by Steven J. Owens (unless otherwise attributed)
The Financial Crisis In 4000 Words Or Less
This is an attempt to sum up, in some fashion vaguely useful to a normal human being (i.e. not a political or financial pundit), the financial mess that has been dominating the news for some months (pretty much since mid to late 2008).
It's actually three different-but-interconnected financial crises, so the topic is insanely complex; the mortgage crisis, the subprime derivative bubble, and the credit crunch. The subprime derivative bubble is the real linchpin, the key to what's happened.
Although there are some excellent resources out there that go into it in depth (particularly a pair of This American Life shows), most people just don't have the time and energy to sift through it all and understand it.
Unfortunately, that has left a lot of opportunity for all sorts of idiots to make political hay out of it and hold this mess up as proof that their political ideology should have been followed - even if it was their political party and officeholders that messed it all up. Even this explanation is probably too complex, so I'm going to try to boil it down to a short summary, here at the top. Meanwhile, at the end I have a section about sources of information, so you don't have to just take my word for the facts.
Note: A note about language. If you browse the other pages of this site, you will notice I have a tendency to use some rather, ahem, "direct" language. I am trying to refrain from such in this essay, because the topic affects such a large cross-section of society, many of whom may be struggling with this topic, and the last thing they need right now is the distraction of unaccustomed vocabulary. Please bear with me as I attempt to find sufficiently evocative alternatives to certain popular (but condemned by the FCC) adjectives.
Here's a little outline that I will (hopefully) turn into a really, really streamlined summary for short attention span readers.
First, for all the fractured reporting, there are (or were) three distinct crises, three different things happening. They're interconnected, but they're also distinct enough that it's useful to separate them out when you try to understand them. The Credit Crunch, caused by the bursting of the Subprime Derivative Bubble, caused by the impending mortgage default crisis.
Second, lots of people are talking about bank this and bank that, and it's kind of confusing things. The ordinary person hears "bank" and they think about that marble-columned building down the block. But the vast majority of "banks" in this whole mess are "investment banks", which have almost nothing in common with traditional banks and much more in common with wallstreet stock speculators.
In fact, you could make a strong case that the whole mess is a direct result of letting wallstreet hotshots play fast and loose in territory that for eighty-some years was reserved solely for the stodgy bankers, specifically because they were stodgy and therfore safer than wallstreet hotshots.
Working backwards, the most recent and most obvious problem is the Credit Crunch. This is sort of like a run on a bank, where everybody freaks out and thinks their money isn't safe, so they withdraw it all.
The thing is, a real bank isn't just renting vault space, they're actually in business to do the safest sort of money management. They figure out who's safe to loan it to, and then charge interest to make a profit. They're supposed to be good enough at it, and careful enough, that the wins outweigh the losses, and no one loss is big enough to threaten the whole deal.
Because of the above, not all of the money is in the real bank at any one time, and if everybody freaks out and tries to withdraw their at once, the real bank can't pay them all at once... and of course, that means they freak out even more.
The recent Credit Crunch was like that, only on a much bigger scale, involving gigantic corporations and vast sums of money. Unlike most credit crunches, this one was kicked off by a very specific thing, which is Lehman Brothers going completely under.
When it gets right down to it, we have three distinct financial crises (or crisises) going on:
The mortgage default crisis is the first domino, but it hasn't actually hit the floor yet, though it's been slowly toppling for the past year or two. As the mortgage default crisis has become more real, however, its impending reality has, like the rays of a dawning sun, burned away the mist of lies that were propping up the subprime derivative bubble, thus kicking off that crisis.
Don't get me wrong, we are indeed having a mortgage crisis; a crisis of what looks likely to be 2 million americans losing their homes due mostly to shady lending practices. A lot of people are trying to distract you from the real culprits by blaming the victims, so let me say that again, SHADY LENDING PRACTICES.
We'll talk more about those shady lending practices later But the subprime derivative bubble didn't result just from subprime mortgages. That "subprime" means, "not the best", which is a nice financial euphemism for "risky". So, what do you do with something risky?
If you're sane, you manage the risk carefully.
If you're not sane, you form "securities" and let the wallstreet hotshots play with them.
A security is sort of like a company with stock; people buy shares and if the company makes money, the money is distributed according to how many shares each shareholder has. Except, in this case it's not shares in a company, it's shares in a loan, and the profit comes from the loan being repaid.
If you're sane, you very carefully assess the probability of these securities failing to make money because they depend on risky loans.
If you're not sane, you have credit agencies give them triple-A ratings, you assume they're can't-lose investments, and you have an an internet-boom-scale feeding frenzy of trading.
