The current economic crises around the globe make it a fascinating time to study economics. Given all the current focus given to the economy, I think a "here's what's happening" post is a great way for me to try to fuse together things I read about, things I hear, and what I'm learning in my various classes. Let's be honest though- no one really knows what's going on. It seems that economists are constantly disagreeing with each other. Also I'm a student, so my knowledge is SEVERELY limited. What I present is in extraordinarily simplified terms.
So, here it goes:
(1) Interest Rates:
In the 1990s, the stock market was booming. However, this was short-lived because the dot-com bubble bursted in the early 2000s, causing a stock market "crash." To solve the stock market problem, then Chairman of the FED Alan Green Span lowered INTEREST RATES. I don't really know how stocks relate to interest rates, that link is really above my head). Regardless, interest rates were kept REALLY REALLY low for a long period of time.
So what does that mean? Okay, to understand that we need to understand how a bank works. People deposit money (savings) into banks so that their money collects interest and increases in value. The banks then use that deposited money to make loans to other people. People want to save more when interest rates increase because, obviously, they'd be making more money.
In a similar vein, people want to borrow more when interest rates are low, because the interest they pay on their loans are lower. By keeping interest rates low, Greenspan lessened the incentive for people to save, plus he made it easier for people to borrow. Because they would collect less interest, a lot of rich people took money that would have gone into savings and began to buy equities/securities/assets instead. Moreover, less "normal" people were saving. Consequently, banks weren't able to make as many loans, and they were making less money off interest for the loans they did make; as a whole, banks were losing money.
(2) Sub-prime Mortgages:
In order to compensate for this loss of revenue, banks decided to lend to people they had never lended to before, people that were enormously high-risk (meaning there was a low chance that that they would pay back their loans). Often these people are referred to as 'ninja families,' meaning they have no income, no jobs, and no assets. Why did banks think this was a good idea? Because the banks held people's houses as collateral. At the time, the housing market was booming, meaning the value of a house only went up in value. So, if people defaulted on their loans, the banks didn't care because they would seize the high-value house, which was worth more money that the loan itself.
(3) Mortgage-Backed Securities:
Banks took these mortgages, and re-packaged them into "assets". The value of these assets depended on the average probability that the person would pay back the mortgage (hence the name mortgage-backed). These assets were re-packaged again, and again, and again. For a while, these assets only went up in value because they were backed by the fact that (a) people weren't defaulting because interest rates were low, and (b) even when people defaulted the house [collateral] only went up in value. (I find it helpful to think of these re-packaging of mortgages as a box inside a box inside a box inside a box-- the thing in the original box almost gets forgotten).
(4) Collateralized Debt Obligations
Then, the "financial innovation" occurred. Basically, firms began to rank every asset in a tiered hierarchal system. Those mortgage-backed securities ranked at the top of the hierarchy had the lowest risk (meaning that there was a really low probability of those borrowers defaulting). At bottom of this hierarchy were the "toxic assets," assets that had an extraordinarily high probability that the borrowers would default on their loans. So, you would ask, why would someone buy a toxic asset? The booming housing market virtually guaranteed securities-holders a positive return on their investment because the securities were backed by houses that were rapidly increasing in value.
(3) Mortgage-Backed Securities:
Banks took these mortgages, and re-packaged them into "assets". The value of these assets depended on the average probability that the person would pay back the mortgage (hence the name mortgage-backed). These assets were re-packaged again, and again, and again. For a while, these assets only went up in value because they were backed by the fact that (a) people weren't defaulting because interest rates were low, and (b) even when people defaulted the house [collateral] only went up in value. (I find it helpful to think of these re-packaging of mortgages as a box inside a box inside a box inside a box-- the thing in the original box almost gets forgotten).
(4) Collateralized Debt Obligations
Then, the "financial innovation" occurred. Basically, firms began to rank every asset in a tiered hierarchal system. Those mortgage-backed securities ranked at the top of the hierarchy had the lowest risk (meaning that there was a really low probability of those borrowers defaulting). At bottom of this hierarchy were the "toxic assets," assets that had an extraordinarily high probability that the borrowers would default on their loans. So, you would ask, why would someone buy a toxic asset? The booming housing market virtually guaranteed securities-holders a positive return on their investment because the securities were backed by houses that were rapidly increasing in value.
(5) Valuation and Insurance
There are also other reasons why people bought these assets. There were only two agencies that rated the "risk" of these assets: Moody's, and Standard and Poor's. Because the housing market was booming, these raters gave many toxic assets "low-risk" ratings, even if the probability of the borrowers' defaulting was very high. In addition, companies like Freddie Mac, Fannie Mae, and AIG used these ratings to INSURE these assets.
Here's a Hypothetical Situation to illustrate these concepts:
Side 1: The borrower
Mary has no job, little income, no assets. Someone tells her that she can buy a house and pay very low interest in the loan. WOWEE! She goes to the bank, takes out a loan right away, and gets a lovely house. Of course, nothing about the nature of the loan was explained to her.
Side 2: The Capitalist.
