The latest economic crisis explained
Written by Walid on Tuesday, November 18, 2008
You are all aware of the latest economic crisis that resulted in the bankruptcy of many major financial institutions like Lehman Brothers and many other.. But do you know what triggered it? Why the world is suffering?
Well, back in 2007 and mainly in 2008, I've been listening and reading about this "economic crisis" everywhere! On the news, on the radio.. everywhere! I became very curious and I decided to dig deeper and try to understand this crisis! I have very little background in economy, many terms were very new to me, but in the end here's what I gathered regarding the subprime mortgage crisis that triggered today's worldwide economic crisis.
By the way, Thais bull above is the Charging Bull (sometimes called the Wall Street Bull or the Bowling Green Bull) is a 3,200 kg (7,000 pound) bronze sculpture by Arturo Di Modica that sits in Bowling Green park near Wall Street in New York City. The sculpture depicts a bull, the symbol of aggressive financial optimism and prosperity (quite a , leaning back on its haunches and with its head lowered as if ready to charge. The sculpture, one of the city's most photographed artworks, has become a tourist destination in the Financial District. It has also come to be an unofficial symbol of the Financial District itself, and it often appears in the local news media to punctuate stories about optimism in the financial market.
Bow, back to our crisis! This crisis is shaping up to be the worst economic crisis since the market crash in the 1930s, and it is having a profound effect on the economy of the rest of the world. This crisis began reaching critical mass in 2007, with 2008 seeing the collapse of large firms like Bear Stearns and the federal takeover of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, known as Fannie Mae and Freddie Mac, respectively, among other major events like The Fed’s emergency bailout loan to AIG and Merrill Lynch agreeing to sell itself to Bank of America.
There are, of course, different perspectives as to what caused the recent economic crisis but most will look towards the subprime mortgages when discussing the recent collapse of some the world’s largest financial giants.
The traditional Home Loan process:
First, let me explain the home loan or mortgage process in general. Many of you know how the home loan system works: a couple who want to buy a home for let's say 300,000 USD but who cannot afford it, would go to a good bank to ask for home loans. There, the couple would meet with a representative who would take a look at their credit history, job history, and current financial situation. The bank representative would help the couple understand the mortgage price finances and ultimately decide whether or not he thought the couple could afford the house and pay the monthly principal and interest on the mortgage. Based on all this, the bank agrees to offer the couple a mortgage of 250,000 USD that should be paid back monthly over 30 years.
Once the couple obtained the mortgage from the bank, they could buy the house and begin paying off their 30-year loan in monthly amounts to that bank (which would profit from the interest). Everyone is happy here, the couple are like: "mmmm, we have to pay 1500 USD every month for 30 years, but at least we got our dream house! If we can't afford to pay our monthly amount, we'll sell our house for a higher price because prices are increasing!". The bank will get almost double of these 250,000 USD through the upcoming 30 year: "The more mortgages we give, the more money we get back. That's good business!"
A new Home Loan process - Mortgage-backed securities (MBS):
Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do.
But in recent years, banks have moved to a new model where they sell on the mortgages to Wall Street firms: the big investment houses like Bear Stearns or Merrill Lynch, Fannie May & Freddie Mac and so forth and he receives a huge amount of money for selling this loan. These are called Mortgage-backed securities (MBS). In other words, let's say that a bank received 100 mortgage applications, traditionally, this was hard to accept all these applications. But now with this new model, the bank can sell these mortgages to huge investement firms in the form of packages called Mortgage-backed securities (MBS).
The bank would turn and use that money to finance another mortgage to a different customer, and turn around and sell that to Fannie Mae as well. Now the original customer is sending his monthly payments to Fannie Mae; it is the exact same mortgage, just now owned by a huge national banking institution. Fannie Mae effectively enabled the local bank to finance countless extra loans by giving a percentage of that 30 year profit immediately, leading to better profits for everyone and more loans for the American people.
These Wall street firms, buyers of mortgage-backed securities, take security in the knowledge that the value of the bond doesn't just rest on the creditworthiness of one borrower, but on the collective creditworthiness of a group of borrowers and on the increasing value of homes in general.
After acquiring many MBS, Fannie Mae looked real good on paper. They owned lots of mortgages that they would be collecting on for years to come, but as we'll see, all the wealth was just paper. It was all imaginary.
According to The Bond Market Association, gross U.S. issuance of agency mortgage-backed security (MBS) was:
- 2005: $967 billion
- 2004: $1,019 billion
- 2003: $2,131 billion
- 2002: $1,444 billion
- 2001: $1,093 billion
with a total of $6.1 Trillion in the first quarter of 2006! This is the largest single part of the whole $27 trillion US bond market.
