Why are we in this Financial Crisis?

Update 3/15: I just added this video to the top of the post which I feel does a good job giving an overview of the Credit Crisis.

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

First I want to thank my friend Chris who works in finance for the all the sources and explanation of how everything works, I couldn’t have put this together without you. The punch line of all this research is there are several parties and institutions who share the blame for this crisis. Below I have grouped my bullet points into three main categories of the offenders: Government, Regulators, The Market.

If you don’t want to read through all of this, here is a quick animated explanation of the crisis (Thank you Madame for the link)

As always, please comment.  Even if it is just to say good job or you suck and missed something.  If you like the post please add it to your social networks or forward it along.

Thanks,

-ep

Government

• Congress overhauls bankruptcy laws in early 2005 making it much harder to be freed from debt when filing bankruptcy, instead forcing people into payment plans (8). This led to more aggressive lending practices as the risk of a debtor filing bankruptcy was reduced. Senator McCain voted yes for this legislation, Senator Obama voted no. (9)
• In 2002 legislation was passed deregulating of the finance and banking sector, allowing companies like AIG and Lehman Brothers to begin participating in markets they were previously not allowed to and with less oversight. The bill was sponsored by McCain’s current economic advisor Phil Gramm and supported by McCain (Obama was not in the Senate at the time). (10)
• President Bush and Congress (both parties) began pushing Fannie and Fredie to fulfill their chart to help low income homeowners. This lead to Fannie and Fredie making a strong entry in the subprime market in 2006-2007 (3).
• Fair Market Value accounting law passed at the end of 2007. This requires companies to list the current fair market value of an asset. In a falling market this can create a snowball effect for driving the value of an asset down, and it has for CMO’s. (1)

Regulators

• Greenspan and the Fed increased money supply before the y2k in fear of computer glitches causing economic panic. Nothing happened and the extra money was not taken back out of the economy.
• After the Internet Bubble collapsed, Greenspan infused the economy with additional money and lowered the Fed funds rate. This led to lower lending rates overall.
• The lower cost of money meant that people could afford more expensive houses for the same monthly payments.
• Greenspan steadfastly refused to enforce existing regulations or enact new ones when earlier warning signs of the crisis started appear (3)(6)
• Underwriting guidelines put in place after the Depression were ignored and companies were not punished for violating the regulations (5)
• Greenspan admits he has some culpability for the mortgage crisis(4)
• SEC created in 1934 to ensure that companies accurately disclose their financials and risk. An unwillingness to exercise their power helped to allow banks to not fully disclose their risk (7)
• Weakened rules for allowing mortgages to be combined into backed securities. Such as not having stringent income verification, max loan value over 400,000 etc. added more risk.
• Reduced the ratio of capital required for investment banks so now $40 could be borrowed for every $1 of capital to back it up (7)

The Market/ Wall Street & Main Street

• Investors moving money out of the stock market after the Internet crash moved to the ‘safe’ investment of real estate. Thereby increasing demand.
• The way mortgage were sold fundamentally changed. Traditionally a bank would loan individuals money and hold the note. So it was in their interest to be sure the person would be able to repay the loan. This has transitioned into a market where mortgage brokers would write the loan and then sell it for a commission. Therefore the person writing the loan had no interest in if the loan could ever be repaid.
• Country Wide begins to aggressively offer subprime loans, swelling their profits and created new products such as interest only ARMS, reverse amortization loans, etc.
• Other banks begin to follow Country Wide’s lead in an attempt to bring their performance in line with Country Wide
• Mortgages were combined into mortgage backed securities of different risk levels. The problem was that when high risk mortgages fail (foreclosures, etc), they affect the value of the ones with low risk too. This was not factored in heavily enough.
• Mortgage backed securities risk is rated by rating agencies, like Moodys. The issuer of the debt (the bank) pays the agency who’s rating it likes the most for that rating. Therefore there is a clear incentive to give high ratings. In their defense, the rating agencies didn’t have visibility into all of the risk.
• Insurance companies, like AIG, begin to sell CDS (Credit Derivative Swaps). A CDS acts as insurance against a mortgage backed security in this case. As an example, Bear Sterns might have paid $100,000/ year in premiums for 5 years to ensure that $10,000,000 in securities don’t default. If they do, then AIG has to pay the $10,000,000 in principle. This obviously creates a cash obligation for the holder of the debit to pay the insurance. However if you realize that your $10 million security is only worth $2million, paying $500,000 to insure it becomes very steep premium.
• CDS are considered ‘Level 3 Assets’, as such their disclosure requirements are VERY weak. Basically a footnote saying we have some CDS exposure but it never makes it to the balance sheet. This makes accurately evaluating the risk of the CDS impossible.
• CDS are traded in a liquid market much like options or futures traded on an exchange, minus much regulation.  The value of these securities therefore fluctuate daily based on market sentiment and appetite for such insurance on bonds (supply and demand).  Companies like AIG and Bear Stearns sold CDS to bondholders, hedge funds and market speculators.
• As the credit market began to weaken the premiums required / aka price for protection of the underlying bond (cds) rose dramatically.  As each of these securities is a contract between two parties, AIG or Lehman may have sold the insurance for 1% a year for 5 years on a $10 million face (resulting in a $100,000 a year premium).  In order to close the position however, it may now cost $200,000 a year because of the demand going up for the insurance due to worry of default.  Thus, the insurer side of the CDS contract has two options: Hold a liability on the books that is a level 3 asset and hope the bond does not default OR buy the insurance back at a significant premium.  Most institutions choose to hold on to these assets as Level 3 assets.
• Eventually several companies who were holders of the mortage backed securities ran into cash flow problems.  This was partially caused by the fact they had an abundance of illiquid assets on their books (mortage backed securities) and nobody willing to extend them a line of credit.

Timeline

(1) Wall Street Points to Disclosure as an Issue http://www.washingtonpost.com/wp-dyn/content/article/2008/09/22/AR2008092202688.html

(2) A Lesson the Market Ignored http://www.washingtonpost.com/wp-dyn/content/article/2008/09/22/AR2008092201922.html

(3) The elephant in the control room http://www.cjr.org/behind_the_news/the_elephant_in_the_control_ro.php

(4) Greenspan Confesses (Sort Of) http://www.businessweek.com/the_thread/hotproperty/archives/2007/09/greenspan_confe.html

(5) Wall Streets Blame Game http://savannahnow.com/node/579613

(6) Greenspan’s Folly http://www.newsweek.com/id/159346?from=rss

(7) How Much is the SEC’s Cox to blame http://www.time.com/time/business/article/0,8599,1843519,00.html

(8) Congress Overhauls Bankruptcy Laws http://www.npr.org/templates/story/story.php?storyId=4600645

(9) Project Vote Smarthttp://www.votesmart.org/issue_keyvote_member.php?cs_id=V3480

(10 )McCain Embraces Regulation after Many Years Opposed to it http://www.washingtonpost.com/wp-dyn/content/article/2008/09/16/AR2008091603732.html?hpid=topnews&sub=AR