Snarky Behavior

Dropping Knowledge: Financial Crisis

September 23, 2008 · 2 Comments

I’ve had a few requests for a “Dropping Knowledge” post so I’d like to share my understanding of “Black September” vis a vis my class on International Capital Markets.

A lot of the conversations you read about the crisis pick up at a point where you really need some fundamental background knowledge to understand what’s going on, so I’ll start from the beginning:

Have you ever heard someone say that financial markets “exist to efficiently allocate capital?”  Well that’s true… some people and entities have immediate needs for money (we’ll call them borrowers), and other people and entities have excess savings which they’d like to invest to earn a return (we’ll call them investors).

Borrowers look to borrow a lump sum of money up front in return for the promise to pay installments over the long-haul (basically an IOU, or “receivable”).  The IOU carries with it a small fee – an interest rate – for which the borrower agrees to pay over-time in exchange for the lump-sum up front.  The interest rate is determined by many things, the most important of which is determined by the borrower’s perceived ability to pay back the installments (or credit risk).  The higher the borrower’s credit risk, the higher the interest rate offered to them will be.  Obviously, the borrower would prefer to pay the lowest interest rate available to her.

On the flip side, Investors are looking to lend their money and capture the highest “return” on each dollar they lend.  Investors have a lot of opportunities available to them in terms of how they lend their money (to companies in the forms of equity/stocks, to individuals or groups of individuals, to government), but they typically have a preference for the highest available return at the lowest available risk of losing their investment.

Investment banks exist to find and research investment opportunities (i.e. finding borrowers in need of money, such as start-up companies, municipal governments installing a light-rail system, firms expanding their productive enterprise– “The Buy Side”), packing them up in some form (stock, bonds and securities), and selling them to investors (”The Sell Side”).  They make a hefty commission on this, because it involves a lot of work, and long hours.  In a global economy, money never sleeps! (i.e. there’s always an overnight demand for money or liquidity, and investors typically give their money over to managers to put it to use at all times).

Investment banks compete with each other in terms of the price and quality of the investment opportunities they make available to their customers.  Some investment banks (like JPMorgan, Bank of America) are also commerical deposit banks, meaning they have a broad deposit base from people like you and me who have checking and savings accounts with small amounts of money in them.  Other investment banks (like Lehman Brothers and Goldman Sachs) are “stand-alone,” meaning their only deposit base (i.e. “cash on hand”) comes from private investors (personal equity) and fund-managers (mutual, pension, hedge, or otherwise).

One of the many “packages” investment banks sell to investors are called securities.  Securities basically take a bunch (say 100 or so) of the individual IOUs from borrowers and package them together into a single “vehicle.”  The intuition behind a security is that it pools the risk of default of each individual IOU, so that collectively, the “vehicle”  has an overall expected return and performs with low rates of volatility.  That is, if a few people can’t pay back the IOU, that’s still OK, as long as everyone else still pays on time.

In terms of the current crisis, you had a situation where the IOUs “backing” these securities were American home mortgages.  People were borrowing money from small banks or places like CountryWide in exchange for IOUs to pay back both principal and interest over a period of 30 years or so.  Historically, preferred individual borrowers (i.e. people with good to great credit ratings) could borrow from banks at an interest rate called “Prime.”  The prime-rate is typically set variably 3% above the rate at which the banks themselves lend to each other over-night (the federal funds rate).  People with poor to fair credit ratings were required to pay “prime plus” some percentage amount, and also to place a large down-payment as collateral against their mortgage loan to off-set their risk of default.

Now, in the late 1990s and early 2000s, the American housing-market was booming; especially in places like Florida, Michigan, California and Arizona.  The boom was partly driven by consumer demand, but it was also driven by inflated prices caused by loose lending practices.

You see, as investment banks diversified their securities, they found that the mortgage-backed security “vehicles” were performing at a very attractive rate with an extremely low risk of default.  In fact, the agencies responsible for rating the risk of securities had given these vehicles AAA-ratings, which in financial terms means “money good” or “just as safe as a US treasury-note.”  Every investor wanted these security assets as a fundamental part of their investment portfolio.  And investment banks were buying individual mortgages off of the Country Wides of the world like crazy, so that they could turn around, package them up and sell them off to meet investor demand.  At a VERY handsome profit, by the way.

