This is a lengthy post, but I hope you’ll find the subject as interesting as I did.
One of the good things about my riding the bus last night was that I was able to listen to the Lehrer News Hour on my Sony walkman while reading a novel (I am a multi-tasker).
Paul Solman, the News Hour’s Economic correspondent, did a terrific job of explaining the housing crisis and why it’s happening. I knew bits and pieces of it, but he put it together so nicely I wanted to share.
Here are the points he made (I ended up taking notes) along with some additional points from today's New York Times:
The present situation is the result of Wall Street moving into the mortgage market. In the past, mortgages were the sole province of the banking industry, which is VERY heavily regulated.
Following the end of communism and the development of more global markets like India and China, there was a great deal of foreign capital available for investment.
Because the U.S. had a history of housing prices going up and good interest rates, the mortgage industry was a logical place for foreigners to put their excess dollars. A secondary market developed with brokers buying mortgages and pooling them together into instruments called collateralized debt obligations (CDOs). Mortgages were securitized; turned into salable securities.
Unlike the banking industry, this new secondary market was essentially unregulated, but because the U.S. housing market was so stable, it was very attractive to investors seeking high rates of return and low risk.
The security firms doing the packaging mixed the mortgages up. Rather than separating the high risk mortgages from the low risk mortgages, they sold them together in a pooled bond. This pool helped to spread the risk out over a group of investors. The broker then asked the individual investors to decide on the level of risk they were willing to take. If the investor was willing to take a low-rated mortgage like a B-, he could get 18% interest. This is called the subprime market, or below the prime market.
However, along with that high rate of interest came a catch. That investor receiving the 18% rate had to agree to swallow any losses incurred by mortgages defaulting within the CDO. In other words, the higher the level of interest the investor wanted to earn, the greater the level of risk she assumed when foreclosures occurred within the bond. The investor who wanted to invest in safe
A-rated bonds became the last man standing when the money was handed out. The entire instrument had to crash before he took a hit.
These mortgage bonds became enormously popular because, of course, U.S. housing prices continued to climb. Mortgage companies didn’t mind lending money to risky prospects because they were going to sell the mortgages to the secondary market anyway. They offered incentives like teaser rates and low down payments to new home buyers. And--remember--this was all happening outside of the banking industry so it was largely unregulated. No one stepped in to stop the crazy escalation.
Everyone got into the secondary market for mortgages. Late night television even offered programs teaching ordinary citizens how to flip (buy and immediately sell) properties for profit. The deals got more and more unstable, but everyone trusted the strong housing market to absorb the risk.
It was inevitable that the unsophisticated people who had bought into the crazy deals being offered would eventually crash and burn. Balloon payments came due and mortgage holders couldn’t make the payments. First-time buyers, buyers who’d bought too much home and buyers who were poor credit risks began to go into foreclosure. The CDO-holders suddenly found themselves on the losing end of the deal.
Solman made a point of saying that the word “credit” comes from a Latin word whose root is “to believe.” The credit system is based on the faith that everyone has in it. Once that faith is lost, investors begin to bail out (remember the bank runs of yore?). The result of all these CDOs falling apart has been a stock market experiencing enormous fluctuations.
Wall Street has been looking to Federal Reserve Chairman Ben Bernanke to provide some direction and reassurance. Both he and President Bush have spoken multiple times about the risk-takers and con artists who have created this problem.
Today, both men spoke out. Yahoo News reported:
Federal Reserve Chairman Ben Bernanke pledged Friday that the central bank will "act as needed" to keep the credit crisis that has unhinged Wall Street from hurting the national economy . . . Even as Bernanke vowed Fed action, he sought to temper investors' expectations.
"It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions," Bernanke said. "But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy."
In a related story, the Associated Press reported:
President Bush on Friday announced a set of modest proposals to deal with an alarming rise in mortgage defaults that have contributed to turbulent financial markets over recent weeks . . . Officials in the troubled housing industry said the important thing was that the administration had finally offered a proposal, a step they said should help calm global financial markets that have been on a rollercoaster ride in recent weeks as investors worried about a serious credit crunch . . .
“It’s not the government's job to bail out speculators or those who made the decision to buy a home they knew they could never afford," Bush said in the Rose Garden. "Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders or a little help from their government."
Paul Solman closed his piece by pointing to that old saw, “the higher you fly, the farther you fall.” In this case, the greater the investment return demanded, the higher the risk the investor must take--and then live with.