Economy

The Finance Crisis in Eight Painful Steps

By Ryan McGreal
Published September 25, 2008

So why are all these financial institutions in crisis? Here's what happened.

Step 1: The Setup

Joe wanted to buy a house, so he went to a mortgage broker and asked for a mortgage. His income was stagnant and his credit wasn't very good and he didn't have a down payment, but he got a mortgage anyway: a no-doc, no-money-down mortgage on an adjustable interest rate with two years of "negative amortization", meaning his monthly payments would be less than the minimum required to pay interest on the principal.

The broker found a bank who approved the mortgage and Joe signed it because house prices were increasing and it looked like they would go on increasing indefinitely (the start of the bubble). Pundits who ought to have known better were claiming that the old economic paradigm no longer applied and the market could grow forever.

Now multiply Joe by several million.

Step 2: Mortgage Guarantees

The banks had another reason for approving these risky mortgages and home equity lines of credit. The Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), both Government Sponsored Enterprises, were more than willing to guarantee over $5 trillion in risky mortgage debts, freeing the banks from obligation if the homeowners defaulted.

Other financial companies bought these mortgages off the banks, bundled them together in big blocks of securities, and sold them to still other financial companies on Wall Street.

Step 3: Mortgage Backed Securities

The Wall Street investment houses didn't just buy these blocks of securities (assuming that the homeowners at the end of the line would continue being able to make payments); they bought them on margin. That is, for every dollar they had to buy securities, they borrowed another twenty or thirty dollars and invested those, too.

Quite simply, there was very little fiduciary or regulatory oversight into whether these risky and in some cases highly exotic investments were a prudent investment. The Fed was more interested in stimulating the economy with low interest rates; the underwriting was done automatically; the credit rating agencies were asleep ... and after the Savings and Loan bailout many executives just assumed that the government would step in again if any "too big to fail" companies ended up over their heads.

Step 4: The Bubble Burst

Everyone who could remotely afford a house (and many who clearly could not) already owned one, so there were no new buyers to keep the bubble inflating.

Incomes had remained stagnant for several years but house prices had kept going up, so people were spending larger and larger proportions of their income on mortgage payments.

Many homeowners had used the rising values of their houses to borrow money against their home equity (called home equity lines of credit), so the principal on their mortgages were actually going up, not down. Net personal savings in the US fell to zero.

The introductory teaser rates on adjustable rate mortgages began to expire for many homeowners, causing their mortgage payments to jump.

Oil prices were also rising steadily, eating into scarce income through higher vehicle fuel prices and higher consumer good prices. This put a further squeeze on homeowners who were already paying as much as they could afford on their mortgages.

Interest rates started rising in response to rising inflation from energy costs, a slowing economy and a dawning realization in financial markets that many investments were actually quite risky. That caused mortgage payments to go up for everyone who was on an adjustable rate.

As demand for new houses dropped off, the prices of existing houses flattened and began to fall. People suddenly found themselves carrying mortgages for more than their houses were worth.

All these financial pressures started to force some homeowners into foreclosure and bankruptcy. This increased the supply of houses on the market as banks repossessed properties and tried to unload them, which further depressed housing prices.

Because much of the economic growth of the past several years was in the homebuilding industry, the collapse of demand for new houses threw more people out of work and slowed the economy further, which left more people vulnerable to foreclosing, which in turn fed back into the vicious cycle of falling house prices.

Step 5: Subprime Exposure

Financial institutions that had invested heavily in subprime mortgage securities started to unravel. The subprime sector was the most vulnerable because the people making payments at the end of the line were the most likely to foreclose.

One of the biggest early failures was the Bear Stearns investment bank, which declared bankruptcy after their subprime hedge funds were revealed to have lost nearly all their value. Several Bear Stearns managers have been charged criminally for defrauding their investors about the risks of those funds.

At the time, Wall Street insisted that the financial crisis was confined to the Subprime sandbox and that it wouldn't effect other parts of the industry, but foreclosure rates were also increasing among prime mortgages as people on adjustable interest rates fell behind in their ability to keep making payments.

