Thursday, September 25, 2008

The Idiot's Guide to a Financial Mess

[You can read parts 2 & 3 here and here.]

My friend Husain, also known as Ali Mir in other parts of the world, had posted this on Facebook and one is free to "use this in anyway you wish. No attribution necessary."

Now, I'm one of those people who could use an explanation of this kind, and I'm aware that plenty of you will know more, have more to say that will whizz over my head so I will just promise to point out comments to Husain and,

so without further ado, ladies and gentlemen........

FAQ about the U.S. Financial Crisis

If you don’t understand the financial crisis on Wall Street, don’t fret. No one does, least of all the experts. What we do know is that it is an unholy mess, which is about to get worse. Here’s my quick FAQ for those who don’t wish to wade through dense treatises on collateralized debt obligations, asset backed commercial papers, and blah-blah-blah. It’s hardly comprehensive, but it can serve as a starting point for engaging with the issues surrounding the greatest financial debacle since the Great Depression. Let me know if any of this doesn't make sense.

Do the roots of this crisis lie in the housing bubble?
The roots are all over the place (in the absence of regulation and oversight, for instance), but for the sake of simplicity, let’s say yes. After 2001, the Fed kept its interest rates low in order to increase liquidity and encourage spending. Financial institutions offered easy credit to those who wanted to borrow money to buy a house. Many who did not qualify for loans at regular market rates – the subprime borrowers – were persuaded to take out mortgages despite the fact that their income level, ability to make a down payment, and credit history made them high-risk debtors.

Why did so many borrowers take out mortgages?
As the number of buyers increased, the values of homes started going up. And as the values of homes started going up, the number of buyers increased. Everyone wanted to jump on the gravy train. In 2005 and 2006, 40% of homes sold in the U.S. were purchased as either investment or vacation homes. Financial institutions offered subprime borrowers “teaser rates” which were scheduled to go up after a period of time (these were the so-called ARMs – adjustable rate mortgages). Existing homeowners assumed that the value of their principal asset – their home – had increased (when they noticed, for example, what their neighbors’ home was selling for) and refinanced their mortgages, spending the borrowed money.

Why did the financial institutions lend so much money to these “subprime” borrowers? Weren’t they worried about defaults?
Not really. For one, most mortgage brokers do not lend money of their own; they merely collect commissions. Besides, the system is geared towards increasing revenues and profits in the short run. Bonuses are linked to current performance. But more importantly, many of these institutions were not planning to take much of a risk. Because of a lax regulatory system, these loans were allowed to be “securitized”. In other words, the rights to these mortgage payments along with the accompanying credit risks were sold to third-parties.

So the risk passed on to the third parties then?
In some cases, yes. But for the most part, these third parties cut up these securities, mixed them up, repackaged them, and sold them down the line in the form of Mortgage Backed Securities (MBS) or Collateralized Debt Obligations (CDO). There was little, if any, regulatory oversight. At each step, the parties in this chain collected profits, and believed they were handing off the risk.

What was the role of AIG?
AIG offered insurance to those who bought MBSs and CDOs in exchange for a fee. Credit rating agencies such as Moody’s and Standard and Poor’s gave a high grade to these securities, thus reducing the amount of collateral that AIG was required to post in order to demonstrate that it had the ability to make payments in case there were defaults.

I am not sure I understand.
Assume that you bought $1 million worth of securities. You are worried that the assets behind these securities are not a sure bet. So you hedge by buying $1 million insurance from AIG. If there is a default on the payment, AIG pays you your $1 million. These are the so-called “credit-default swaps”. Pay attention to that term. We will hear a lot about it in the near future. There is currently a $62 trillion (yes, that’s a trillion) market for these swaps which is absolutely unregulated.

How much is a trillion anyway? Apart from being a really large sum of money?
As figures keep getting tossed around, one begins to suffer from number fatigue. How does one make sense of these large values? Here’s one way to imagine a trillion dollars. Let’s say you have a magic machine that spits out a $100 bill every second, all day and all night long. In the first minute, you’d have $6,000. In the first hour, $360,000. In the first 24-hour day, you will possess more than $8.6 million. A year later, you’ll have a little more than $3.15 billion. In other words, it will take you and your machine more than 317 years to produce a trillion dollars.

