A Simple Explanation of What Went Wrong
I read this interesting Brookings paper yesterday, titled "A Brief Guide To Fixing Finance." The most intriguing part of the paper was this simple explanation of exactly how things managed to get so bollocked up in the first place.
The authors note the “domino-like” character to the financial crisis:
1. The bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;
2. The peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;
3. Losses thereafter on the complex “Collateralized Debt Obligations” (CDOs) that were backed by these mortgages;
4. Increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued “credit default swaps” contracts (CDS) that insured the CDOs;
5. Losses suffered by financial institutions that held CDOs and/or that issued CDS’s;
6. Cutbacks in credit extended by highly leveraged lenders that suffered these losses.
Sure, that's an oversimplification. But it is a good place for the layperson to begin trying to comprehend what exactly went wrong here . . .
>
Source:
A Brief Guide To Fixing Finance
Martin Neil Baily, Senior Fellow, Economic Studies
Robert E. Litan, Senior Fellow, Economic Studies
The Brookings Institution, September 23, 2008
http://www.brookings.edu/papers/2008/0922_fixing_finance_baily_litan.aspx
Wednesday, September 24, 2008 | 12:15 PM | Permalink
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How about an overly simplistic way to fix the problem?
What if the gov't buys these loans and passes on the savings directly to the borrower? For example, if they buy the loans at 60 cents on the dollar, give 35 cents of savings to the borrower directly (through a decrease in loan balance) and the 5 cents left over for the private sector who buys them from the gov't?
Posted by: Joshua | Sep 24, 2008 12:32:08 PM
You forgot to add that it got "bollocked up" over a long period, during which time a number of "gangstas" were selling dodgy mortgage loans to people who couldn't read, while "ho's" of all shapes and sizes were showing off new condos in Miami.
Furthermore, during this time a "bunch of tools" claimed that we had a "Goldilocks economy", and that if anything goes wrong "the free market will sort it out"......
Posted by: leftback | Sep 24, 2008 12:37:58 PM
Barry,
Thanks for passing that along - it is good information. Looking though the list kept raising to me these two themes: 1)unregulated securitization 2) unregulated derivatives.
In a pristine environment, where originator holds the note, this scenario is virtually impossible because of the nature of risk aversion; however, when the risk is passed via securitization and then that risk is amplified with the leverage magic of derivatives you are walking a fine line between innovation and collapse-a-dation.
Posted by: Winston Munn | Sep 24, 2008 12:38:07 PM
So what cause the bubble? Or what caused too much credit to be available? I've heard some argue that it was predominately Freddie and Fannie which had too low a cost of capital and too much leverage and that if only that had been reined in by Congress in 2005 or 2006, none of this would have happened. That strikes me as a somewhat political argument, but I'd like to know what the facts are or what the counter argument is.
Posted by: Neil Faden | Sep 24, 2008 12:39:57 PM
."gordon BROWN has turned himself into a DOMINO BANK in order to be able to draw upon the new squillion dollar BAILOUT courtesy of ADMIRAL PAULSON the American leader.
...short selling had been threatening to bankrupt his premiership and the whole of the shadow political system but this has, now, been banned by the SEC...
SAFE AS HOUSES
...there is, now, no chance of a challenge for the leadership as, should the domino BROWN fail, then no potential challenger will risk being the next domino to fall...."
Posted by: peterthepainter | Sep 24, 2008 12:44:04 PM
1) De-tox the paper by destroying it and replacing it with paper at a set initial value backed by reformed, more-affordable mortgages. Real property value should be based on the predicted 30%-35% housing market correction (AKA actual current value corrected for fraudulent financial sector activity).
Surplus debt over actual value should be canceled provided homeowners agree to wage garnishment/nondischargeable federal obligation.
Resulting new paper will be valuable.
Posted by: Boy Wonder | Sep 24, 2008 12:50:17 PM
What’s missing from the analysis is the opportunistic (if not parasitic) nature of those involved. No doubt many Wall Street operators knew that the whole system would come crashing down - - but they participated anyway.
Posted by: DL | Sep 24, 2008 12:53:19 PM
Since mortgages always (well...) require an appraisal and since appraisals in the US are based on 'comps', appraisal values will follow a bubble right up, justifying it all the way.
