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Financial Crisis For Beginners

October 16th, 2008 1:50 PM by Lehel Szucs

Here is a good article that helps explain why we are in trouble and gives everyone an idea as to how the loan business works behind the scenes.


Everywhere I go, people ask me how we got into this financial crisis that has seized up credit and driven the stock markets down 40% or more, most of it in just the last few weeks. Obviously, the simple answer is that the housing bubble burst, and as home prices tumbled, mortgage delinquencies and home foreclosures spiked, and banks and other financial institutions got into trouble. In fact, many have failed.

Millions of Americans do not understand many of the financial terms that are used to identify many of the mortgage-related instruments, nor how intertwined all of the major banks and financial institutions are. This lack of understanding and confusion make the fear even worse. This is one big reason for the collapse in the stock markets.

I recently ran across the following very good explanation of the financial/credit crisis at BaselineScenario.com. BaselineScenario.com is a very useful website/webblog that was founded by Peter Boone, an Associate at the Centre for Economic Performance at the London School of Economics, Simon Johnson, former chief economist of the International Monetary Fund and professor at the MIT Sloan School of Management, and James Kwak, a former McKinsey consultant and co-founder of Guidewire Software. These are some smart guys.

On their website, they have a lot of useful information, including the article reprinted below entitled Financial Crisis For Beginners. This article explains in understandable language many of the intricacies of the credit markets, along with some of the technical terms such as CDOs, CDSs and others. If you want to better understand the credit crisis, this is a good place to start.

Finally, since their website is also a blog, I would suggest that you visit there at least occasionally to keep up with their latest thinking on the global credit crisis.

Financial Crisis For Beginners

We believe that everyone should be able to understand how the financial crisis came about, what it means for all of us, and what our options are for getting out of it. Unfortunately, the vast majority of all writing about the crisis - including this blog - assumes some familiarity with the world of mortgage-backed securities, collateralized debt obligations, credit default swaps, and so on. You've probably heard dozens of journalists use these terms without explaining what they mean. If you're confused, this page is for you… (Some of the explanations on this page are simplified and not 100% accurate; their goal is to explain the key concepts to a general audience.)

Historically local banks took deposits from savings account customers and lent money to homebuyers. They paid 1% for the savings accounts and collected 6% on the mortgages, and the spread (5 percentage points in this case) was more than enough to compensate for any homebuyers who couldn't pay their mortgages. (The numbers are illustrative only.)

Then, as any explanation of the subprime crisis says, banks started reselling and securitizing mortgages. But what does it mean to resell (let alone securitize) a mortgage?

To understand this, you have to look at it from the bank's point of view. To them, a mortgage is a product. This product gives them a monthly stream of payments - about $1,000 per month for a 30-year, fixed-rate mortgage on a loan amount of $150,000 (numbers are very approximate), but that stream is not guaranteed; the homebuyer might not be able to pay (in which case they might have to renegotiate or foreclose, both of which are costly), or might pay the whole thing [off] early. The price they pay for this product (this stream of payments) is just the loan amount; from their perspective, they are "buying" the stream of payments by paying you the loan amount. The lower the interest rate you get, the higher the price they are paying for your payments.

If Bank A resells your mortgage to Bank B, Bank B buys your payment stream from Bank A in exchange for a lump sum of money. Under stable market conditions, the lump sum that B gives A will be about the same as the lump sum you received from A (in which case A only makes money from various fees). You can also think of this as Bank B loaning you the money for your house, with Bank A acting as an intermediary.

Now, in practice, Bank B (or C, or D, …) is often an investment bank. And Bank B often securitizes your mortgage. This means they take your mortgage and combine it with many (thousands of) similar mortgages. If the mortgages are similar according to certain objective criteria - creditworthiness of borrowers, loan-to-value ratios, etc. - they can be treated as homogeneous. (Something similar happened with corn in the 19th century; certain standards were established for different grades of corn, and from that point bushels of corn from different farms didn't have to be separately shipped and inspected by buyers, but could be poured together into huge vats.)

Now you have a pool of, say, 10,000 mortgages, with about $10 million in payments coming in from borrowers every month. That pool as a whole has a price - the amount someone would pay to get all of those payment streams of that riskiness. In a securitization, the investment bank divides the pool up into many small slices [also referred to as tranches] - say 1,000 in this case. Each slice can be bought and sold separately, and each slice entitles the buyer to 1/1,000th of the payments streaming into that pool.