So, back to our story. Wasn’t everyone making money?
Until a certain point in time. But as usually happens with a bubble, the quid came calling for the quo. Subprime borrowers defaulted on their loans when the higher ARM rates kicked in. Foreclosures increased, putting a pressure on the now heavily inflated home prices. Excess inventory created by builders and speculators during the boom started to mount. As prices began to deflate, owners found it increasingly difficult to refinance their homes. The MBSs were not so attractive any more.

So institutions that owned MBSs were in trouble?
Exactly. Bear Sterns was the first to crash. The Feds had to step in and facilitate its “sale” to JP Morgan at the cost of $29 billion to the taxpayers.

And why did AIG stumble?
Credit rating agencies woke up to the fact that they had assigned AAA ratings to relatively worthless securities, so they downgraded the credit of AIG, requiring it to post additional collateral. Since AIG didn’t have the billions it would have taken to do this, it had to be rescued if it was to be prevented from declaring bankruptcy.

Why would that have been such a terrible thing?
If AIG went under, all those who had hedged their bets would have suddenly found themselves in a heap of trouble. They would have most likely gone belly-up too.

So AIG was too important to allow it to fail?
That is the narrative being bandied about. But the bailout wasn’t about AIG. It was done in order to save its “counterparties”, the ones who had bought insurance.

Who were these counterparties?
We are not sure. But most of them (around three-quarters) were probably European banks.

Why wasn’t Lehman bailed out?
We don’t know. Perhaps it was the luck of the draw. It came second in line (after Bear Sterns) and maybe the government wanted to play it tough. Or perhaps its counterparties were not important enough to rescue.

What was the story with Freddie and Fannie?
Mae ‘n Mac owned or guaranteed many of the MBSs and several mortgages that were subsequently bought by foreign banks (China was a big player), who assumed that these government sponsored enterprises (GSEs) would not be allowed to fail. Since foreign funding (those trade surpluses China has with the U.S.) are essential to making up budget (and trade) deficits, the government had to step in and rescue the GSEs, lest foreign capital wander off elsewhere.

Now what?
The U.S. government is planning to bail out the financial institutions whose reckless greed produced the mess in the first place.

What if it doesn’t?
Financial institutions devastated by this crisis have very little capital to lend. Without the credit that they provide, the economy will suffer. How much is unclear, but the impact is likely to be quite severe.

What does the administration want?
The Treasury secretary is asking for unfettered access to $700 billion in order to buy any asset from any institution at any price he thinks is right. Further, the Secretary says that his decisions will be “non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” The government plans to buy up the MBSs at a price it determines (critics worry that lobbyists of the financial institutions will play a role in this), thus freeing the institutions to infuse credit into the markets.

Who will foot the bill?
Ordinary citizens – the taxpayers – who will see a skyrocketing deficit, and most likely, shrinking investments in public goods, dwindling retirement accounts, and greater inflation.

Is there any alternative?
If it doesn’t want to think outside the box (and it is clear that it doesn’t), the least the government should do, in my opinion, is to demand an ownership stake in the companies it bails out. That way, if they recover, the bailout money can be returned to the treasury. The current plan only rewards those who drove the economy into the ground, and who made a lot of money during the good times.

So one final question. Was the crisis primarily caused by irresponsible borrowers who took on loans that they did not have the ability to repay?
No. It’s true that defaults on mortgage payments, especially in the subprime segment triggered this crisis-in-waiting. It is also true that borrowers, both prime and subprime, failed to read the fine print, took out larger loans than they could afford to repay, and got carried away by the thought of buying property that was supposed to keep increasing in value. But the subprime loans were pushed by an unscrupulous industry, which preyed on a population that did not have the wherewithal to figure out the swindle before it was too late. A lot of educated, middle-class Americans lost out too, but the subprime crisis represents the greatest transfer of wealth from the poor to the rich in recent times, and the greatest loss of wealth for communities of color in the post Civil War period.


Falstaff said...

You know, I would have liked this much better if it didn't come so weighted with value judgments. This pathological need people seem to have to find a villain in the narrative bores me. All this talk about 'greed' for example - as though Wall Street had single-handedly invented capitalism, as though nobody outside of an investment bank really cares about money, as though these 'taxpayers' weren't the same people who voted for a government that believed in minimal oversight.

swar said...

This is an idiot's guide? I had to read it twice to get a minor grasp.

Lekhni said...

I agree with Falsie on the value judgements. Besides, I usually start questioning the knowledge of people who cannot even spell "Bear Stearns" properly.

Or claim that "Because of a lax regulatory system, these loans were allowed to be “securitized”. (In fact, that comment alone should have made me stop reading).

