Understanding the Financial Crisis, Part 2

Barry Ritholtz, who writes a very popular blog, The Big Picture, often discusses the causes of the financial crisis. How Lending Standard Changes Led to the Housing Boom/Bust, posted on October 21st, blames the problem squarely on the lax standards of lenders. I agree with his main point, which he makes persuasively. Maybe it is a question of emphasis, but I believe that there is enough blame to go around.

Many of us acted as if housing prices could only go in one direction – up. Individuals bought as much house as they could get approved for. Some investors/speculators bought several condos when they were under construction. They hoped to “flip” the apartments as they were completed, thereby making exceptional profits.

With the very low interest rates promoted by the Federal Reserve, there was a big demand for any investment that promised higher returns. Investment banks packaged questionable mortgages, and investors bought the complicated financial instruments without asking enough questions. Rating agencies blessed the securities with triple A ratings, never imagining that home prices could actually fall substantially.  Regulation did not keep up with the changing markets for securitized debt instruments.

This housing bubble or mania could not go on forever, and it did not.

Here is Ritholtz’s article.

There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust.

Let me take another shot at clarifying this:

Underlying EVERYTHING — housing boom and bust, derivative explosion, credit crisis — is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift — it was an abdication of the traditional lending standards that had existed for decades, if not centuries.

After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized — purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper.

In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.

So long as the mortgage did not default in that period of time, it could not be “put back” to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.

What do rational, profit-maximizers do? They put people in houses that would not default in 90 days — and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators — by then, it was Wall Street’s problem.

This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.

This was a simply unprecedented shift in lending standards.

And, it is why 293 mortgage lenders have imploded — all of these bad loans were put back to them. Note that the fear of this occurring is what was supposed to keep the lenders in line. The repercussions of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm.

If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the “2″ of the 2/28) of these mortgages so attractive.

Contrary to the cliche, failure is not an orphan in the current crisis — it has 100s of fathers. But these four are the primary movers, the key to everything else. The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings — these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.

photo credit: eron_gpsfs

Criticism of the U.S. Bailout Plan, Part 2

“The Devil Is In The Details” – Proverb

Paul Krugman is a Princeton Economics professor and columnist for The New York Times. In his September 22nd column Cash for Trash, he claims that although Treasury Secretary Henry Paulson is “a smart guy” as far as his plan to bail out banks, “He’s making it up as he goes along, just like the rest of us.”

So let’s try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?
Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

I’m aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad.

But I’d urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don’t let yourself be railroaded — if this plan goes through in anything like its current form, we’ll all be very sorry in the not-too-distant future.