Monday, January 2, 2012

Financial Crisis In A Nutshell

Financial Crisis In A Nutshell

Before we get into 2012 all that much, perhaps we should take a look back at what caused the last few years worth of financial hardship. Namely from the 2008 financial crisis and what really caused it.

As it stands now, it has become apparent to me that lots of people, even those on the ground protesting, still don't really understand the 2008 Financial Crisis. Not everything to it and certainly not the cause of all of it. And much like the saying goes, those who do not learn from their mistakes are doomed to repeat them, here's my best attempt of a straightforward explanation that will be easy to bear with and understand.

The 2008 Financial Crisis

You are an American looking to buy a home. 40 years ago…
…when you needed a home loan, you gave a local bank a mortgage. A mortgage is an agreement where the bank lends you money to buy a home, and you agree to pay back the money with interest; if you give up paying it off, they will foreclose and take the property as collateral, which they can then sell to recoup the loss. Over the life of the loan (generally 30 years), you made your mortgage payments to the bank, and the bank made money off the interest it charged you. The rate of interest depended on how risky the loan was, i.e. how likely you were to continue making your mortgage payments. Less risky borrowers got lower interest rates. This basic lending structure has been around for centuries. However, circumstances changed drastically in the 2000s.

You are an American looking to buy a home. Five years ago…
… when you needed a home loan, you gave a local bank a mortgage. The local bank then turned around and sold that mortgage (the mortgage, remember, is an intangible agreement, and freely transferable) to an investment agency (e.g. Goldman Sachs). The same investment agency also bought other debts, for example: student loans, credit card debt, and business buyout debt from other lenders. They combined these debts, along with your mortgage and thousands of others like it, into bundles called Collateralized Debt Obligations (CDOs). CDOs were then sold to investors. Investors were often retirement funds, pension funds, as well as regular foreign and domestic investors.

Because investors were buying debt that had come through three steps of restructuring (you to local bank, local bank to investment bank (who combined it with other forms of debt), and investment bank to them), it was impossible for the investors to tell how risky a CDO was just by looking at it. This is where credit rating agencies came in.

Credit rating agencies (e.g. Standard & Poor) rated CDOs based on their risk of default—the risk that you and all the people whose debt was in the CDO would stop paying your debt. AAA was the highest rating a credit rating agency could give, and were usually reserved for government bonds, which were the most secure investment available. Governments don’t usually default on their debt, and if they do it’s a big flippin’ deal (see: Greece). Rating went down through BBB to BB to C to D; anything BB or below was considered “junk.” This is the technical financial term. A CDO with a BB rating would have been a CDO comprised largely of risky subprime loans. Investment banks paid credit rating agencies to rate their CDOs so investors would feel confident buying them. We’ll come back to this.

Now the investors, the “retirement funds, pension funds, as well as regular foreign and domestic investors” from before, after they bought a CDO, took out insurance on their CDO from insurers like AIG. This worked like regular insurance: the investors paid AIG a comparatively small amount of money every month, and if the CDO defaulted, AIG would pay them the amount they lost on their investment. These insurance policies were called Credit Default Swaps.

However! Because there was no regulation in this sector, AIG could give out credit default swaps to multiple people for the same CDO. In simile form: say you bought a car, and took out auto insurance on it. I could also take out an insurance policy on your car. You and I would both pay the monthly insurance premium, and if your car got totaled, we’d both get paid the full price of the car. You’re making your car purchase safer; I’m gambling that your car will get totaled. Back in the non-simile world, speculators would take credit default swaps out on CDOs with companies like AIG and get paid if the CDOs defaulted. This didn’t affect the original CDO investor’s credit default swap, but it did mean AIG was on the hook several times over for every CDO out there, because every CDO had several credit default swaps attached to it.

If you haven’t already figured it out, get ready to say “Mother Fucker” out loud to yourself. The investment banks, seeing a way to make more money, paid credit rating agencies to rate what were actually crappy CDOs as AAA; they then sold these trumped up CDOs to investors, and got credit default swaps through AIG against the exact CDOs they sold their investors in hopes that they would fail. Goldman Sachs and other investment agencies mislabeled bad CDOs as good, then sold to them to someone else, then took out essentially an insurance policy against them. Back in simile world, it’s like this: your car company sells you a car which they have designed to blow up if you get a fender bender. Then they take out an insurance policy on your car and wait for you to screw up trying to parallel park, and when the car blows up, which, again, they have designed to blow up, they get paid its value. Probably not a super good way to structure lending.

At the local level…
…local banks were no longer collecting money on the mortgages they gave; remember, they were flipping them to investment banks right away. Their incentive is now to get as many mortgages as possible, even from people who don’t have much money and will probably default. After all, it’s no risk to them, and they actually make more money on bigger loans.

Meanwhile, real estate agents and brokers get paid based a percent of every house they sell. Their incentive is to get prospective homeowners into as big a house as humanly possible. After all, it’s no risk to them, and they actually make more money on bigger sales.