Step 6: Socializing the Debt

Freddie Mac and Fannie Mae became insolvent. Because they were stuck guaranteeing tens billions of dollars in defaulted mortgages and could no longer finance those debts with new mortgages (since house sales had dropped off), they could no longer raise new capital.

The Federal Housing Finance Agency placed both entities into conservatorship under the FHFA, dismissing their boards and taking over their management. The US Treasury effectively assumed over $4 trillion in mortgage backed securities and over $1 trillion in debt, adding this to the existing $9.5 trillion US public debt.

Step 7: Mainstream Bankruptcies

Mainstream financial institutions started to unravel. Organizations like Merrill Lynch and Lehman Brothers started to acknowledge that they, too, had gotten in on the act and invested billions of dollars in highly leveraged blocks of risky mortgage backed securities.

Suddenly these institutions discovered that their assets - the right to collect payments on those securities - were worth as little as pennies on the dollar compared to what they had borrowed and paid to buy them.

This crisis extended to banks and financial institutions in other sectors (like AIG, an insurance company) and other countries, particularly in Europe.

Lehman declared bankruptcy - the largest bankruptcy in American history with over $600 billion in corporate assets. Merrill Lynch accepted a buyout offer from Bank of America. AIG accepted an $85 billion Federal Reserve bailout after losing some 95% of its stock value when its exposure to bad mortgage securities became known.

Step 8: The Big Bailout

Financial institutions hold untold billions of dollars in mortgage backed securities that are effectively worthless, not only because so many of them have defaulted but also because everyone's trying to unload them at the same time.

Treasury Secretary Henry Paulson insists that Congress has to approve $700 billion - chosen, according to a Treasury spokesperson, because it's "a really large number" - for the US government to act as buyer of last resort and snap up huge amounts of those crappy, devalued securities at a premium price so the financial institutions don't go bankrupt.

Paulson, a former CEO of Goldman Sachs, which stands to gain from the plan, warned that without a bailout, the financial sector itself could collapse entirely, throwing the economy into a deep, long-lasting recession and costing the government even more money in federally guaranteed bank deposits.

Under the Paulson plan, the government would end up owning up to $1 trillion in worthless securities and the financial institutions would return to solvency and profitability with those bad debts off the books.

The US Congress rejected the plan on the grounds that it essentially rewards the executives and boards of these corporations for their irresponsible and possibly even illegal management.

They are now adding conditions to the plan, including: limits on executive pay for the companies benefiting from the bailout; more assistance for homeowners facing foreclosure; government equity interest in the bailed out companies; and judicial and congressional oversight including the right to audit.

Paulson insists the bailout is necessary to solve the financial crisis, but the Congressional Budget Office argues that it could actually cause the crisis to deepen by exposing still more insolvent corporate assets.

It remains to be seen exactly how it will look when Congress approves it, but some form of bailout seems inevitable at this point.

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan wrote a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. His articles have also been published in The Walrus, HuffPost and Behind the Numbers. He maintains a personal website, has been known to share passing thoughts on Twitter and Facebook, and posts the occasional cat photo on Instagram.

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By jason (registered) | Posted September 25, 2008 at 16:58:33

I wonder if you should add one more step early on when the US passed their 'deregulation' bill regarding these companies? After all, this is a free market, capitalist democracy. We don't want the guv'ment getting in the way of private business (although we'll gladly accept their billions once our 'unregulated' greed wrecks the economy).

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By Frank (registered) | Posted September 26, 2008 at 11:21:06

I don't understand why a government chooses to bail out whining fat cats who've proven they can't handle money responsibly rather than give it to the people who actually need it!

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By ventrems (registered) | Posted September 29, 2008 at 09:03:15

"the people who actually need it" would never get the money because, every American who made their mortgage payments would be UP IN ARMS (literally, it's the US) if the defaulters were given the cash to make payments.

imagine if all credit card debt holders were given cash to make payments so Mastercard didn't go bankrupt. how would that go over?

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By Bring tha noize (anonymous) | Posted September 29, 2008 at 09:50:48

I don't know if thats true ventrems. People don't get up in arms over someone getting subsidized housing or a free transit pass if they can't afford it, hows this any different if there in crisis.