Sounds like a brilliant idea, right?
And finally, we get to the Credit Crunch, which is what happens when the Subprime Derivative bubble bursts and it's not just the wallstreet used car salesmen who get hurt. "Unsinkable" investment firms like Lehman Brothers find out that the guys in the subprime derivatives office have written checks that their company's ass can't cash. The company disappears in a puff of debt, but the problem is that it takes money in very "safe" investments with it.
People panic. There's plenty of money "in the system", but the people who have it are looking across the street at their neighbor who lost his shirt doing something incredibly safe and cautious, and they're holding onto that cash as tightly as possible and waiting for the storm to blow over.
The credit crunch was what the whole $700 billion bailout was supposed to be about. The system got into a financial gridlock where everybody's afraid to move, so nobody can get anything done. This is bad at any time, but it's especially bad when everybody's already worried about the economy. The $700 billion is supposed to un-stick things and get the game of economics going again.
In a little more depth, it works like this:
In a simple world, everybody would just buy for cash and sell for cash and nobody would ever have multiple balls in the air and be in danger of dropping them.
Then again, in a really simple world, we'd all just barter chickens for grain & etc. We use money as an abstraction mechanism, so we don't have to do stupid things like lug a box o' chickens around, or trade people one and a half chickens for one steak. Money flows more easily and can be divided and combined more easily. That's one abstraction mechanism*.
Note: One abstraction mechanism of many, and its these abstraction mechanisms that make our economy much, much better at adapting and working better and, ultimately, making everything work more effectively and thus creating more value -- and making some people a lot richer, but at the same time making the rest of us a little richer, too, and that's what makes it all worth while.
So, back to "multiple balls in the air": lots of businesses have money coming in and going out at the same time, and it's hard to make it all match up perfectly, every day. So we have a similar (in principle) abstraction mechanism to make commerce flow more evenly, except that this abstraction mechanism is bridging gaps across time instead of across physical goods.
Besides the companies that need to even out the ebb and flow of money, there's another side to the abstraction mechanism, companies with large amounts of cash reserves. They need these reserves to stay fairly liquid (spendable) and reliable. But just letting the money sit around collecting dust and costing overhead to protect is missing an opportunity. Even a tiny investment profit overnight can be a heck of a lot of money when you're juggling billions. So they invest it in very liquid (i.e. can put the money in and pull it back out pretty quickly) but extremely safe investments.
However, this abstraction mechanism, like almost all investing, relies on reliable middlemen. Part of what makes those investments extremely safe is that they're spread around, like mutual funds. That's where the reliable middlemen come in.
But those reliable middlemen are stuck with brother-in-law partners who, as it turns out, have been sniffing the cocaine of the subprime derivative scams. Now those reliable middlemen go to the safe and find it empty (e.g. Lehman Brothers going bankrupt, not because those extremely safe investments were bad, but because an entirely different department did something idiotic; trouble is, this department or that department, Lehman Brothers still has to foot the bill).
So now the companies with large reserves are stuffing the money in their mattress and sitting on it with a loaded shotgun. And meanwhile, business grinds to a halt, in the middle of an already-dicey economy. This is a Bad Thing. That's why the US government got involved in this whole mess.
As I say above, some people are trying to distract attention from the fact that their favorite political ideology (deregulation) created this mess. As a result, they're scrambling around for somebody, anybody to blame but themselves. I'll get to that in more detail below.
But another detail I think a lot of folks didn't quite catch - the really toxic derivatives aren't just securities backed by risky subprime mortgages. They're securities backed by insurance payments on risky subprime mortgages, as if this insurance was never, ever going to have to pay out. These are the Credit Default Options and Credit Default Swaps you may have heard mention of, in passing.
This is also why AIG got caught in the middle - they were the clearinghouse for this sort of deal. If they evaporate in a puff of bankruptcy, it's not just them going down, it's everybody and his brother who got a "just in case the sky falls" backup plan from AIG. And that is, well, everybody (at least in the financial world). That's why the US government got involved in AIG.
Note: I know I said I'm going to try to avoid the more "direct" adjectives, but sometimes you just have to call it what it is: bullshit.
Okay, so now the blame-the-victim-game. Here is a list of bullshit excuses made up by people who don't want to take responsibility for creating this mess. For specifics to back up the following, see the "Primary Sources" section at the end.
a) "banks being forced to loosen regulation" is bullshit, since most of these loans were made by non-banks (aka "investment banks", not the marble-columned traditional bank down the street, but wallstreet hotshots and used car salesmen). They were never subject to most of the regulation, and that lack of regulation is what lead to the bad loans.
b) "people buying houses they couldn't afford" is bullshit. According to a 2006 report by that bastion of liberal journalism, the Wall Street Journal, 61% of those subprime loans were to people who qualified for regular loans, but were conned into taking subprime loans instead.