Root of the Crisis:
In 1994, President Clinton had the good intention of raising home ownership over the United States. For this reason, he sponsored the revision of the Community Reinvestment Act (CRA) regulations, which required banks to increase mortgage lending to low- and moderate-income families. The banks complied and increased their lending to these families by 80%, more than twice any other group. In this case, low-income families can now easily get a mortrage without checking their credit history, job history and financial situation!
Moreover, "anxious to boost the U.S. economy out of its dot-com-bust doldrums, Alan Greenspan and the Federal Reserve Bank lowered interest rates to rock bottom in 2001. The resulting flood of cheap money encouraged borrowing at every level of the U.S. and world economies. Whether you wanted to buy a house or a multibillion-dollar conglomerate, lenders were your best friends, falling over themselves to offer you whatever amount of capital you desired -- and charging low, low rates of interest. Cheap money led to a growing complacency about risk. If you ran into trouble, you could just refinance your house, or borrow a few billion more dollars today to pay off the billions you might owe tomorrow." (Panic on Wall Street | Salon Technology)
Everyone is pleased and happy until now!
The Subprime Mortgage
Cleveland, Ohio - 2002
Alice and Bob are a married couple with 2 children, they live in Cleveland, Ohio: a poor, working class city, hit hard by the decline of manufacturing and sharply divided along racial lines. The couple currently live in a humble rented house in the suburban of Cleveland. One day Alice thinks: "hmmm, why don't we get a mortgage and get ourselves a home!? We can get a mortgage now because of the CRA and the low interest rates!" Alice goes to Bob and tells him about that. Bob panics: "What! Can we afford this?" Alice replied: "Of course we can, banks are now offering mortgages for anyone, including low-income families like ours!" Needless to say, Alice convinces Bob to get a mortrage to get a home.
Alice and Bob went to a bank that offers home mortgages, they meet the bank representative and show poor credit histories and weak documentation of income. The bank representatives meets with the bank manager, who thinks: "hmmmm, I have a lot of cash from Fannie Mae's mortgage-backed securities, money is flowing because the Federal Reserve Bank lowered the interest rate, and selling mortgages is an easier investment tool compared to buying stocks. I can give them a mortgage and then sell it as Mortgage-backed securities, I don't have to worry if they will pay back, this will be none of my business after I sell their mortgage!"
The bank representative comes back and surprisingly states: "hmmmm, you are a low-income family, but hey, I can put you in this home with no money down. I can even give you 110% of the amount you are asking. Your loan will have a rate of 3.5% for the first year. All you have to do is refinance (when you refinance your mortgage, you are paying off your current mortgage by taking out a new home loan) within a year with the extra money you are getting. No problem, home prices are increasing, you might even sell the house and make MORE money. Everybody is building new houses all over the place, they are popping up like mushrooms and people are buying right and left. Prices are going up, now is a good time to buy. Oh and one more thing, this type of mortgage is called the subprime mortgage." A sub-prime mortgage describes a “risky loan” on the part of the bank to someone who doesn’t meet normal lending standards. To compensate the bank for taking that risk, sub-prime mortgages are characterized by high interest rates and lots of profit for the bank if the mortgage is successfully paid off. However, since these subprime loans were at higher risk of default than prime loans, over the life of the loan the interest rates were higher, and so the cost of the loan to the borrower was structured to rise significantly over the life of the loan. Further, these borrowers who were likely fairly unsophisticated loan consumers, were enticed to buy a loan by an artificially low upfront monthly payment that did not represent a realistic monthly cost in the long run. The subprime mortrage and the flow or cash has made it much easier to fund additional borrowing, but it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.
Bob thinks about it and figures it's risk free, no money down, in fact he is getting paid to buy a house and he takes the deal since home prices ARE going up!
That night, Alice and Bob celebrated in a fancy restaurant, they are going to move to their new home soon! The bank representative got another bonus for selling yet another subprime loan.
What went terribly wrong?
As the economy grew, the Fed began raising the interest rates from 1% in 2003 to 5.25% in 2006. This increase in interest rates had the effect of shrinking the money supply because it made borrowing money more expensive. This caused economic growth to slow and real estate value growth to slow or stop. Another result of increasing interest rates was that the subprime mortgage monthly cost to borrowers went up increasing the number of defaults, which means that the yearly amount got even higher. Moreover, there are too many homes on the market which also contributed to the real estate value to shrink.