(Side note:  it is at this point where AIG becomes involved.  AIG agreed to insure each one of these assets at a tiny, tiny premium.  They were, after-all, rated AAA.  That’s how a company with market value of $150 billion drops to $5 billion in the span of a year).

(Second side note:  This is where the shit really hits the fan.  Once the institutional investors (i.e. banks, funds, etc.) realized how well these investments were performing, they started borrowing money themselves in order to purchase the securities, and at astonishing rates.  Some funds were “leveraged” at ratios as high as 30:1, meaning for every $30 borrowed, they only had $1 on hand to back it up.  This creates a dangerous situation of musical chairs… once the music stops, the scientific term is “absolute shit storm.”)

Meanwhile, the Country Wides and other small banks were in a bind:  as intermediaries, they could not possibly find traditional mortgages fast enough to sell on to the Investment Banks.  But the Investment Banks were telling them “risk is fine.  We’ll diversify (i.e. pool and mix) the risk.  You just get us the mortages.”

And so the banks started to loosen up their lending practices.  Prime rate went out the window (enter: Sub-Prime lending).  Mortgages were offered without down-payment.  Then without proof of any assets.  Then without any proof of any job or income (NINJA loans – No Income No Job or Assets). When you offer to lend money to someone without running a credit check or requiring them to have any equity-stake whatsover in their home… you can pretty much guarantee that their risk of default is 100%, no matter how low you make the interest payment.

Simply put:  banks preditorily lent money to people to purchase homes that they could not afford.

Why would they do this?  Why would anyone with any sense take an investors money and give it to a borrower, when they knew with near-certainty that the borrower would/could never afford the payments?

Well, for one thing, they were relying on “finely tuned instruments” to monitor the performance of the securities.  Even when some people defaulted, the banks assumed the asset of the house, and could turn around and sell it at the current market price, for a profit.  It was win-win.

Until it became lose-lose, around August 2007.  Times thirty.

Once the housing market bubble bursts, those security vehicles stop performing so well.  And it’s a downward cycle (hence:  “toxic” assets).  If someone defaults on their mortgage, the bank now has to assume and sell the home.  If the bottom of the housing market has fallen out, the banks sells the home for a HUGE loss (which translates to a small drop in the value of the asset it is partially-backing).  Suddenly the supply of available housing vastly exceeds demand.  Everyone is trying to get out of the house they couldn’t afford in the first place.  Consumer spending drops, because everyone’s trying to pay down their house.  The economy tanks.  People get laid off, and can’t afford to pay their mortgages.  And the cycle exacerbates.

The thing is, on Wall Street, nearly everybody has these assets on their books.  As the value of these assets drop, so do the value of their companies, and so does the value of their stock.  Investors see where the economy is headed, and so they withdraw their funds, or stop buying the securities the Investment Banks are trying to sell (er… get rid of).  Who’s going to buy toxic assets?  Nobody knows the values of these assets. There is literally no market for them.  Lehman Brothers, Bear Sterns and Merryl Lynch were scrambling to get rid of them, but they finally had to admit that they just couldn’t do it.  The money was gone.  The wealth was destroyed.

Well, scratch that last part.  Part of the wealth COULD be recouped, but it would require financial backing from someone bigger than Lehman Brothers or Bear Stearns.  In fact, it would require the financial backing of the US Treasury.  If the US taxpayers buy the assets from these companies, then the banks have the required liquidity to perform their normal operations, without having to worry about the perfomance of the toxic assets.  Now they have a fixed interest rate to pay-back the Treasury, which is easier to manage around.

Bernake’s hope is that over-time, that the $700 billion dollars “worth” (I use that word in quotations since nobody knows the “worth” of the assets due to the absence of a market) will be a wise investment.  How?  Well, if the underlying mortgages start getting paid off (i.e. the housing market swings back upward)… that’s how.  The stronger our economy performs in terms of quality job and wealth creation, the greater the return on those assets.

