A detailed look at the current financial crisis

It’s the economy, stupid.  Something we often hear, especially after the midterm elections made clear Americans displeasure with the current state of affairs. The financial crisis of the late 2000’s will continue to dominate the economic and political worlds for years to come, but its rare that anyone ever takes the time to examine why this happened in anything outside a sound bite.

If one remembers back to before the collapse of Lehman Brothers, one will remember that back then, pundits spoke of a Housing Crisis. After the minor recession of 2001-2002, the economy grew hesitantly. The job market was slow to recover, and GDP growth was slow to recover, considering it had just emerged from a recession, which usually spurs growth. However, the percentage of Americans who owned their home, as opposed to renting, grew dramatically. Home prices, and by extension real estate as a whole, increased dramatically. Shows proclaiming the good sense of house flipping, buying a house, doing a few cosmetic improvements, then selling it for a huge profit, became popular. People bought second homes just because they assumed that they could sell them at any time for a guaranteed profit. People would always need homes, the population would always be growing, and people were always moving, so it made sense that prices would only rise, correct?

Houses are almost always bought on credit. A bank gives a loan, the house is bought with the loan money, and paid off over time. If the house is sold, the selling money repays the loan, but the house is likely bought with another loan. In normal times, a bank loaning money out this way creates liquidity, that is, the means to move goods around to the people that want them. This process is controlled by interest rates. If one has to pay more over time to get a certain amount of money now, they will be less likely to take loans of such a large amount, and vice versa. In this way, if interest rates are high, there is less liquidity; if interests rates are low, there is more liquidity.

Banks can increase liquidity by becoming more efficient, figuring out how to loan more money, and therefore receive more interest payments on that loan. Loans have premiums added to account for uncertainty, the chance that the person who took the loan will be unable to pay. However, if the bank comes up with a clever way to reduce that risk, the premium to the loaned can be reduced. This is the origin of the mortgage-backed security.

Banks, and the associated financial institutions, make a number of individual loans into a package of loans, then sell it as a financial asset. The owner would receive the payments of all of these loans added together, and if any one loan defaulted, the others would still pay in. The value of this asset would be calculated by taking the total stated value of the loans, then multiplying by the chance that any one loan would default. If there were 10 loans, each for $100,000, adding to $1 million, but there was a 5 percent chance that any one loan would default, the value of the asset was $950,000, without risk of default altogether. In reality, the calculations would be more sophisticated, but this was the essential logic behind it. This asset would then be broken up into smaller assets by simply dividing the payments, and traded like any other financial good, like a stock or bond.

Financial institutions began to make derivatives out of these assets by this exact same process, combining mortgage backed securities into packages, then splitting these packages up into smaller pieces, and repeating the process. In this way, the risk of anyone of these individual loans was spread around the entire financial market. Each derived asset is made up of so many parts that it would be considered as safe as an asset could be, earning AAA ratings from agencies like Standards and Poor, or Moody’s. This same process was used for sub-prime mortgages, that is, loans to homeowners that had unusually high levels of risk in their loans. As long as the loan was discounted by the predicted rate of default for high risk loans, the combining and recombining process would make them safe. As long as the borrowers kept making payments, the money would flow through the system to the eventual owners of the derivative securities. This process seemed to eliminate risk from the mortgage market, and thus made credit incredibly cheap to obtain for people who never had access to it before.

This cheap means of buying houses on credit lead house prices to rise rapidly, especially in areas where housing was already in demand. Bankers were told to make loans wherever possible in order to make loans that could be sold into the financial markets as securities. People would be shown that they could make loan payments far below what they were renting for, and be pushed to buy. People would be encouraged to build houses on empty land on the assumption that someone would be soon along to buy it, and for some time, that was the case. High risk borrowers that a bank would normally never touch were given cheap loans, a foreclosed house could be easily sold at the same profit everyone else was seeing. Loan papers would be rushed through the system, often overlooking important standards to ensure that these people could pay. It was assumed that the derivative system made lenders immune to the risk however, and the process continued.