Update: And, not too surprisingly, according to this recent New York Times article, mortgage defaults are now much higher - nearly twice! - among the rich (1 in 7 for million-dollar mortgages, versus 1 in 12 for sub-million-dollar mortgages). When you get to "investment homes", you can drop the "nearly": 23 percent versus 10 percent.
http://www.nytimes.com/2010/07/09/business/economy/09rich.html?_r=1&hp
This is, of course, old news. All of these folks shaking their finger and scolding middle-income home-owners are quite used to turning around and doing the same thing they're decrying.
c) "darkies buying houses they couldn't afford" is bullshit, since the statistics actually show that minorities are more reliable mortgage holders.
d) "government regulations (CRA) forced banks to make bad loans" is bullshit, because CRA loans actually performed better in all categories.
d1) CRA-governed loans are literally not the loans causing problems.
d2) CRA loans have a much better default rate.
d3) CRA loans in general are mostly not subprime loans.
By the by, when I first wrote all of the above in a discussion on an internet forum, some folks who read it got their back up at the implied accusations. Those accusations are based on facts that have already been proved repeatedly (see "Primary Sources"). Some of the URLs given at the end provide those facts, or link to the direct sources of those facts.
Other folks (perhaps somewhat more reasonably) got their backs up at the casual dismissal of an entire class of possible culprits that their pet ideology prefers to blame: government overregulation.
I'm not going to worry overmuch, here, about proving those accusations, and re-proving those facts. Although I believe in the honest intentions of the folks in the discussion above, I think they're a bit asleep at the wheel here, and buying the snake oil being sold by certain politicians.
Is it fair to discuss whether any given law had an effect or not?
Sure.
Is the CRA relevant to the current financial fiasco?
No (see above).
Is it fair to indulge in fantasies about the CRA indirectly contributing to the financial crisis, instead of actually looking at the facts?
No, no more than it is fair to devote serious attention to whether or not Santa Clause had something to do with the financial crisis.
Because when it comes right down to it, the points have already been refuted and it's a core strategy of certain types to just keep repeating the lies, over and over. At best, people believe them. At worst, they trick you into wasting your time in refuting them, and by engaging them again and again, you grant them credibility.
"Scientists say the sky is blue, however, some scientists disagree" is not "fair and balanced."
The proper response to inane insistence that "the sky is green" is not to explain how water reflects more of the blue wavelengths of the spectrum, and water moisture in the upper air, even if not visible as clouds, results in the sky looking blue.
The proper response, particularly when you recognize that the green sky crap is a deliberate tactic, is to point and laugh, loudly and publically, and invite the proper public ridicule of these clowns.
I think it's possible for reasonable people to honestly disagree. I am, however, quite willing to brand others as liars, quite possibly with underhanded motives, or as gullible tools of such liars, or as self-deluded fools too in love with their pet ideology to see when they're being used as tools, if I see evidence of such.
If they insist that the sky is green, I will not engage them in reasonable debate about the possibility that it might indeed be green. Nor will I enquire if they happen to be wearing tinted glasses, and what color might those glasses be.
Some people are making noises about "We can never know for certain how much of this could have been avoided with even less regulation than the weakened, and even more weakly enforced regulations we did have."
Hogwash.
What we choose to spend our attention on can be just as important as how we conduct that expenditure. We may not have it down to a science, but we have a heck of a lot of perspective and data, and certainly enough to say definitively that the "blame-the-victim" mentality is horse manure.
Now, since everybody has an axe to grind, I'm going to state my own axe up front. Here's what I think should be done about the crisis:
Fix the mortgage crisis first, and do it with brute force and the heavy hand of government; the problem is fundamentally a problem of gridlock, so we need a traffic cop to come in and sort it out.
Treat it as a financial disaster area and declare financial martial law long enough to sort out the gridlock, make sure the safeguards that were torn down to allow wall street into the mortgage game are put back in place, then let traffic flow.
While the vast wave of failing mortgages is not the actual cause of the crisis, it is one of the earliest dominos to fall. It's also one of the areas where just about everybody involved -- even the people who are owed money from the mortgages -- would really rather have some money than no money at all:
Also, for the majority of cases, the actual financial shortfall that caused the default is relatively minor compared to the cost for everybody (even leaving out the impact on the economy).
The problem is really organizational and political, not practical.
Almost every bank would have a much better bottom line if they could "work out" the mortgages in that majority of cases where the shortfall is relatively minor, before forefeiture. But almost no banks are set up to actually do this, in terms of organization, training, software, etc.
