Hope you guys all had a great thanksgiving. As promised, I will try to provide an overview of the financial meltdown that has led the government to pursue unprecedented measures to prevent the second Great Depression.
First and foremost, you do not need to have a background in finance or economics to understand the underlying problems that created this whole mess. In fact, despite all the technical jargon that investment managers and other financial experts use, there are simple concepts that help explain the heart of the issue.
The First Stage: The Subprime Mortgage Crisis
First, we all know that in the past decade, America's housing market was booming. House prices were skyrocketing and everybody was trying to buy a home quickly because they believed prices would continue on that trend. Furthermore, the government has always encouraged home ownership and has instituted the policy of increasing home ownership.
(This is not a bad thing, quite the contrary, it is actually good to have people in homes because they are "investing," and because it is the ideal of society. A problem is created when we take it to the extreme and this is what happened.)
To increase home ownership, mortgage institutions have made it easier for people to get funds. On a simplistic level, they have done so by either decreasing down payments or decreasing credit rating requirements. However, a problem arose when the requirements became too lax and mortgage institutions started lending money to individuals that could not afford homes. In particular, the Clinton Administration pressured Fannie Mae, a government sponsored enterprise (GSE) to provide funds for sub-prime borrowers - borrowers that have a higher risk of default because they have a history of either: a) history of loan delinquency or default, b) history of recorded bankruptcy or c) those with limited debt experience. Fannie Mae's problem was compounded by its shareholders that wanted the entity to maintain its profits.
Many of these sub-prime borrowers entered into contracts with initial low payments -payments they could afford -but the contracts would later inflate to larger payments - which they could not. Yet, most, if not all borrowers, were also informed that house prices will go up, so borrowers could refinance at more favorable terms, or worse yet, just sell the house for a higher price. This was a significant misconception that most people had. From 2000-2005, house prices were rising and no real apparent problem surfaced in the sub-prime market. However, in 2007, the sub-prime crisis manifested itself when house prices started declining precipitously. While historically, it is true that house prices do increase over time, in the short run, prices can decline significantly as evidenced by the recent occurings. Thus, many home owners were left with payments they could not meet and the foreclosing avalanche ensued.
What has made the sub-prime crisis worse is the fact that many borrowers that already owned homes were baited into sub-prime loans through the refinancing process. Predatory lenders persuaded them into subprime contract terms that many did not understand. As a result, many home owners that would have been okay, are now in trouble as well. Additionally, the situation has gotten so bad that prime rate borrowers are starting to have problems meeting their payments as well.
The Second Stage: Securitization and Leveraging Activities Within the Shadow Banking System
While the sub-prime crisis itself has created a myriad of economic problems for the nation to deal with, it is the packaging and creation of complex derivatives or investments that have magnified the issue to a near catastrophic state.
The main culprits to this financial fallout have become part of a lexicon of financial terms that you may have heard of in the news this past few months:
- Asset Backed Securities ("ABS")
- Mortgage Backed Securities ("MBS")
- Collaterialized Loan Obligations ("CLO")
- Collaterialized Mortgage Obligation ("CMO")
- Collaterialized Debt Obligations ("CDO")
- Credit Default Swaps ("CDS")
Why 'Fallout' for the financial crisis? from Marketplace on Vimeo.
So hopefully you watched the video and now understand the investments conceptually. Essentially, the ABS, MBS, CDO, CLO, and CMO are all just invesments in fixed income securities backed by some type of asset, whether it be a mortgage loan, a car loan etc. These investments have been rated by rating agencies and priced using complex models. CDOs are the most risky because they evolved into CDO^2, CDO^3, whereby investors in the riskiest tranche (slice) are most likely not paid at all given current market conditions.
Despite the riskiness of all these investments, rating agencies made the mistake of relying upon "experts" and rating the securities based on limited knowledge.
The firms themselves also made a mistake by mis-pricing all these investments using PhD economists to build complex models. In essence, they tried to put numbers on their investments that account for human behavior and obviously their models did not work. Most of the documents trying to describe the mathematical derivation of these securities were 200 pages long that many doctorates working at these companies could not even fully understand. For instance, Blinder, the former Fed vice chairman, holds a doctorate in economics from the Massachusetts Institute of Technology but said that he had only a "modest understanding" of complex derivatives. "I know the basic understanding of how they work," he said, "but if you presented me with one and asked me to put a market value on it, I'd be guessing."
The main players engaged in the trading of these credit derivatives are part of the shadow banking system - A community that includes Wall Street firms such as hedge funds, investment banks, money market funds, and other financial institutions that perform functions beyond that of a regular commercial bank. Basically, all these firms just followed the crowd and didn't want to miss out on the exorbitant amount of profits these investments provided. Moreover, they leveraged, or borrowed so much money to make these investments that once the economy turned bad, they could not cover the claims or losses these investments incurred.
What makes these investments dangerous is that they are traded in the over-the-counter market ("OTC") - A market that is not regulated like the stock market, the bond market or the futures market. Therefore, we do not know who is trading with whom, or even the amount of money that is involved. A recent voluntary survey valued the total credit default swap ("CDS") market at approximately $60 trillion dollars. Yep, that's right, $60 trillion, about 6 times the US budget deficit. This does not include the asset backed securities market that in and of itself is tens of trillions of dollars.
Note: Companies are not disclosing the values of their asset/mortgage backed securities on their balance sheets. They are not required to since they bought it in the OTC market. That was why there was huge sell-off on banks in the past couple weeks. In particular, there were huge concerns over Citigroup because investors were worried about their access to short-term cash since they have less depository institutions than its competitors.
Furthermore, although CDS' are essentially "insurance," the financial institutions issuing them have not been calling it "insurance," because, calling it such, would result in meeting certain requirements. One important requirement that has to be met by an insurance issuer is that the entity has to have sufficient capital reserves to be able to pay off insurance claims. The issuers of the swaps, or CDS', did not have adaquete reserves to cover these claims and thats why they're in trouble. American Insurance Group or AIG is a prominent culprit of this phenomenon.
There are so many questions that remain as we are still in a precarious economic environment. Are the governments actions enough to thwart a global economic collapse? Probably, but we may still suffer a severe recession. One thing's for sure, the Obama administration will enact new regulatory measures to improve transparency and oversight of the credit derivatives market.
I firmly believe that it is important for every one of us to be competent in investing and in managing one's own money. In the past few decades, people have relied upon investing experts to perform this task for them. This has mostly come about because individuals are intimidated by the investments available to them; whether it is the stock market, the bond market, the futures market, or even a retirement fund such as the 401k, most people mismanaged their investments because they did not understand the inherent risk involved.
There are plenty of resources out there for you to learn and equip yourself with the right tools to handle these investments wisely. So many people have been burned this past year because they did not know how to mitigate their risk exposure. We are lucky because we did not have to suffer these massive losses that have compromised our future. However, we must learn from others' mistakes in order to avoid a similar fate. To do this, we must empower ourselves with the knowledge of prudent investment strategies and I hope this can be a forum that will help us to do that.
In Him,
Sean
sources:
- http://articles.latimes.com/2008/jul/05/business/fi-refi5
- http://www.nytimes.com/2008/02/12/business/12credit.html
- http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
- http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html
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