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
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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)
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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)
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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).
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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
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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.
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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.
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The lower cost of money meant that people could afford more expensive houses for the same monthly payments.
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Greenspan steadfastly refused to enforce existing regulations or enact new ones when earlier warning signs of the crisis started appear (3)(6)
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Underwriting guidelines put in place after the Depression were ignored and companies were not punished for violating the regulations (5)
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Greenspan admits he has some culpability for the mortgage crisis(4)
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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)
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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.
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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
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Investors moving money out of the stock market after the Internet crash moved to the ‘safe’ investment of real estate. Thereby increasing demand.
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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.
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Country Wide begins to aggressively offer subprime loans, swelling their profits and created new products such as interest only ARMS, reverse amortization loans, etc.
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Other banks begin to follow Country Wide’s lead in an attempt to bring their performance in line with Country Wide
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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.
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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.
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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.
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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.
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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.
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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.
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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
- Credit Crisis Timeline
Image from: http://www.marketoracle.co.uk/Article3859.html
(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
22 Responses to “Why are we in this Financial Crisis?”
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I think it’s also important to note that the bankruptcy laws were overhauled after the credit company lobbies started crying about how hard it was for them when a mean borrower deliberately spent a ton on credit and then filed bankruptcy to avoid paying and took all of their profits away. This legislation stripped consumers of the previous protection that they had via bankruptcy because that particular Congress sold us all out. In truth, a LARGE majority of bankruptcies are a result of a medical tragedy and the ensuing bills. (Apparently health issues are not enough punishment on their own for being human, as far as the creditors are concerned.) I’m sure we all realize how perilously close most of us are to that happening, and I know that Obama has said he wants to reform those specific laws.
[...] Slideshow (some adult language here): Subprime Explained MP3: Giant Pool of Money-Great insight into liar’s loans. What they are, who bought and sold them, and their lifecycle. Blogpost: Why We Are In This Financial Crisis [...]
No one forces us to borrow money. When we borrow, we sign a contract agreeing to pay back. I personally know people that have declared personal bankruptcy because they bought a house they couldn’t afford, a car, truck, motorhome,etc. The lender was guilty of unethical lending practices, but this does not negate the moral obligation of the borrower. Reforming laws to make bankruptcy easier is not a viable solution. The ONLY solution is to be a responsible borrower.
I agree responsible borrowing is needed. In the case of the current financial crisis irresponsible borrowing only accounts for a portion of what got us to where we are.
People should also read to their kids every night, not drink, get 10 hours of sleep, etc. Point is greed and envy are awfully powerful. Personally I’m not willing to bet on other’s human nature not to be greedy and put us in the same situation again when I am getting ready to retire.
So yes, responsible borrowing is the answer. I just don’t think it something you can expect to really happen.
Bullshit, Greg. When you go to a mortgage broker it should be no different from going to a doctor or a lawyer. There should be some kind of an expectation of professional conduct. Let’s face it, people were LIED to about these mortgages and the future values of their homes. I personally know mortgage brokers who were trained to LIE to people.
And don’t forget that it was none other than George W. Bush who told us to “go shopping” after 9/11. Consumer spending is 70% of our GDP. We have become the largest debtor nation, whereas we used to be the largest creditor nation, as recently as the early 80’s.
Who are you people kidding, with your “blame the people in debt” nonsense? If it weren’t for the people in debt, our economy would have crashed years ago!
Donna
“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered.”
Thomas Jefferson 1802
I Agree with you donna! MONEY = DEBT and DEBT=MONEY !
When we pay bills it goes to debt collectors wich goes to small and large businesses wich lowers prices saving money so i think its also the fear of paying bills.