This resulted in local banks and real estate agencies openly colluding to get people into huge homes that they couldn’t afford for basically no money down and at insane interest rates. They gave what are called Stated Income Loans, where the bank wouldn’t even run a credit or employment check on the buyer; for the “annual income” box on a loan application, there was literally just a blank for the person to fill in. Real estate agents called these “Liar Loans.” They were also able to spring higher loan rates on people by using what’s called an Adjustable Rate Mortgage (ARM), a mortgage that starts off with a low rate, but can be raised at any time. An ARM that starts off with a 3% interest rate can jump to 15% literally overnight. People could take out bigger and bigger loans to pay for bigger and bigger houses, which spurred on a huge McMansion construction boom.

I think you see where this is going…
…right? Millions of people bought millions of houses that they couldn’t afford, and then collectively defaulted on their mortgages. All the CDOs that held their mortgages defaulted, and all of a sudden AIG, which had insured the CDOs several times over with credit default swaps, was on the hook for like, a trillion dollars in defaulted loans. These credit default swaps were held by investment banks like Goldman Sachs, who had created the bad CDOs and then got TARP bailout money to keep them from going under, and retirement plans and pensions and regular foreign and domestic investors, who sat on a dick and died. Millions of people lost their homes, millions more lost their entire savings, people lucky enough to still be in their homes saw the value of their home collapse, so now they had a $400,000 loan outstanding on a house worth half as much, AIG, Lehman Brothers, Meryl Lynch, and a couple others went bankrupt or sold themselves, and the entire global financial system collapsed. And that brings us to today, where people upset about this are getting gassed and beaten by police for peacefully protesting a system that is self-destructive by design.

Who is responsible for the collapse?
The Investment banking industry: Does this even need to be explained? These guys pumped huge amounts of money into the political system in support of deregulation, controlled the Federal Reserve and the SEC, set up the system as it existed in the 2000s basically top to bottom, deceived their own investors, then ran the whole thing to its logical end – complete collapse – and got paid for their time by the taxpayer to the tune of close to a trillion dollars with no repercussions besides a couple embarrassing visits to the House of Representatives.

The rating agencies: These guys took money to cook books, plain and simple. Their dishonesty ran so deep that they actually created a market among themselves where, if they wouldn’t take the investment banking industry’s money to rate bad loans AAA, one of the other agencies would with 100% certainty.

The insurance agencies: These guys gave multiple credit default swaps out on the same CDOs. This multiplied their revenue when CDOs were doing well, but basically set them up for the tidal wave that resulted in their own bankruptcies.

The Fed: Nothing that happened was illegal – none of it – and it’s entirely their fault.

Congress: Congress was actually pushing homeownership at this time, and didn’t see this situation as a bubble but as an expansion of homeownership. Usually homeownership creates stability—people stay employed when they have land, markets are built on a tangible asset, crime goes down, etc. Even the “good ones” advocated this system, not because they were financial industry cronies, but because they thought it would help get Regular ‘Mericans into houses. As usual, Congress wasn’t evil, just totally, totally oblivious. Also they repealed the Glass-Steagall Act, which had created a firm division between commercial and investment banks. None of the CDOs and transfers would have been possible without that repeal.

The Local Bank and Real Estate Agencies: These guys were completely complicit in the investment banking industry’s bad loan extravaganza. They cultivated relationships with the homeowning public that suggested they were their representatives (they weren't) and would do them no wrong, put millions of people into much, much, much bigger houses than they could afford, made a quick buck off the loan, then flipped it to someone else.

The Foolish Average Joe Who Has Had Home Ownership Imprinted Into His Brain Let's face it, the American dream of having a home, a white picket fence and all that other bullshit you have been told to want growing up is all just that. Bullshit. You probably shouldn't have been looking to take a loan you clearly couldn't pay back to begin with.

But I can't blame them specifically. No-one, not even dumb ass Americans buy homes that they don't think they can afford. They were specifically told they could afford it by the bank, and moreover, they were constantly bombarded by propaganda saying they were an idiot for not getting on the property ladder as prices would only go up u and up. The notion that renting is like burning your money or throwing it away always persist as well.

In fact, we are still told this and the common idea that you're better off owning than renting keeps growing. Though I guess it can be said that they had the option to take the loan to a lawyer and say "what's the deal with this crazy loan I'm getting?"

Which would be nothing more than the worse kind of weaselly libertarian argument to that. Let's face it, the average person doesn't have that option. In fact the average people don't even know you can go to a lawyer for stuff that isn't criminal or family law. Even if they did, finding a lawyer in their area that practiced the right type of law, was taking new clients, and had affordable rates is all a pretty tall order. Not to mention the total lack of freedom during business hours that most families suffer through means even scheduling that meeting is next to impossible. It's really easy to say "they could have just....!" about something a victim did, but it is almost always a sign that something ignorant is about to follow.

Most people come to trust bankers. I wouldn't, but most people do under the assumption that they know the law and the procedure and they sure as hell wouldn't want to do something stupid with their money like lend it to someone who isn't approved to be able to pay it back. And even then, a $200 lawyer wouldn't have spotted the problems in the deals made because the problems were entrenched and structural like so.

There you have it. If that wasn't some sort of awesome explanation that deserves a AAA rating, I don't know what is.


Viral Gala said...

Awesome n simple ...

Anh Quynh Le said...

A very easy to understanding explanation. Thank you so much!