There are a very few banks who are, and they're doing very well by taking on other banks' problem cases and sorting them out. Unfortunately, they're relatively small organizations, and the big boys are much slower to react and adapt. This is generally a good thing - we want the people handling our money to be stodgy and boring and reliable and slow to change. We don't want banks reinventing themselves every week. But now we're in a crisis and it's getting in the way.
But a bigger problem is, even if you could do something, it's very hard to sort out who actually owns the mortgages. We can't even figure out who all the owners of a particular piece of paper are, let alone get them all in the same room to discuss working something out.
So the right answer is for the government to exercise a sort of (metaphorical) eminent domain, and take over those mortgages. Establish some basically sound financial equations for the value of the mortgage and the payments. They will be a little suboptimal. Stricter than what some homeowners who don't qualify would hope. Riskier than what a (sane, non-wallstreet-hotshot) loan officer would like on the homeowner end. Not as lucrative as the criminally stupid derivatives buyers thought. But at least the whole thing won't fall apart.
Net result: Most homeowners will get a chance to renegotiate to a sustainable loan. Most securities holders won't have to write it all off. The cost of writing off the securities will no longer threaten to randomly destroy long-trusted investment banks. The government won't be just dumping money in a huge hole. The financial industry gridlock will end. And the rest of us can be done with the panicking and get back to work.
Note: Of course, now it's several months later and we know what's happened... with the wallstreet used car salesmen. We still don't know how it's all going to work out for the mortgages.
I think McCain's "fundamentally sound" soundbite is regrettable, because he's right. The media jumped all over it and the results made him look stupid. But I think he's fundamentally right:
The subprime derivatives mess doesn't change that, and it can only kill our economy if we buy into the idea that it can.
We have to make the current stupidity somehow more illegal, going forward, to make the problem finite. I'm not sure how to accomplish that, because we had plenty of laws and processes that should have made the current mess illegal. All the unenforced laws in the world won't make a squat of difference.
We had regulation and oversight in place for decades before 1996 and it worked fine, but we're already seeing yammerheads come out of the woodworks and claiming that not only was deregulation not at fault, but we didn't have enough deregulation (see everything I wrote above). What's to stop these yammerheads from popping back up a few years down the road and repealing the next set of safeguards? Who regulates the regulators?
We do have regulations to tell the regulators to enforce the regulations. They don't work very well when the president has the DOJ out chasing imaginary "fraudulent voters" instead of doing their jobs, and idiot voters buy nonsense like "we're fighting them over there so we don't have to fight them here."
What happens when we get another administration that looks the other way? How do we keep it from being sabotaged from above the next time?
One possibility is to find a pressure point here - some very specific, easily identifiable, strategically absolutely necessary practice that can be pin-pointed and made illegal.
Or, alternatively, something systemic, like making key players more criminally liable for their actions, in the future.
Or some other way of decreasing their ability to insulate themselves from the consequences of their laxness.
I doubt we'll see anything that sane come out of congress, but one can hope...
At the bottom of this section is a list of resources that you can follow up on your own to see for yourself where I'm getting the facts above.
Note that several of these sites are not, in fact, facts, but are something I normally despise: people talking about people who are talking about facts.
However, this situation is just that complex and twisty -- not to mention polluted with plenty of idiots trying to twist the facts to their own ends -- that it's better to start with some coherent summaries. These sites are the best I've found, not because they confirm my own beliefs (I shaped my beliefs based on the facts, I didn't choose the facts to confirm my beliefs) but because, on the whole, I found the fewest errors, misunderstandings or lies in them.
So if you want to see for yourself, follow the links and try to follow them at least three levels deep, so you see for yourself that the original and actual facts are actually in the primary sources, and are as reported in the secondary sources.
You have to read a lot of sources and cross-correlate the facts, and you have to know that "source" doesn't mean some idiot's opinion, but some idiot's citation of actual fact, and you have to assess the credibility of that claim...
You assess credibility both by the tone and content of the writing. It's amazing how often somebody will cite a fact as supporting a theory or opinion that it actually directly contradicts. When it does so, that's a pretty strong clue that any other facts might be mis-cited, misinterpreted or flat out made up.
Also by the credibility of the organizations and associations of the writer.
Also by the other writings and actions of the writer.
And finally, yes, their own political beliefs are a factor in assessing credibility - if a cited fact happens to dovetail nicely with the writer's ideology, look carefully and hard to make sure they aren't engaging in wishful thinking (even my own citations; I'm only human).
(These links are discussed in more detail below).