Of course, there’s just as large of a risk that those assets severely underperform, and our economy goes into a recession, if not a depression.  And then as tax-payers, we’re out $700 billion.

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2 responses so far ↓

  • Xdm // September 24, 2008 at 5:51 pm | Reply

    1) thank you for this
    2) Why would Dems ask that mortgages be lowered for those in default when they shouldn’t have been able to buy a house in the first place? Will that help? And how?
    3) Isn’t the bail out a good idea/best effort to save things? Isn’t the Us (if not the global) economy a good “investment? (What do we have to show for the billions in Iraq?)
    4) Please discuss the Steagall act (repealed in 99 WHY?) which was put in place to stop these greedy bastards from over leveraging and causing situations such as the one we are all in currently.
    5) In the words of Gordon gecko, is Greed good?

  • Jon // September 24, 2008 at 10:20 pm | Reply

    1.) You’re welcome. I ditched the stats class I’m supposed to TA for to write it.

    2.) There are basically two approaches to how to increase the value of these assets. The first is to take them off the books of the banks (government “buys” them with treasury bonds or equity stakes) so that they stop trading. Then the banks have solid, valuable assets with which to leverage against. The government then can withstand the down swing until the housing market is fully corrected. This of course is good for banks, but bad for people who are trying to keep their homes. An alternative approach would be to try to establish a “floor” on these assets by restructuring the debt… ie refinancing everybody’s mortgages to more reasonable levels. Then you could put a price on the assets, because there would be a limit to the losses, and people would still keep their houses. Wall Street likes this idea less because it guarantees a realized loss on the holdings, and it’s not an immediate infusion of cash.

    3.) The bail-out is the best idea if you believe that when the rich sneeze, the poor catch a cold. The economy skids to a halt when banks fail. Unemployment soars. The thing is, it’s not entirely clear that ALL banks will fail. Just the stand-alone investment banks. And my professor says that the stand-alone model is destined to fail. If you really think about it, they’re buying something on one end and selling it out the other. If something was really valuable, why wouldn’t they just hold on to it themselves? Why would they pass on the opportunity, and try to pawn it on to someone else? A lot of investment banking is hyping opportunities.

    As for whether the US is a good investment… the reason everybody buys our treasuries is because we play by market rules. That is, when there’s a correction, we don’t step in to distort the correction by nationalizing stuff. Or that is, we didn’t used to do that. A true free marketer like Greenspan would say that a correction is necessary to flush out all the bad, speculative investments. Let the smart and prudent weather it out, and the naive and foolish wither and die. International investors love this philosophy, because they don’t have to worry about political bullshit that you might have to deal with in, say, Russia. Well, market corrections are painful processes at the macro level, and don’t really mesh well with representative democracy, especially in the midst of election season. So something “must be done.” I think ultimately this will hurt our reputation internationally worse than Iraq, because it damages international trust in the strength of our market. The dollar should decline in value significantly, and we’ll see a decline in the US standard of living as a result.

    4.) I don’t know enough about financial regulation to speak to this. The only thing I know is that credit default swaps (which took down AIG) seem to be on their face the most nefarious tools ever. You’re basically making a huge bet that a company (say Bear Stearns) will fail, and it’s in your tremendous financial interest that the company then fails. If you’re Goldman Sachs, and you own credit default risk on Bear, you can spread terrible rumors about their liquidity crisis, even if they’re no better off/worse off than you are. When they fail, you hit up AIG to collect on your bet. I’m not saying that this happened, but the potential for this to happen seems enormous.

    5) This is interesting. I think greed can be good, in the sense that Warren Buffet is greedy. Buffet never loses sight of “value” — and that word can mean multiple things. But he’s interested in the underlying values of things, and gaining ownership in companies that he sees as holding potential to offer more value than they are appraised at. The danger of greed is when you lose sight of value. You want something to be valuable even when it’s not. And you lose your own personal values (i.e. business ethics) as a result.

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