Pretend I'm a capitalist. I want to buy a security. I go to Lehman, and they tell me there's a particularly nice security that I might be interested in. Of course, I don't trust Lehman for shit, so I go to Moody's and see how risky this investment is; they tell me that it is a AAA grade investment, meaning the risk is low. But, because I'm a miser, i'm still pretty unsure, so I go to AIG and get this security insured, so that even if it goes down in value, I can recover some amount of money.
Already we can see a bubble forming...
Now, to get to the government.
Now, to get to the government.
(6) Basel Accords
There was a rule from the second Basel Accords that mandates a specific ratio of loans to capital for banks. If this number was 30%, that means for every $3 in loans that I make, I have to have $10 in the bank. So if a bank wants to give more loans, they need more capital, thereby prohibiting the number of people they can lend to.
(7) CONDUIT
How did banks get around Basel? They created funds called "conduits." Basically, this FUND can go to the bank, and buy the mortgage-backed securities, which increases the banks "capital." With this increase in the bank's "capital," banks can now loan more money.
A problem with Basel: From some stupid reason, Basel II said that you don't have to integrate a fund's balance sheet with the banks'. This means that banks were able to make investments "off the balance sheet," meaning that the government could not see this investments.
(8) Regulation?
The government furthered all these crazy practices by (a) lowering interest rates, (b) not regulating these assets.
MORAL HAZARD:
Furthermore, in 1998 Alan Greenspan bailed out Long Term Capital Management hedge fund. This hedge fund in particular had made "unsound, esoteric bets." Moreover, "when Russia’s inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse. Because Long Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts" (nytimes.com). When this happened, other banks basically thought: "just like that hedge fund, the government will do all it can to make sure we don't fail. Thus, we can take high-risk investments because we know that the government will bail us out." Thus, banks became much more reckless with the risk they undertook because of precedent established by the bailout of Long Term Capital.
(9) BUBBLE:
Housing Market Booming --> Subprime Families taking out loans --> Mortgage Backed Securities --> Increase "capital" in bank --> Banks make more loans.
This is fine as long as HOUSING PRICES ARE INCREASING.
In 2006: Residential Construction Peaks, and interest rates increase.
The increase in interest rates made it more difficult for those sub-prime families to pay back their loans. Consequently, many of these ninja families began defaulting on their loans and declaring bankruptcy, starting the foreclosure crisis.
However, no one cared about people defaulting on their loans because banks would get valuable houses as collateral, remember? Well, all of a sudden, residential construction peaked; the demand for houses began to decrease, meaning the value of houses started going down. And, as we've learned, ALL THESE ASSETS hinged on the fact that the housing market was booming....
(10) Liquidity Crisis/Credit Crunch
Shit. All these securities start rapidly decreasing in value because people start declaring bankruptcy, and the houses (which were held as collateral for the loans) are worth pennies. In addition, a ton of assets were given a "AAA grade" (low-risk) rating, meaning nobody knows which assets are actually toxic. Banks are thus afraid of lending to eachother because nobody knows which banks have these toxic assets.
Consider this example: Bank X wouldn't want to lend Bank Y 10thousand dollars because Bank Y might declare bankruptcy tomorrow and never pay back their loan, meaning I lose all money.
(11) Insurance Companies Fail
Moreover, the insurance companies (like AIG, Fannie Mae, and Freddie Mac), which insured all these toxic assets had to start paying securities holders insurance! But these insurance companies simply do not have the money to pay security-holders insurance because they insured a crazy amount of investments. Thus, Fannie Mae and Freddie Mac failed, and AIG is a disaster zone.
(12) Link to the rest of the economy
When the financial sector collapses and banks stop lending to each other, they also stop lending to normal people and normal companies. Meaning now, it's difficult for people to get loans for cars, houses, businesses; really, basically anything. Because people can't buy stuff, industry, retail, and food all suffer. Because those companies are making less money and even going into debt, they have massive lay-offs, making unemployment an enormous problem.
(13) Globally
To be honest, there is no simple way to explain how the US financial crisis spread to the world. However, I will try.
a. A lot of banks overseas bought these toxic assets.
b. Morever, the US is a really important market for Chinese, Indian, and European goods, and when American demand for goods decreases, those economies suffer.
c. Asia & the United States: For more about this phenomenon, read Paul Krugman's article in the times. He summarizes it remarkably. http://www.nytimes.com/2009/03/02/opinion/02krugman.html
(14) Solution?
I HAVE NO CLUE.
Bailout: The goal of the bailout is to buy up all these toxic assets so that banks will feel more comfortable lending to each other and to normal people. Plus it increases government control of banks for regulatory purposes, scaring the shit out of current bankers, making stocks plummet.
Interest rates: The slashing of interest rates was meant to stop more people from defaulting on their loans.
Fiscal Stimulus Package: Attempts to induce more consumption and less saving by giving people more money through tax cuts. Plus it attempts to create jobs through public works projects.
Yeah, I hope this post wasn't too long and was pretty understandable. My facts came from the New York Times, the Economist, Prof. Xavier Sala-i-Martin, and my aunt (a central banker).
-Pari
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