Sunday, October 12, 2008

Understanding the financial crisis: the basics

The causes of the current financial crisis are obviously complicated, but many of them are rooted in human nature-- the way people tend to think about decisions in general and financial decisions in particular-- and there are lessons from the crisis we can apply to our personal finances.

I've spent a lot of time lately reading about what has happened, and I've also had a fascinating time learning more about behavioral economics. (Traditional economics assumes that people always make rational decisions. Behavioral economics explores whether or not this is true-- and suggests that it often isn't.) In future posts, we'll look at some of the rationality-skewing factors that were at play. But to start, we need a basic understanding of what actually has happened. So here's the chain of events (to the best of my understanding):

  • In the last few years, a significant number of mortgages were issued to people who were at risk of being unable to pay if housing prices did not continue to rise. Most of these were adjustable-rate mortgages, with lower interest rates in the first few years but the risk or certainty of higher payments afterwards (unless the mortgage was refinanced based on a higher home value.) These risky loans were not entirely subprime mortgages (mortgages where the borrower paid a higher interest rate than the prime rate), but there is a strong overlap, both because riskier borrowers are more likely to be charged subprime rates and because subprime terms themselves can make repayment more difficult for borrowers. Subprime borrowers were a wide-ranging group-- about 45% had bad credit, but the rest had credit scores of 620 or above; approximately 10% were investors or speculators, about half were refinancing their home "for cash-out purposes," and the rest were home-buyers; the majority were white and middle or upper-class, but blacks and Hispanics were twice as likely to have higher-cost subprime loans as whites with the same income and loan amount.
  • Most of those loans, and their associated risk, did not stay with the businesses that issued them. In many cases, commission-based mortgage brokers who never owned the debt were making the loans. And regardless of who actually issued the loan to the borrower, by 2006 75% of subprime mortgages were being "securitized"-- which meant the loan and the risk was not held by a single bank, but spread around by being made into securities in the financial markets.
  • Banks used subprime loans to create and sell complicated financial instruments. Financial institutions, especially investment banks, bought a lot of subprime mortgages and pooled them together into what are called mortgage-backed securities (MBSs), and then sold a few different types of bonds based on each pool, earning themselves big commissions and fees. The pools as a whole were considered somewhat risky because everyone expected that some of the homeowners would default on their mortgages-- but the banks segmented the risk by selling some people "super-senior" bonds and promising that they would be paid in full before anyone holding the more junior bonds got paid. This made the most senior level of bonds very safe, as long as mortgage defaults were within the range that people expected. It also made the highest-paying highest-risk junior bonds so risky that they actually call it "toxic waste." Sometimes they rebundled the medium-risk and/or toxic waste from a bunch of different pools into what's called a CDO (collateralized debt obligation) and re-sliced it, making new super-senior bonds out of the riskiest parts of a risky pool.
  • Ratings agencies gave super-senior bonds backed by subprime mortgages the lowest-risk rating. They almost always got AAA ratings, the lowest-risk designation there is, the same as U.S. government bonds. This was based on the belief, backed up by computer modeling, that it was extremely unlikely that enough of the underlying mortgages would default to cause super-senior bond-holders not to be paid in full. The computer models only included the worst-case scenarios that their programmers at the rating agencies thought possible: a relatively low level of mortgage defaults.
  • Some buyers of the bonds hedged their bets by purchasing credit-default swaps (CDSs), essentially insurance in case the bonds they bought didn't pay out. But because they thought the scenario was so unlikely, issuers of these CDSs (who ran the gamut from insurance companies like AIG to investment banks to other institutions) sold many more than they could actually afford to pay back, including selling many CDSs to people who didn't own any bonds and were just placing a bet that the bonds would default. And because many buyers thought default was unlikely, not all of them bought CDSs, especially on the highest-rated bonds.
  • The bonds, which paid higher interest than other options with the same risk ratings, were very popular and there was high demand for as many as could be produced. But to make more MBSs and CDOs, you needed more mortgages. The bond buyers made it very profitable for the investment banks to buy and pool and slice mortgages and they didn't mind (and sometimes preferred) high risk loans-- so the investment banks made it very profitable for the subprime lenders and mortgage brokers to make mortgage loans and theydidn't mind (and sometimes preferred) high risk loans-- so the subprime lenders and mortgage brokers did everything they could to push as many mortgages as possible, marketing their loans aggressively, steering borrowers towards bigger loans, and getting riskier and riskier with mortgages that sometimes didn't require any verification of income or assets. (This chain of supply and demand also sometimes led to deceptive and predatory practices by lenders and brokers.)
  • And then the "unthinkable" happened: home prices fell and many more people defaulted on their mortgages than expected. I won't go into all the details of why and how it happened, but suffice it to say, it was a bubble and the bubble popped-- and as home values began to fall and people began to lose their homes, the problem fed into itself, leading to bigger drops in value and more non-paying borrowers.
  • Because there were so many defaults on mortgages, the value of the bonds fell. This was/is partially because that they're paying out less than expected and are thus actually worth less than initially thought-- but also because they're so complicated (after slicing and double-slicing) that no one knows what they're actually worth, so they fear the worst and won't buy except at rock-bottom prices. Yet another reason for falling prices is a much higher supply to go along with that low demand: along with those trying to sell the bonds because they wanted to get rid of them, were many institutions who had to sell the bonds once they were no longer rated low-risk AAA (since investors like pension funds are required to hold only AAA bonds.)
  • Banks were especially exposed to these risks, and things have been going downhill for them over the last year or two, with a sharp acceleration recently. Banks held a lot of these bonds (ones they bought from other issuers and/or the risky parts of their own that they couldn't sell) and sometimes they had to buy back bonds from their buyers because they'd guaranteed to do so if things got bad. And because they had used the bonds as collateral to take out loans for investing purposes, when the value of the bonds fell they often had to sell (even at rock-bottom prices) in order to somehow come up with enough cash to pay back the loans. They were also hurt by the CDS situation in several ways-- sometimes banks had issued CDSs which they now had to pay out on; the prices of CDSs on their bonds went up now that it was clear how risky they were; and the issuers of the CDSs on their bonds (often banks or insurance companies who'd issued many more CDSs than they could afford to pay back) were often struggling financially, raising fears that they would not be able to pay out to the banks.
  • Banks got pushed towards collapse, which began to snowball. As banks' situation got worse, their share prices fell and investors in their financial products pulled out their money, worsening their financial condition. And as each bank (or insurer) collapsed or came close to collapse, it raised worries about how a collapse would affect the finances of all the other banks, increasing the nervousness still more.
  • Banks are now much less willing to lend out money because they're worried about having enough cash to keep themselves afloat. They can't sell their mortgage-backed securities to raise cash, and they don't know if they'll get payouts from any CDSs they have. And banks now think that lending to eachother is too risky, which is a problem for everyone. Interbank lending is important because the timing of banks' income (payments from loans) and the debt payments they pay out don't always match perfectly; typically this is solved by banks making short-term loans to each other. But that process has frozen up because banks are afraid that if they lend to another bank it might collapse before they get their money back. That makes banks reluctant to lend the cash that they do have to people or businesses, because they don't know if they can get an interbank loan to make up for it if needed. And when businesses can't get loans, that slows down our economy.

Well, I didn't promise it would be an uplifting story! But by taking a closer look at how we got into this mess, we can think about how to avoid dangerous, irrational decisions in our personal finances (and about what policies and regulations in the financial system can prevent against future disasters like this on a larger scale, too.) And that's what the other posts in this series will be all about.


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