FEAR!!! FEAR of what, remember we get into, what we get into because we really are not erudite in that area and at the time it is what we really want to do. It is like buying something you may want, you are only buying because you really want it and it may look cute on you and you’re going to impress this or that person. Keep in mind we buy only what we want and not what we really need (just like we felt into a mortgage crisis), because we want too, not because we really need it. I am a single mother of three and renting one apartment for us and if I really wanted a house I know I can get one, but in reality I know I do not need it. Plus I am a 10 hour worker, College student, and a mother just trying to live day by day and my days are like living like rich>>>
Then When they are Allowed to Insure Fuzzy Math Investments IT WAS SO EVIL.How can they Lose?They just keep on Stacking it and The Responsibility has been Passed so Many Times that the Blame is on The Politicians for Not ACTUALLY REGULATING by Law and Making This Insanity Against the Law.The ealthy have so mUch money that It seems like the Politicians are CHEAP.Those Bastards that Made Billions On the Hedge Fund Circuit by Talking the VALUE WAY UP and Out of Proportion.The Damn Derivatives are Like Making Twenty pounds of Shit from a 15 pound Kit using Fuzzy math and Talking The Value Way Up Knowing Damn well it is worhtless.Then The Mortgages they Sliced Up default Too on Top of Being Worth less To begin with.The Twenty Pound Lie becomes Five Pounds of Real Shit.They have No Ethics and sit on their Money Knowing the Time Bomb didn’t go Off in their Face.Sharks are all the same.There is only one way to hold them Responsible and The Politicians will never do it.They have NO BALLS and Not enough money to defeat the Lies and deceit that can be Produced by the Absurdly Wealthy who have most of the Resources.The Absurdly Wealthy HIre People to take care of those worries.The Bottom Feeders.They Call them Lawyers.The Wealthy make me sick.Kindness Kills Apathy .Why do the Wealthy let People die in the streets.
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Let’s face it they are crooks.I lived it and I am now homeless.I depended on that low cost ROOM I was renting in Vallejo.I had Bailed Kris Out and he bailed me out.He was lied to by the bank.The bank sent an appraiser that valued the house at 531 Wallace in Vallejo at just under 400,000 dollars.Kris owed about 80,000 dollars.He had a second already.They gave him another loan.The loan was given in 2002 after the BS appraised value.Then Kris owed over 100,000 dollars on a home valued at a much higher amount.
Kris had lived there for over twenty years.He raised kids watched a wife succomb to cancer,The Mortgage company was the devil in disguise.Kris had a full house he has heart.My sister came along.They had a rocky relationship but it worked out.The house being taken wasn’t good.The KIDs didn’t need the upset.The adults will live.
The House just sold in 2010 for 108,000 dollars.The bank had it listed for 80,000 dollars.The Buyers who thought they were getting a deal in 2004 when they bought the house from the bank on the courthouse steps.They paid 330,000.They lost their ASS.The CRIMES that happened in these kind of HOODS was unforgiveable.The CRIMES against the POVERTY stricken citizens is what England was dealing with when we broke off and started THE USA.
WTF happened? KINDNESS KILLS APATHY yes indeeed.
DogEatDogma.blogspot.com
That was in 2004 and I have been struggling ever since.
I am not alone.There is an SRO Hotel Shortage and that is the ROOT of homelesness in San Francisco.Before 50,000 SROs were RAZED for progress.The Cost of a FLOP house was miniscule.That Drug Thug Ridden closet is NOW 650 a month.WTF happened a world class case of Hate Apathy and Ignorance.The Newspapers went on a HATE campaign and words like Flop House and Skid Row were used to RAZE the Habitat for 50,000 old men at the time.Those old men are now homeless and dying in doorways The Answer is The Community Housing Partnership and The White House Council for Community Solutions and Civic Participation.Maurice Lim Miller and the Other Council Members can bring Obama solutions he can ACT ON.REALLY.Time to PARTICAPATE!.DogEatDogma.Blogspot.com
efficient post about financial crisis.
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This is PERFECT Thank You Mr Jarvis and I have used it in my BLOG NOW
So much has changed in the last few months
The Revolution has begun
Occupy Wall Street
DogEatDogma.blogspot.com
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