The price of these slices is based on current assumptions about the riskiness of those payments - the riskier those payments are perceived to be, the lower the price anyone will pay for a slice of them. The problem is that at the time those mortgages were securitized, the buyers assumed that housing prices could only go up, and therefore the payments were not very risky; when housing prices began to fall, many more borrowers became delinquent than had been expected. As a result, if you own a slice of that pool, you still own 1/1,000th of the payments coming in, but your expectations of how many payments will come in are much lower than they were when you bought the slice.

(A collateralized debt obligation [CDO] is a securitization where the slices are not created equal. Some slices are entitled to the first payments that come in each month, and hence are the safest; some slices only get the last payments that come in each month, so when people start defaulting, those are the slices that lose money first.)

This brings us to writedowns and, eventually, to the subject of banking capital. Let's say you are an investment bank and you paid $1 million for a slice of a securities offering (a pool). You put that on your books as an asset (in the world of finance, a stream of payments coming to you is an asset) valued at $1 million. However, a year later, that slice is only worth $200,000 (you know this because other people selling similar slices of similar pools are only getting 20 cents on the dollar). You generally have to mark your holding to market (account for its current market value), which means now that asset is valued at $200,000 on your balance sheet. This is an $800,000 writedown, and it counts as a loss on your income (profit and loss) statement. And that is what has been going on over the last year, to the tune of over $100 billion at publicly traded banks alone.

The next problem is that, over the last two decades, most of our banks have become giant proprietary trading rooms, meaning that they buy and sell securities for profit. Let's say you start a bank with $10 million of your own money. That's your "capital." You go out and borrow $90 million from other people, typically by selling bonds, which are promises to pay back the money at some interest rate. Then you take the $100 million and buy some stuff (like slices of mortgage pools), which pays you a higher interest rate than you are paying on your bonds. Suddenly you are making money hand over fist. But then let's say that housing prices start falling, securitized subprime mortgages start plummeting in value, and your $100 million in assets are now only worth $80 million. Since the value of your debt ($90 million) hasn't changed, you are technically insolvent at this point, because your losses exceed your capital; put another way, the money coming in from your slices of mortgage pools isn't enough to pay your bondholders.

According to some observers, this is where Fannie and Freddie were until they were bailed out by the U.S. government; by certain accounting rules, they had negative capital.

Crises of confidence and bank runs

The discussion above describes how a bank can become technically insolvent - that is, their assets become worth less than their liabilities. However, since the Lehman bankruptcy on September 15, the crisis has moved into a new phase. In this phase, financial institutions are facing liquidity runs, or bank runs, whether or not they are solvent. How can this happen?

To understand this, first you have to understand the time dimension of assets and liabilities. A 30-year mortgage, for a bank, is a long-term asset. They will get a mortgage payment every month for 30 years and, most importantly, they can't call in the loan before then; that is, they can't demand that the homeowner pay it back [early]. Bank assets have different maturities, or durations, but a lot of them are medium and long term. On the other side, banks have liabilities with different maturities. For example, deposits (savings accounts) can be withdrawn at any time, so their maturity is essentially instant. Banks also issue bonds: in exchange for some money up front, the bank typically has to pay the bondholder (lender) a fixed monthly payment for some period of time, and then pay back the face value at the end of that period. Banks also engage in many more exotic forms of financing, such as repo agreements, where the bank sells a security to a counterparty for $99 and promises to buy it back for $100 some time later.

The general point, though, is that banks tend to borrow short and lend long. In the classic case, the bank takes money from depositors and loans it out as mortgages. The bank may have $100 in deposits and may lend $80 of it out as mortgages, which means it has $20 in capital and a leverage ratio (assets to capital) of just 5, which is pretty low, and it is very solvent on paper. But do you see the problem? If every depositor tries to withdraw his money at the same time, the bank can't call in its mortgages, and there won't be enough cash for everyone. Now why would this happen, since it is unlikely that everyone will need his cash at the same time? It happens if each depositor starts worrying that his or [her] money might not be safe, and that every other depositor will try to withdraw money, then everyone tries to withdraw his money at the same time.

In ordinary times, bank runs don't happen. First, the FDIC insures all deposit accounts up to $100,000 [now $250,000] per account holder, precisely to prevent this kind of panic. However, in a real bank many of the liabilities are not deposit accounts and hence are not insured. Second, banks can ordinarily borrow money "against" their assets; that is, a bank with $100 in good mortgages can borrow almost $100 from another bank - or, under certain conditions, from the Federal Reserve - by pledging those mortgages as collateral. If the bank's assets are securities - mortgage-backed securities or CDOs, for example - they can also be used to raise short-term money.