This American Life 355: The Giant Pool of MoneyThese two are a pair, the second has some really interesting followup conversation of the first:
http://www.rgemonitor.com/globalmacro-monitor/254123/cra_and_fannie_and_freddie_as_betes_noireAnd finally:
http://www.ritholtz.com/blog/2008/12/kroszner-cra-the-mortgage-crisis/If you're not up to reading and you just want to hear it explained in an articulate, accessible way, I can't highly enough recommend the following recordings:
This American Life 355, The Giant Pool of Money and This American Life 365 Another Frightening Show About The Economy are two great shows explaining this stuff.
This American Life 355: The Giant Pool of MoneyYou might also find interesting This American Life 380, No Map, Act 1, The Mod Squad, which is about how banks are trying to react to and prevent mortgage foreclosures. To make a long story short, they'd save a ton if they could renegotiate them (and the home owners would love it too), but the banks just can't manage to do it, organizationally:
This American Life 380: No Map, Act 1, The Mod SquadFor a less rounded, but more acerbic commentary, check out New York Times columnist Paul Krugman's "Google Talk" lecture. The google talk video is misleadingly titled with the title of his new book, Conscience of a Liberal, because the original plan was to talk about the book. However, the subprime derivative crisis boiled over that day (to quote from the talk, "these are interesting times"), so of course he ended up talking about subprime derivatives instead.
Google Talk, Paul Krugman(Or go to youtube and search for authors@Google: Paul Krugman)
This one's pretty sharply left-slanted, of course, but it's also the shortest and simplest one, and, like the rest of these URLs, it includes plenty of links to more specifics and real, concrete data:
http://www.prospect.org/cs/articles?article=did_liberals_cause_the_subprime_crisisThis one gets more into the numbers:
http://www.rgemonitor.com/globalmacro-monitor/254123/cra_and_fannie_and_freddie_as_betes_noireThis one is a copy of the rgemonitor.com article directly above, with an extensive followup discussion, so you can see some back and forth between economist types. There are some interesting dissenting replies, but I notice that most of the dissenting replies lack hard data.
http://www.econbrowser.com/archives/2008/10/cra_fannie_and.htmlHere's a post about Kroszner's (the Fed governor) speech about the Fed report on the CRA, and the links to the full speech transcript and full report:
http://www.ritholtz.com/blog/2008/12/kroszner-cra-the-mortgage-crisis/"Krozner's speech summarized research the Fed has been doing on two basic questions: (1) What share of subprime loans were related to CRA? Loans that are the focus of the CRA represent a very small portion of the subprime lending market, casting considerable doubt on the potential contribution that the law could have made to the subprime mortgage (2) How have CRA-related subprime loans performed relative to other loans. [D]elinquency rates were high in all neighborhood income groups, and that CRA-related subprime loans performed in a comparable manner to other subprime loans.
Fed economists found that about 60% of higher-priced loan originations -- the technical definition of subprime -- went to middle- or higher-income borrowers or neighborhoods who aren't targeted by CRA. More than 20% of the higher-priced loans were extended to lower-income borrowers or borrowers in lower-income areas by institutions that aren't banks -- and aren't covered by CRA.
"The striking result", Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluatio purposes."
"This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. In other words, the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis." Banks can also meet CRA obligations by buying loans from mortgage brokers, he noted. But less than 2% of the higher-priced loans (those would help banks meet CRA requirements) sold by independent mortgage companies were purchased by CRA-covered institutions."
http://blogs.wsj.com/economics/2008/12/03/feds-kroszner-defends-community-reinvestment-act/Here's a pretty good BBC article about the shift from the traditional mortgage approach to the approach that resulted in the fiasco, with lots of pretty graphs to make the hard data more accessible:
http://news.bbc.co.uk/2/hi/business/7073131.stmHere's an interesting article from a unique perspective, one of the guys who worked as a relative peon inside the system, giving his account of how the whole morgtage-backed scheme came about:
http://nymag.com/news/business/55687/I don't think I gave a URL for the 2006 Wall Street journal article that reported that 61% of the subprime mortgagees qualified for normal, prime mortgages, but that's enough detail to dig it up and verify it yourself. Likewise, you can probably do a little digging yourself to find backing for the facts that minority loans perform better (i.e. they default less often).
Recent Updates: Somebody just forwarded me this link about the "Lehman Black Hole". Looks like a good read.
http://www.nakedcapitalism.com/2010/06/the-continuing-mystery-of-the-lehman-black-hole.html
Also, Krugman recently (June 3, 2010) again addressed some of the common bullshit explanations claimed for the crisis:
http://krugman.blogs.nytimes.com/2010/06/03/things-everyone-in-chicago-knows/