.
Over the last few weeks, I have been receiving increasing numbers of emails from people wondering about the financial problems in the U.S. markets. Questions I have heard range from “should I move my savings account away from X Bank?” to “which political party should I blame for this?”
First, some disclosure: I’m not an expert in financial matters, I am not a money manager and nothing in this series should ever be taken as definitive advice — find a good financial advisor and vet anything I say against their advice. These are just my random thoughts; my background is that of a corporate lawyer with some experience in the global markets, including collateralized debt obligations.
So, some Q&As. The Qs: (1) what the heck is going on? (2) Where did it start? (3) Where will it end?
(1) Here is what is going on: a global economic crisis that includes inflation (linked at least in part to high oil prices); a credit and lending crisis leading to the collapse of several large investment banks; sizeable unemployment; and to top it off, a stock market crash worldwide, largely the result of investor fear. Put them all together and you have a remarkable confluence of horrible financial results and the possibility of a global great depression. The NYTimes, the Financial Times and The Economist are great resources to get the layman’s view of what is going on. The NYT recurring Freakonomics series has a good article. Here is a fun powerpoint, which is a bit bitter but gets some of it right (language warning). Here’s a quote from a NYT blog, responding to a request to tell us in English what’s happening:
Banks used to make mortgages and hold them; so they only wanted to make good mortgages. With securitization, those who made the mortgages were different from those who held them, usually in the form of mortgage-backed securities that represented bundles of mortgages. Then, with house prices only going up, they started adding weak mortgages to the mix to increase return.
It worked well for a while so it grew and grew. Then the unthinkable happened: house prices started falling and people all over the world had a piece of the bad stuff.
From Dwight M. Jaffee, of the Haas School of Business at the University of California, Berkeley:
1) Mortgage lenders (and borrowers) did not anticipate that if the lending slowed down, then house prices would crash, creating an enormous wave of bankruptcies. You might think this was really stupid on their part, but remember that we had no such wave of national house price declines since 1935, which is to say for almost 75 years.
2) Liquidity. Investment banks, Fannie, and Freddie alike all borrowed short-term while investing long-term, assuming they could always roll over their maturing debt. They assumed the market would always be there to make a new loan, even if the interest rate might be higher. Turned out not to be true. In the week leading to its demise, Bear Stearns could not find anyone willing to lend it money. — Dwight M. Jaffee
(2) It started here, in the United States. Well, kind of.
On the inflationary side, oil and food prices rose dramatically in the last year, with oil going well above $100/barrel. Oil and food prices today tend to go hand-in-hand, as so much of the production and distribution of food globally is utterly reliant upon petroleum, whether to power farm machines, create artificial fertilizers or to ship your Costco strawberries in from Chile. The reasons for the rise in food prices are not settled, but massive drought in 2006-2007, increasing use of crops for biofuel, and changes in diet towards meat consumption are factors. Oil prices, meanwhile, have been steadily rising for decades due to inflation, ever-increasing demand, changes in state fuel subsidies and other reasons.
Regarding the subprime mortgage crisis, a couple of terms are useful if you want to sound intelligent in your cocktail hour discussions: “securitization” and “CDO” (or CMBS). Securitization refers to the process of taking something that is not a financial security (i.e., some asset that provides cash flow that is not inherently tradable like a share of stock is tradable) and turning it into a security by bunching it with a group of other similar assets and selling it to a special purpose company, which in turn then sells shares in itself (the wiki is pretty good on this). A CDO is a collateralized debt obligation, which is an unregulated sort of asset-backed security (CDOs are a frequently-blamed villain in this story). A CMBS is a commercial mortgage-backed security, or a bond related to one of these securitized products where the underlying asset is a group of mortgages of various qualities.
Mortgages by their nature are not very portable products. They are contracts between two parties, irrevocably tied to the collateral (such as your house). The gist is that someone figured out how to get around that importability, and how to trade on that mortgage. The only problem is that to do this, you need a lot of mortgages — and the more you want to do this (and make loads of money doing it), the more willing you need to be to include in your securitization bundle some mortgages of dubious quality. You effectively separate the loan from what gave the loan value and moral hazard, i.e., the quality of the collateral and the reliability of the debtor. As bloggernacle denizen Mathew has noted, “this is the functional equivalent of the separation of ownership and control in business.”
So at the top of the chain (at say, Lehman) you have investment banks who see easy money in CDOs, which are untested securities — but they’re backed by mortgages on real property, which means they’re not ultimately not worthless, and everyone knows that real property is the top of the food chain when it comes to collateral. These securitized products and CDOs are unlike their traditional assets or securities, but they shoehorn them into their existing financial models because the prospect of not selling them is intolerable. Nobody is able to vouch for the veracity of the models–but everyone can see that the models don’t exactly fit the asset classes they were now dealing with. The ratings agencies are either silent as to the value of these packages, or their ratings are spurious at best. Risk factors are included in each prospectus, making it clear that each investor could theoretically lose his or her shirt — but nobody seems to care.
At the bottom of the chain, you have local property mortgage lenders (like say, Countrywide), who get paid for each mortgage they make. Property values are skyrocketing in previous deserted wasteland areas, and any fool can see that you can make a fortune in real estate — after all, markets go up and down, but real estate has been a great overall bet for decades. So people with no down payments, no prospects for payment, no history of lending or clue of what they are doing are nonetheless handed low-interest loans (or ARMS or other balloon-payment products), which bear obligations that they cannot fully understand.
It is in nobody’s interest to verify the quality of the loan.
With the benefit of hindsight, a crash seems inevitable. Couple that with a declining dollar, extremely low GDP, the highest unemployment in five years and global inflation, and we are faced with an unprecedented challenge.
(3) Where will it end? None seem to know. A Harvard economist I heard last night predicted several years of depression before fundamental economic indicators began to turn around. Others are predicting fallout from the current crisis that will last seven to nine years. Best-case scenarios are still showing serious economic troubles in the U.S. until at least 2010. This much is clear — the golden days are over, and Joe Investor needs to be ready for a long tough haul for years to come. It is as Joseph saw:
And, behold, seven other kine came up after them, poor and very ill favoured and leanfleshed, such as I never saw in all the land of Egypt for badness: and the lean and the ill favoured kine did eat up the first seven fat kine.