The banks who lend mortgage loans are regulated. That's not the issue. Nor is Securitization - in fact, securitization of mortgage receivables is how the mortgage industry works. What securitization does is spread the risk,and allow banks to lend. Otherwise, since an individual bank in a city (and lots of banks here are local) can only make one type of mortgage (say, loans above $300,000 if it's a prosperous locality), it increases the bank's risk and limits its ability to lend. Securitization removes this risk.

I have to give your friend credit for attempting to explain, but since he doesn't have a good understanding himself, he ends up perpetuating some serious myths :(

Alok said...

Unlike falstaff or lekhni, I feel there is not enough moral outrage which probably is because people don't really understand what is exactly happening. Again something that is very typical of the times we live in. "Experts" telling people that they know what is good for them because they know all the fancy mathematical equations and jargons. If you speak even in low tones they will show you their equations about how mortgage backed securities are valued!

about american politics: most of these problems were started during Clinton's time. So it is not really a problem of democrat or republican. These bureaucrats who are working for the government come from wall street, i don't know if anybody thinks about things like conflict of interest when they are chosen for the job. To me this seems like the same old case of military-industrial complex which bypassed democratic processes only now add the wall street to them too.

everybody cares about money and everybody is also greedy to an extent (though that shouldn't stop us from expressing our condemnation) but it gets worse when it is institutionlized in an organization. all that stuff about diffusion of responsibility, goal displacement, moral alienation that you read in holocaust theory books are more or less applicable in these situations too.

Most of last year I was working for people who handle the so called "commodity desk". A few months back there was lot of outrage about rising prices of essential commodities and starvation and inside the bank you could see clearly that it was a case of betting and hoarding. But it didn't matter everybody was just doing what they were told to do. Nothing illegal about buying and selling things after all... if you ask people they will give you some spiel about demand and supply and price equilibrium.

In short, I believe we need more value judgements. More outrage and we shouldn't let these so called experts do the decision making for us.

Falstaff said...

alok: I don't disagree that we need more outrage, but I see no reason why it should be targeted exclusively, or even primarily, at Wall Street. Wall Street is simply the ultimate embodiment of a market society - if you live in a society where money is the arbiter of status and individualism and consumerism are feted, you inevitably end up with a system that is 'unscrupulous'. It's not as though bankers are greedier / more wealth crazed than the people who want to own homes they can't afford - they're just smarter and more successful. And it's patently ridiculous to make financial service firms responsible for safeguarding the economy - if for not other reason than the fact that that kind of collective action by firms that are essentially competitors would be impossible anyway. As for not letting the experts make our decisions for us - it's a pretty sentiment, but who would you suggest makes our decisions for us then? The same people who don't understand what's going on?

Look, I'm not saying Wall Street isn't culpable, I'm saying they're only culpable to the extent that they're part of a larger social system that we're all part of. It's convenient for society to blame this mess on Wall Street (as though they were some kind of spectral Other, rather than a sub-section of that society that has been consistently envied), but it's time that society started to accept its own responsibility for what's happened. The message we should be taking away from this crisis is not that we need to stop short-selling or that we need more regulation of banks (by, as you point out yourself, potentially inept and self-interested regulators) or that the Investment Banking model has been proven to fail, or that the whole thing is a conspiracy by the elite to snatch the food out of the mouths of African-American children or any one of the dozens of other childish myths doing the circuit. The message we should be taking away is that we need to think carefully about what we, as a society, value, and how our obsession with money and our addiction to debt leads inexorably to meltdown.

In any case, my point in the first comment was more that a piece that claims to be a primer on the financial mess should not be so overwhelmingly partisan. Because it combines factual information with random speculation and subjective value judgments, without making a distinction between the two, this piece is propaganda.

Rahul Siddharthan said...

spacebar - nice summary, thanks.

falsie and others: here's a piece by Robert Samuelson, someone who's hardly a leftie anti-capitalist, squarely blaming the Wall Street culture (and in particular the change in that culture since the 1980s) for the mess. (The short reason: the focus on short-term gains, plus the reliance on "leverage", i.e. borrowed money. As I understand it, if one single regulation would have helped, it would have been limiting leverage ratios. But as long as the money was coming in, who worried?)

Another aspect, apparently, is that the modern "instruments" are so complicated that nobody understands how it works.

Yes, greed is everywhere, but the big guys and the governments should have caught it and controlled it, especially after the Barings Bank collapse in 1995 and the Société Générale incident this year, both of which involved astronomical losses run up by speculating on borrowed money -- exactly what hit Lehman and others.