These are no ordinary times, however. The fundamental problem is that all players in the financial system have realized that a bank that is solvent (assets > liabilities) can still be subject to a bank run. Once that happens, Bank A doesn't want to lend money to Bank B for two reasons: first, Bank A wants to hold onto its cash in case it becomes the target of a bank run; and second, Bank A is afraid that Bank B could be the target of a bank run, and hence is afraid that if it lends to Bank B it won't get its money back. Like all such panics, of course, this becomes self-fulfilling: because banks don't want to lend, banks can't get short-term credit, which makes them vulnerable.

This hits home when a bank has to "roll over" its short-term liabilities. Remember, banks borrow short and lend long. So periodically - almost continuously, in fact - banks have to pay off and replace their short-term liabilities (or just agree with the lender to extend the loan another 30 or 90 days). And even though depositors are insured, all the other liabilities are not insured. The bank run happens when none of the short-term lenders want to extend their loans, and no one else is willing to offer a short-term loan.

In short, this is what has been going on during the last few weeks. The key characteristic of such a crisis is that banks can be hit by bank runs - and go bankrupt - even if their assets are worth more than their liabilities. The Fed has vastly expanded the amount of money it is willing to lend to banks and the range of collateral it is willing to take in an effort to provide the short-term funding banks need to fend off bank runs. In the longer term, though, the Fed is a relatively small player combined to the entire market for short-term credit, and the problem will not go away completely until that market is working properly again.

Credit default swaps

A credit default swap (CDS) is a form of insurance on a bond or a bond-like security. A bond is an instrument by which companies raise money. A company, say GE, issues a bond with a face value of $100 and a coupon of, say, 6%. This means that if you hold the bond, they will send you $6 per year (6% of $100) until the bond matures (say in 10 years); at that point, they will pay you $100 (the face value). To buy that bond, you pay them about $100. If you pay exactly $100, the yield is 6% ($6 divided by $100). If you pay less, the yield is more than 6%. How much the bond actually sells for depends on how risky you think GE is (the chances that they will go bankrupt and won't pay you) and on what interest rates you can get for other, similarly-risky bonds in the market. Bond-like securities, like CDOs, are similar in these basic respects.

When you buy a bond, you are taking on two types of risk: (a) interest rate risk and (b) default risk. Interest rate risk is the risk that interest rates in general will go up. If interest rates go up, the value of your bond goes down (bonds are traded in the secondary market), because you are still only getting $6 per year. Default risk is the risk that the bond issuer goes bankrupt and doesn't pay you back. A CDS is called a "swap" because you are swapping the default risk - but not the interest rate risk - to another party, the insurer. The bond holder pays an insurance premium - typically quoted in basis points, or one-hundredths of a percentage point, per year - to the insurer. In exchange, the insurer promises to pay off the bond if the issuer goes bankrupt and fails to pay it off. At the time the CDS goes into effect, the expected value of the premium payments (a small amount every year) should exactly equal the expected value of the insurance payments (a large amount, but only if the issuer defaults).

This sounds pretty simple, right? So how did CDS become a dirty word? There are two main wrinkles to be aware of.

First, in order to buy a CDS (I call the bondholder in the above example the "buyer," and the insurer the "seller"), you don't actually have to own the bond in question. These are over-the-counter derivative contracts, which means they are individually negotiated between buyers and sellers. As a result, CDS became the tool of choice for betting on the likelihood of a company going bankrupt. If you thought the chances of company A going bankrupt were higher than everyone else thought they were, you would buy a CDS on company A. Three months later, when everyone else realized company A was in trouble, the market prices for CDS would have gone up, and you could either sell your CDS to someone else at the higher price, or you could sell a new CDS at the higher price. (In the latter case, you still have your original contract, and you [write] a new contract with a new buyer.) As a result, there are a lot of CDS out there; estimates are generally around $60 trillion, which means the total face value of the bonds insured is $60 trillion.

Second, CDS are not regulated, and in fact there was a measure inserted into an appropriations bill in December 2000 that blocked any agency from regulating them. Traditional insurance, by contrast, is highly regulated. Insurers have to maintain specific capital levels based on the amount of insurance they have sold; certain percentages of their assets have to be investments of specified quality levels; and, for personal insurance and workers' compensation at least, private insurance companies are generally backed up by state guarantee funds, which charge a percentage of all insurance premiums and, in exchange, pay off claims for bankrupt insurers. The CDS market had none of that, so a bank could sell as many CDS as it wanted and invest the money in anything it wanted.