Has anybody anywhere seen any suggestions for alternate ways to appraise and value property that might prevent this? Are they anything other than subjective? As soon as you try to tie values to an objective standard like new construction prices or a fixed square foot allowance, you get arguments like "location, location, location" and "this is a better neighborhood".
Posted by: wally | Sep 24, 2008 12:54:17 PM
"fueled by the ready availability of credit"
I think it's very important to call out the removal of regulatory requirements that allowed for massive leveraging. The housing bubble was just a place for the credit expansion to be realized. The root was in increasing available credit by leveraging to ridiculous levels.
And it is that over-leveraged position that allowed for even small amounts of defaults to cause massive declines.
Posted by: caleb Mardini | Sep 24, 2008 12:57:58 PM
does anyone know of a reason for Lennar to be up so much today?
Posted by: jon j | Sep 24, 2008 12:59:25 PM
it was not meant to be like this...
the originate-to-distribute model was heaven sent: make commissions without ever worrying if the loans you arrange will be paid back.
then the brilliant minds forgot about their lax lending practices (that's what is happening when you stay too long on the golf course) and decided to keep the junk as they could finance it short term.
from here goes what barry described.
Posted by: baychev | Sep 24, 2008 1:02:35 PM
You forgot #0 --
"Rather than raise rates in a time of war, the Bush administration forced the Fed to keep interest rates at an unnaturally low level to prop up the economy."
Posted by: jmay | Sep 24, 2008 1:08:41 PM
I don't see any mention of FNM, FRE, CRA, or Barney Frank, which means the study is not complete.
Posted by: TheMongbat | Sep 24, 2008 1:10:48 PM
At some point here soon we should start a topic on the real estate business model. This model obviously needs huge reform. I visit a mortgage broker/ loan officer forum (just to really piss me off) as one of the variables I use to gauge the future and direction of our economy. It shocks me (not really) that “mortgage fraud/broken business model” even today is still going strong. Everyone gets so caught up in the big picture sometimes we forget to “check back in” to see if we are cleaning up the original problem of this crisis. The realtor, appraiser and loan officer business model is broke but I never see anybody talking about how to remove the multiple conflicts of interest in the industry and clean this up immediately.
People today are still making very big easy bucks fraudulently off a broken business model as we are talking about how to throw 700 billion to keep it going…
Posted by: cindy | Sep 24, 2008 1:12:27 PM
Excellent summary. And for each item, we can easily add factors that enhanced that item, e.g. the liar loans; the endorsements of the complex re-packaged debt by the "esteemed" credit rating agencies...
Posted by: Ken M. | Sep 24, 2008 1:13:29 PM
"I don't see any mention of FNM, FRE, CRA, or Barney Frank, which means the study is not complete."
CRA is irrelevant.
Posted by: Jon H | Sep 24, 2008 1:14:15 PM
Shouldn't the title be:
"A Modest Proposal of What Went Wrong"
This linguistic meme (god, I hate that term) being of Swift-Ritholtz provenance.
Posted by: patfla | Sep 24, 2008 1:17:28 PM
7. And so $700 billion in bailout money is needed from taxpayers to reflate that bubble in housing prices, so that we can begin the cycle all over again.
Posted by: CNBC Sucks | Sep 24, 2008 1:21:52 PM
So why can't the federal gov't announce a mortgage reform program that proceeds in installments? Like Schumer suggested, start with an initial $100 billion and go from there. Take the paper off the banks' hands at a discount.
Then consolidate fractioned mortgage-backed securities in batches and offer homeowners mortgage reformation through an opt-in program. Homeowners that opt out get some tax benefit.
In exchange for receiving the benefits and protections of opting in, homeowners agree that a certain % of new mortgage obligations are personal and nondischargeable; Congress amends the Bankruptcy Code accordingly.
Banks get rid of the paper but take a haircut and homeowners get out from under within reason at a price.
Why not?
Posted by: Boy Wonder | Sep 24, 2008 1:23:13 PM
caleb Mardini: the increased leverage happened well after the credit bubble was underway (the capital requirement exemptions were granted in 2004 - this was a mistake, but not what set off the credit expansion).
