ECONOMIC VIEW
Confused over the credit crisis? You're not the only one
By David Leonhardt
Published: March 19, 2008
http://www.iht.com/articles/2008/03/19/business/leonhardt.php
Raise your hand if you don’t quite understand this whole financial crisis.
It has been going on for seven months now, and many people probably feel as if
they should understand it. But they don’t, not really. The part about the U.S.
housing crash seems simple enough. With banks whispering sweet encouragement,
people bought homes they couldn’t afford, and now they are falling behind on
their mortgages.
But the overwhelming majority of homeowners are still doing just fine. So how
is it that a mess concentrated in one part of the mortgage business - subprime
loans - has frozen the credit markets, sent stock markets gyrating, caused the
collapse of Bear Stearns, left the U.S. economy on the brink of the worst
recession in a generation and forced the Federal Reserve to take its boldest
action since the Depression?
I’m here to urge you not to feel sheepish. This may not be entirely comforting,
but any confusion you might have is shared by many people who are in the middle
of the crisis.
“We’re exposing parts of the capital markets that most of us had never heard
of,” Ethan Harris, a top Lehman Brothers economist, said last week. Robert
Rubin, the former Treasury Secretary and current Citigroup executive, has said
that he hadn’t heard of “liquidity puts,” an obscure financial contract, until
they started causing big problems for Citigroup.
I spent a good part of the last few days calling people on Wall Street and in
the government to ask one question: “Can you try to explain this to me?” When
they finished, I often had a highly sophisticated follow-up question: “Can you
try again?”
I emerged from it thinking that all the uncertainty has created a panic that is
partly irrational. That said, the crisis isn’t close to ending. Ben Bernanke,
the Fed chairman, won’t be able to wave a magic wand and make everything
better, no matter how many more times he cuts rates and cheers Wall Street. As
Bernanke himself has suggested, the only thing that will end the crisis is the
end of the housing bust.
So let’s go back to the beginning of the boom.
It really began in 1998, when large numbers of people decided that real estate,
which still hadn’t recovered from the early 1990s slump, had become a bargain.
At the same time, Wall Street was making it easier for buyers to get loans. It
was transforming the mortgage business from a local one, centered around banks,
to a global one, in which investors from almost anywhere could pool money to
lend. The new competition brought down mortgage fees and spurred innovation,
much of which was undeniably good. Why, after all, should someone who knows
that they’re going to move after just a few years have no choice but to take
out a 30-year, fixed-rate mortgage?
As is often the case with innovations, though, there was soon too much of a
good thing. Those same global investors, flush with cash from Asia’s boom or
from rising oil prices, demanded good returns. Wall Street had an answer:
subprime mortgages.
Because these loans go to people stretching to afford a house, they come with
higher interest rates for the borrowers - even if they’re disguised by low
initial rates - and thus higher returns for the lenders. These mortgages were
then sliced into pieces and bundled into collateralized debt obligations, or
CDOs. Once bundled, different types of mortgages could be sold to different
groups of investors.
Investors then goosed their returns further through leverage, the oldest
strategy around. They made $100 million bets with only $1 million of their own
money and $99 million in debt. If the value of the investment rose to just $101
million, the investors would end up doubling their money. Home buyers did the
same thing, by putting little money down on new houses, notes Mark Zandi of
Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible,
sharply reducing interest rates, to prevent a double-dip recession after the
technology bust of 2000, and then keeping them low for several years.
All these investments, of course, were highly risky. Higher returns almost
always come with greater risk. But people - by “people,” I’m referring here to
Greenspan, Bernanke, the top executives of almost every Wall Street firm and a
majority of American homeowners - decided that the usual rules didn’t apply
based on the idea that home prices nationwide always rise. And they did rise
ever higher, so high, says Robert Barbera of ITG, an investment firm, that they
were destined to fall. It was a self-defeating prophecy.
And it largely explains why the mortgage mess has had such ripple effects. The
American home seemed like such a sure bet that a huge portion of the global
financial system ended up owning a piece of it. Last summer, many policy makers
were hoping that the crisis wouldn’t spread to traditional banks, like
Citibank, because they had sold off the underlying mortgages to investors. But
it turned out that many banks had also sold complex insurance policies on the
mortgage debt. That left them on the hook when homeowners who had taken out a
wishful-thinking mortgage could no longer get out of it by flipping their house
for a profit.
Many of these bets were not huge. But they were often so highly leveraged that
any losses became magnified. If that same $100 million investment I described
above were to lose just $1 million of its value, the investor who put up only
$1 million would lose everything. That’s why a hedge fund associated with the
prestigious Carlyle Group collapsed last week.
“If anything goes awry, these dominos fall very fast,” said Charles Morris, a
former banker who tells the story of the crisis in a new book, “The Trillion
Dollar Meltdown.”
This toxic combination - the ubiquity of the bad investments and their
potential to mushroom - has shocked Wall Street into a state of deep
conservatism. The soundness of any investment firm rests in large part on the
confidence of other firms that it has real assets standing behind its bets. So
firms are now hoarding cash instead of lending it, until they understand how
bad the housing crash will become and how exposed to it they are. Any
institution that seems to have a high-risk portfolio, regardless of whether it
has enough assets to support the portfolio, faces the double whammy of
investors demanding their money back and lenders shutting the door in their
face. Goodbye, Bear Stearns.
The conservatism has gone so far that it’s affecting many solid, would-be
borrowers, which, in turn, is hurting the broader economy and aggravating Wall
Street’s fears. A recession could cause automobile loans, credit card loans and
commercial mortgages to start going bad, as well.
Many economists, on the right and the left, now argue the only solution is for
the federal government to step in and buy some of the unwanted debt, as the Fed
began doing last weekend. This is called a bailout, and there is no doubt that
giving a handout to Wall Street lenders or foolish home buyers - as opposed to,
say, laid-off factory workers - is deeply distasteful. At this point, though,
the alternative may, in fact, be worse.
Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep
economic downturns, which is why the Fed has been taking unprecedented actions
to restore confidence.
“You say, ‘My goodness, how could subprime mortgage loans take out the whole
global financial system?’ “ Zandi said. “That’s how.”
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