Alice and Bob moved to their new home, during the first 2 years, they successfully paid their loan percentage. In the third year, due to the increase in the interest rate set by the Federal Reserve Bank and due to the nature of the The subprime mortgage that increases dramatically in 2 or 3 years, Bob can no longer pay his loan percentage, he can't refinance and he can not sell his new home because its price has dropped (thousands of homes are now available because many other loaners have dropped their homes: the supply has increased tremendously) so he is also forced drop his home. Imagine this happening to millions of families, each with its own subprime mortgage: a wave of repossessions (people failing to pay their yearly loan percentage, therefore their home is now returned to the bank, or to the owner of the Mortgage-backed securities) blighted neighborhoods across the nation.
But wait! The the increase in cash flow, the mortgage-backed securities and the greed of some financial institutions allowed anyone to get a mortgage by 2004. ANYONE, including low-income families! Now, imagine what happened to Alice and Bob and multiply this by millions of families. What do ou get? You guessed it, these financial institutions lost most of their cash and instead got millions of homes with decreasing prices.
In brief:
To summarize things, the causes of the latest economic crisis is mainly due to the The failure of the subprime mortgage. The subprime mortgage failure was due to a chain reaction:
- The decrease of the interest rate by the Federal Reserve Bank back in 2001, which allowed an increased money flow, which in return encouraged borrowing at every level of the U.S. and world economies.
- Mortgage-backed securities allowed banks to sell their mortrages, therefore more mortrages can take place now.
- 1 + 2 = Good money is flowing + mortgage-backed securities = banks can issue as many mortgages as they want and they no longer have the incentive to check carefully the mortgages they issue. This means that middle- and low-income families can now get mortgages, in fact, it was possible for almost anyone to get a mortgage by 2004. And this was just irresponsible lending.
- Middle- and low-income families cannot pay their yearly amount, cannot refinance and cannot sell their homes (lower cost) due to the increase in the interest rate set by the Federal Reserve Bank and due to the nature of the The subprime mortgage that increases dramatically in 2 or 3 years (Families entered the later stages of their mortgage agreement and payments began to rise)
- More homes are foreclosing and therefore more homes are available because many people cannot pay their due amount
- Price of homes continue dropping dramatically because of the increase of supply and because the mortgage banks are selling houses at floor prices
- More families cannot afford paying their due amount and at the same time cannt sell their homes
- The whole chain is affected:
- Families cannot pay their annual due amounts
- Homes are foreclosing
- Banks are losing money (no more income from their customers)
- Wall street companies owning the majority of the Mortgage-backed securities are losing billions of Dollars due to these Mortgage-backed securities!
- The crisis goes global, and affects most of the markets in the world
Now another problem is happening. All the money that was suppose to go for new buildings and development, or pension funds that earn income.. has dried up. The same buildings that drives the American economy has come to a grinding halt.
All of the workers that had been getting paid are being laid off or finding there is nothing to build and now THEY are having problems making payments.
As a result over one hundred subprime mortgage lenders have failed or are filing for bankruptcy. New Century Financial Corporation, previously the nation's second biggest subprime lender is one of them. This adds to the problem. Even the companies that foreclose house's are going bankrupt. Over $6 TRILLION in mortgage's have gone belly up - BLINK - disappeared!
Of course with the HUGE banks having problems with money this trickles down to the smaller banks and this is why the Fed want to spend $700 billion of your money to help the Financial sector out of their mess and buy all of these bad loans and stabilize things.
Reference:
What are mortgage-backed securities, anyway? - By Chris Wilson - Slate Magazine
Mortgage-backed security - Wikipedia, the free encyclopedia
Public Enemies - Columbus: SubPrime Crisis 101
Economic Crisis 101 | NYU Local
FOXNews.com - Mike Baker: Subprime Crisis Explained - Opinion
BBC NEWS | Business | The US sub-prime crisis in graphics
The Subprime Meltdown- An Explanation
The Subprime Crisis Part II- Recent Events
A Simple Explanation of the Subprime Crisis Part 1 - InformedTrades
A Simple Explanation of the Subprime Crisis Part 2 - InformedTrades
Subprime Crisis Explained Simply Part 3 - InformedTrades
Notes from the Panopticon: A really simple explanation of the sub-prime mortgage crisis
Panic on Wall Street | Salon Technology
Simple Way to Explain Subprime Crisis
Free Money Finance: How the Subprime Lending Meltdown Happened
Sub Prime Crisis รข€“ what is it? And why it made the US market to crash? | Forex Trading TV Video Blog
Economic Crisis 101 | NYU Local
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