You can thank the Fed's low rates for the expansion of credit, and you can thank government policy for directing so much credit toward "affordable housing," and you can thank regulations for creating demand for these securities by giving weight to the ratings agencies (who were paid by the CDO issuers) and not allowing for incentive alignment between investors and investment managers.
Posted by: Dave | Sep 24, 2008 1:29:03 PM
oh come on.
Lets just look at the first sentence: 'resulted in an understimate of the risks'
Oh, yes the poor victimized banking/investment industry just made a little mistake in making 'estimates'.
The use of the passive voice throughout the piece, implies that the finance industry was the victim of some kind of act of god or something. 'Mysteriously' God chose not to keep assets going up forever. We in our wisdom, had assumed, ignoring all prior data, that God was Dead, and that reality had been suspended. The Republican Party and Fox News assured us that reality was an artificial construct of treasonous liberals (whom we will soon be rounding up)
funny how there's no mention of the seperation of risk and reward that is the hallmark of modern capitalism: Make loans, garner profit, sell loan to someone else, garner more profit. Loan goes bad? Not my problem. If someone tries to make it my problem, I'll use my control of the federal government to make sure that doesn't happen.
The poor itty bitty investment banks just couldn't help but lever up 30, 60, 90 times 'assets'. Fannie Mae doesn't need no sinkin' regulation.
We just made a little error in estimating the value of our assets, we didn't turn the entire the economy into a hedge fund. Oh, hey golly, you mean I can lend 'money' to some guy whose running a holding company and taking over viable businesses, like insurance, and use there short term profits to 'invest' in highly leveraged speculative instruments, then siphon the resulting profits into my own accounts, and watch while the insurance business goes belly up. it's okay, we can get Uncle Sam to inject capital to get the beast going again (gotta have insurance), and when they do, we can start making more highly leveraged speculative buyouts, separating companies that make actual money from that money through the ingenious use of... leverage.
Don't worry folks the real problem is unfairly valuing assets, not leverage, no. In 6 months or a year, all those assets will have their 'true' value back, and you will see what geniuses we are, and how regulation is useless, except of course when we need cash.
Speaking of which, anybody got a dime?
Posted by: VoiceFromTheWilderness | Sep 24, 2008 1:29:37 PM
"What’s missing from the analysis is the opportunistic (if not parasitic) nature of those involved. No doubt many Wall Street operators knew that the whole system would come crashing down - - but they participated anyway.
Posted by: DL | Sep 24, 2008 12:53:19 PM"
Naaah. Most of them were too high on coke to realize what was going on.
Posted by: JoJo | Sep 24, 2008 1:31:48 PM
Also the complete lack of reserves are important; if AIG would simply have followed century old rules for insurance they would be a vital company today.
Plus the weird notion on debt; the UD financial sector now has over 16.5 trillion in debt outstanding and thus has turned into a classical Ponzi financial unit.
Interest and maturing debt can only be paid with new debt...
Alan Greenspan not understanding macro economics has also been very helpful.
The docile nature of the American population, they hug free speech but do not use it.
Corruption in the academic institutions, Nobel prize winners giving the green light to weird tax cut plans.
And so on and so on, the list could easily contain 50 entries!
Posted by: Reinko | Sep 24, 2008 1:39:27 PM
For The Big Picture, a validation of sorts:
"'It’s a sad fact, but Americans can no longer trust the economic information they are getting from this administration,' South Carolina Sen. Jim DeMint said in a comment posted on Politico’s Arena forum."
Economic information ex-real data = Spin
Posted by: Winston Munn | Sep 24, 2008 1:43:38 PM
I think the idea of the business model is correct but misses the real change: the lenders went from a business model in which they made money on the interest on home loans, and thus had a very strong incentive to loan to borrowers who could pay to a business model wherein the goal was to issue as many loans as possible and resell them (essentially). Once the loans were resold they could make more loans, and rising home prices meant bad borrowers could be replaced by new (and usually even worse) borrowers.
It was in the banks' immediate interest to encourage bad borrowers.
max
['That makes a crisis.']
Posted by: max | Sep 24, 2008 1:45:01 PM