I think Husain's article was too balanced, if anything -- it could have fingerpointed more aggressively. The entire point of capitalism is that people (and corporations) are selfish and greedy, and you need to leverage that selfishness and greed for the common good -- not let it go out of control. Milton Friedmanism isn't capitalism.

brinda said...

Agree entirely with falstaff that making Wall Street out to be the devil incarnate and borrowers as baa lambs is a bit much.
swar: This might give you a better idea :-)

km said...

For those who are interested, the Freakonomics blog on NYT carried a terrific analysis in the same FAQ format, minus the value judgments, of course :)(No links, google it.)

Avatar said...

Its all about the Federal Reserve System.

Alok said...

falstaff: i broadly agree with what you are saying. there is definitely a problem with our culture where relentless greed is seen as normal and money is thought to be the sole arbiter of value but wall street still deserves special condemnation because it is basically an institutionalization of all these impulses. I do belive that people (even greedy, money minded ones) can act as moral agents, it is only when they become part of an organization and culture like wall st that things get worse. (All those concepts about alienation and responsibility from sociology or organization theory...) That's why I thought it was encouraging to see that people were finally raising their voices expressing outrage.

it's patently ridiculous to make financial service firms responsible for safeguarding the economy

I don't understand this. These financial institutions do have responsibility towards all of us, even the ordinary person on street, who doesn't know or care what options futures and other derivatives are. the final blame will go on the govt or whoever signs on the paper currency but once you have billions of assets it is your responsibility to see to it and protect it wisely.

Falstaff said...

Alok: Even if we assume, for a moment, that financial service firms (and notice that they're organizations, not institutions) have a responsibility to the economy in general rather than only to their investors, a moment's thought will show you why such self-regulation would never work in practice. It would require dozens of competing firms (not to mention all potential competitors who haven't entered the market yet) to collaboratively agree on a norm to avoid making risky investments, in an environment where a) breaking that norm would allow the norm-breaker to realize super-normal profits b) breaking the norm would not seriously jeopardize the economy if the rule-breaker were the only one to do it c) managerial rewards are based on the achievement of profit, not on the unverifiable avoidance of potential economic collapse and d) it's unclear, ex-ante, what is or is not a economically risky investment. It's precisely because there is no way such collaborative action would ever work that we need government oversight.

It only makes sense to feel 'outraged' if someone betrays your trust / acts in ways that are inconsistent with prior expectations. But from my perspective, at least, Wall Street has in no way done that. Are there seriously people who have believed all along that I-bankers were motivated by the good of the economy and were working together towards (to use rahul's phrase) the common good? Seriously? How totally naive do you have to be to believe that? It's silly to feel outrage over the fact that financial service firms didn't act in ways that they were not designed to and could not be reasonably expected to.

gaddeswarup said...

I found President Bush’s Speech to the Nation on the Economic Crisis quite useful; about a third of it as good summary as any I have seen. Part of it is quoted in Felix Salmon's post Didn't Panic

gaddeswarup said...

The link to Felix Salmon's post does not seem to be working. The bit from the speech which Salmon quoted and which I think is the best (approximate) exposition of the financial crisis for laymen like me is:
"For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions -- along with low interest rates -- made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition -- some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.
Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit -- combined with the faulty assumption that home values would continue to rise -- led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.
Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected -- along with mortgage payments they could not afford. As a result, many mortgage holders began to default.
These widespread defaults had effects far beyond the housing market. See, in today's mortgage industry, home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk."

Lekhni said...

Yes, Bush actually did a great job of putting it in simple terms. I was actually very impressed with his speech (or his speechwriter)..

nowhere man said...

People have seen this yes ?

swar said...

Ha, it took a Bush to do the simple explanation. Against this speech, the rest of the 'experts' sound like they are just talking between themselves.

gaddeswarup said...

The other side:
Rep. Marcy Kaptur

Nick said...

Contrary to what the main stream media says, wall street as a whole (capitalism) should not be blamed for the actions and policies set forth by OUR congress. There are, in fact, corrupt men in wall street who partnered with corrupt men in government to engineer a win-win situation at the expense of the taxpayer. Capitalism (and our nation or any nation) will only survive when the good and virtuous people are running it. Which means, come this November, you must vote for good men and women who stand by principle and uphold our constitution and not just give lip service to causes that seem noble and just.