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By ? (anonymous) | Posted September 29, 2008 at 15:00:23

Have you people not considered the spill-off?

$700 billion is a gross sum of money, but it's probably a lot less than the people and economy will suffer without it.

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By ventrems (registered) | Posted September 29, 2008 at 21:25:28

Bring tha noize: this isn't subsidized housing. this is people living in houses they can't afford. that's why they're defaulting on their mortgage payments.

why should the taxpayer pay for someone to live in a house that is well above the standard of living in typical subsidized housing?

besides, people complain about subsidized housing & transit ALL THE TIME. i recall not too long ago when a number of RTH readers commented on how McMaster students pay far less for a transit pass than normal adult fares, and how that wasn't fair.

it's a contentious issue and it would be political suicide to "bailout" all of the "homeowners" who have defaulted.

though after the disaster today, we may all have to pay for the mistakes of some... hope none of you own any stocks.

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By highwater (registered) | Posted September 30, 2008 at 10:42:59

$700 billion is a gross sum of money, but it's probably a lot less than the people and economy will suffer without it.

You got that right. The stock market lost over a trillion yesterday alone. $700 billion may look like a wise investment by the time this is all over, and it may not be over for years. Scary stuff.

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By Stockwatcher (anonymous) | Posted September 30, 2008 at 14:00:49

"The stock market lost over a trillion yesterday alone. $700 billion may look like a wise investment by the time this is all over, and it may not be over for years."

As I write this the Dow Jones is up 362 points (close to 4%) today, Nasdaq is up 4% and S&P 500 is up 4.28%.

Sky: not falling at this time.

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By nobrainer (registered) | Posted September 30, 2008 at 14:03:23

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By A Smith (anonymous) | Posted October 03, 2008 at 20:45:13

You should take a look at how the US government calculates CPI (inflation) to see how this mess came about.

They use something called owner's equivalent rent, which had the effect of understating inflation during the housing bubble and overstating inflation now that home prices have tanked.

Another great example of government incompetence.

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By Uncle B (anonymous) | Posted October 04, 2008 at 18:20:16

Tender spot hurting a lot? Other side too? bruises on your face and body throbbing? Is that blood running out your nose, skirt above your head in the wind, panties torn and soiled, titties swelling and turning blue by the minute, lost on the roadside, hoping not to die? Did you recognize the tail lights of the limo that threw you off? Was it the same limo that picked you up at election time, promising a good decent clean ride? Will you ever learn? Last time these guys did this to you, your babies were killed in Iraq and your retirement fund spent to do it, your taxes went up, you did not get destroyed by the weapons of mass destruction, they were never found. Poor little America. Our heart-felt prayers from Canada go out to you!

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By Dan (anonymous) | Posted October 05, 2008 at 01:54:17

"6. Finally, it was sold using exactly the same language of fear as the Iraq War".

Wouldn't this plan benefit the government or elite at the expense of everyone else? I mean if they own all these worthless securities, they dont stay worthless forever?

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By WilliamB (anonymous) | Posted October 05, 2008 at 18:45:53

America: the last and greatest betrayer of the last and greatest of human dreams.

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By Lorenzo di Medici (anonymous) | Posted October 05, 2008 at 23:05:14

there is another step - that is where the politicians can't say no to spending. They deal with an electorate that needs instant gratification, and can not understand the concept of personal responsibility. That is why they bray for access to cheaper home loans, but only want to put down 5% and then refinance their way to millions. The Greatest Generation would not have done that, but the Least Generation does. Why not live within one's means and save for a rainy day?

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By A Smith (anonymous) | Posted October 06, 2008 at 00:57:06

Lorenzo, government today wants to be the "cool" parent, not the mean parent.

By focusing so hard on being nice to the people, government naively assumes that it will be rewarded come election time, when in fact the opposite is true.

What most people want, even if they don't say it, is discipline.

If governments can ever figure this out and stop catering to every whim the electorate throws their way, you will have a dynasty.

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By Orangesand Lemmings (anonymous) | Posted December 14, 2008 at 19:45:59

Thanks for pointing out the bullet. Now how about the smoking gun?

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