So, 2008 rolled around, and bonds started going bad. There were CDS not just for traditional corporate debt, but also for mortgage-backed securities, CDOs, and secondary CDOs. During the boom, when everyone was optimistic, CDS for these exotic products were cheap; when they started failing, the price of CDS shot up, and anyone who had sold these swaps was looking at losses on them. So CDS were one way that losses on subprime mortgages triggered writedowns at other financial institutions. This only got worse as banks, such as Bear Stearns and Lehman, started failing, and people who had sold CDS on their debt faced even larger losses. So the most basic problem with CDS is that the insurers selling them (and many of the companies selling them were not insurance companies) sold them at excessively low prices, and now they are facing major losses.

Second, you have the risk that the insurance companies won't be able to pay. If a financial institution - say, AIG - sold a lot of CDS based on the debt of a particular company - say, Lehman - there is a risk that it won't be able to honor all of those swap contracts. In that case, their counterparties - other banks - may be looking at losses they thought they were insured against. If Bank B bought a CDS from Bank C on the debt of Company X, and Company X defaults, Bank B thinks it has a payment coming to it from Bank C; but if Bank C doesn't have the cash, Bank B won't get its payment. Even worse, let's say Bank B bought a CDS from Bank C, and then sold a different one to Bank A. Bank B thinks it is perfectly hedged, and Bank A thinks it has a payment coming. But if Bank C can't pay out, Bank B may not be able to pay Bank A - and these chains can go on and on and on. So CDS are one of the things that create uncertainty in the banking sector; a bank may look healthy, but it may be counting on CDS payouts from other banks that you can't see, so you can't be sure it's healthy, so you won't lend to it.

The cumulative effect of CDS is to spread risk, which sounds good, but to spread risk in unpredictable and invisible ways. One of the major reasons why the government refused to let AIG fail - one day after letting Lehman fail - was that AIG was a large net seller of CDS, and if it had defaulted on those swaps no one could predict what the implications would be for the rest of the financial sector. At this point in the financial crisis, it would be a mistake to blame the whole thing on CDS, but they have had the effect of amplifying and spreading uncertainty in ways that have reduced confidence in the financial sector.

Stock market vs. credit market

Fears of a global economic slowdown are reflected in the stock market. Stocks are claims on the future cash flow of companies, and companies do better during economic growth periods than during recessions. When sentiment shifts from the belief that we will see a short, mild recession to the belief that we will see a long, harsh recession, the stock market goes down. By contrast, the acute credit crunch is reflected in the credit market in the record-high prices that banks are charging to lend to each other and to ordinary companies.

Although you and I and most people with investments have more money in the stock market than in the credit market, the stock market is more a gauge of sentiment than an independent force in the economy. Lower stock prices make it more expensive for companies to raise equity capital, but most companies raise more money by issuing debt than by issuing stock. And when people's investments go down, they tend to spend less, but only a little; if their 401(k) goes down by $10,000, they don't cut back on spending by $10,000. The credit markets, by contrast, have direct and immediate effects on how companies behave; in an extreme case, no credit can mean no cash with which to make payroll.

Now the credit and stock markets are related, because when the credit market freezes up, people's expectations about the future turn downward, and hence stock prices fall. Ironically, all the attention the credit crisis has gotten over the last three weeks has undoubtedly hurt stock prices because of all the talk about potential dire consequences. So in this context, what does the fall in the stock market mean? Probably two things. First, people are only beginning to realize that Europe is in big trouble - given its difficulty in coming up with coordinated economic policy, perhaps bigger trouble than the U.S. Because U.S. companies operate in a global economy, that will hurt all companies. Second, it means that more people are realizing that the Paulson plan is only a partial solution, which is something we (along with many other people) have been saying for a while.

As long as the credit market remains tight, fears of recession will remain high, and stock prices will suffer. The important question is when the credit market will loosen up. Right now it looks like there are still enough open issues with the Paulson plan (what price, which securities, how fast) that lenders are still waiting and seeing. In the long term, though, the stock market will only turn up when people believe there is a credible plan for fighting the recession in the real economy. END QUOTE

I hope the information in this SPECIAL ISSUE of Forecasts & Trends E-Letter has been helpful to you in better understanding the global credit crisis we are in. Feel free to forward and share with others as you see fit.

My thanks to the folks at BaselineScenario.com. As noted at the beginning, since their website is also a blog, I would suggest that you visit there at least occasionally to keep up with their latest thinking on the global credit crisis.

Wishing you better times,

Gary D. Halbert

Posted in:General
Posted by Lehel Szucs on October 16th, 2008 1:50 PM



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