Economics Tuesday: The Economic Crisis

Well, folks, its been a while since I updated my blog, and even longer since an economic Tuesday Blog. Why has it been so long? Meh, I'm lazy and I've been busy. Down to the topic: Why is the economy in the toilet?

Well, I am going to attempt to explain that to the best of my understanding and ability. So, a while ago, at the end of the Clinton years and the beginning of W's years, the economy started to slow down (the internet bubble was bursting). As a result, G.W. gave just about every U.S. citizen a $300 check and the Paragon of Central Banking, Alan Greenspan, lowered the Fed Funds Rate. These two measures were taken to jump-start the economy; and the were moderately successful. While the $300 check's effect is debatable, the consequences of the rate cut, both intended and otherwise, are quite apparent. As money loosened through the middle of 2001 the economy started to strengthen, as banks were willing to take more risk because their Cost of Capital was cheaper. The Federal Reserve (The Fed) was aggressive in their rate cuts to deal with the imploding Internet bubble; and then some whack jobs flew planes into the World Trade Center Towers. The 9/11 attacks sent a barely recovering economy into a full-on crash (no pun intended); and then the Fed got to cutting the Fed Funds Rate in earnest. An initial problem with this is that the Business Community got used to the low Fed Funds Rates; any time the rates were raised the Market punished stocks. So there was a lot of pressure on the Fed to keep rates low, and the pressure came from all side.

Here is how this plays into the current crisis: when the Fed lowers the Fed Funds Rate, the lower rate is eventually reflected in home loans. This made it quite cheaper to borrow money to buy a home. This started to put price pressure on homes to the upside: think about it this way, a perspective home owner would have to pay $1,153 a month for a $150,000 home at 8.5%, the same buyer could afford a $203,000 home for $1,152 a month at 5.5%. So, this increase in people’s ability to get money allowed them to start to pay a little bit more for the same house (it is hard to think someone would pay $203k for a $150k house; however, it isn’t unthinkable for them to pay, say $161k for the house if they really wanted it; a 7.3% premium).

The cheapness of money was on key factor to the credit crunch / housing collapse. Another key factor is the easing of eligibility of credit; the banks made it easier for people with lower credit scores to get good rates. When housing prices started to rise, banks started to make more money on their loans, and once the bulk of the credit worthy borrowers had refinanced and/or bought new homes, the banks had to find new people to lend to keep the money coming in. Banks decided to make it easier for less credit worthy people to get decent rates; and thus lower the eligibility to qualify for, and lowered the rate charged to the dreaded SUBPRIME borrowers. The banks were not being completely reckless with this idea, before the wild lending days of the mid-2000’s, the Federal Government forced lenders to lend to low-income individuals in traditionally disadvantaged groups through special programs. The analysis of this debt showed that these lenders were not much worse on default than traditional borrowers and the Federal Government provided a backstop. So the banks started giving subprime borrowers cheaper money. Guess what this did: it cause housing prices to go up.

This positive pricing pressure caused home prices to go berserk in hot markets. Notably, housing price went through the roof in Las Vegas, southeast Florida, and southern California. And this created the issue that proved fatal: high risk loans to suspect borrowers. Like any good addict, the housing industry kept doing more and more to catch the same buzz. Cheap money to legit borrowers, gone. Cheap money to subprime borrowers, gone. And now, housing prices were so high that legit, and subprime borrowers couldn’t afford the houses at normal rates….. Enter ARMs/Option ARMs; Adjustable Rate Mortagaes, that’s the ticket.

The beauty of the ARMs are what make them so dangerous, and what sent a hot housing market in to fully overheated mode. An ARM operates likes this, one can borrow a huge amount of money at an excessively cheap rate for an introductory period, usually two years (which is soooooo evil, in itself), and then mortgage adjusts to the Prime Rate plus some percentage. Using the old example, let say our guy can borrow for a introductory rate of 2%, so for his $1,153 he can afford a $312,000 home for two years, and if his rate adjusts to 9.5%, he has to pay $2.326 a month. The reason 2 years is evil is this: if you own your primary residence for two or more years, and sell it for a gain, you don’t owe capital gains taxes. The ARM loan was developed to encourage people to buy houses with the intention of selling them for a gain in two years, and if they didn’t; they’d be crushed by the new rate.

A very important part of the puzzle, and perhaps the hardest to understand, is the securitization of the home loans. Freddie Mac and Fannie Mae are companies that would buy up home loans, convert their payments into bonds, and sell the bond to investors. Here is the how and why. The how is like this, if you are giving me a payment of $100 in a year, and I need $90 now, I can sell your $100 obligation to me to an investor for, let’s say, $95. I have $5 more than I need, and the investor get an extra $5 in a year. Now, the math for determining the amount someone is going to pay for the obligations of a home loan is complicated, but essentially it is just selling a future obligation today. The why is this; a bank has to get the principle back on a loan as quick as possible so it can lend it out again, so a way to speed up this process is selling a receivable. So, if Local Bank give me a mortgage at 5.5%, and sells it to Fannie or Freddie at 3.5%, Local bank makes 2% on the loan. Fannie and Freddie take all of those obligations, bundle them together, and sell them as bonds. Think of it as them reselling it again at 3.25% to other investors. (Making only 0.25% doesn’t sound like much, but when they do this with trillions, yes, trillions, of dollars of mortgages, 0.25% ends up being a lot of cash)

The problem started when people refused to keeping paying more for the same houses. Builders kept building, house flippers kept trying to flip houses, and brokers kept trying to sell Adjustable Rate Mortgages; but people kept demanding less. Like any good, when less housing is demanded, the price of housing falls. The only problem is that those damn ARM loans started to adjust up after two years. The US Post Office carrier that was living in a $400,000 home he wanted to flip couldn’t afford it anymore; so the bank took it back. So Freddie and/or Fannie couldn’t make the payment on the bond they issued with the house as collateral. When the bond became less valuable, the banks that made big bets on these bonds saw their returns go from largely positive to largely negative. These banks became less credit worthy because they had too few assets to cover their debts because their assets became largely worthless. Other banks became scared of doing business with these banks because they are less credit worthy. Then there it was, these banks that were century old going concerns became cash poor in short order because other banks were scared of doing business with them; and when a bank is cash poor it is a dead bank.

Everyone is point to the executives at Wall Street as the culprits, but as far as I can see, there are a lot of people out there that share some of the blame: the Fed for cheap money, banks for loosening credit standards, brokers for lending money to speculators, borrowers for speculating and/or trying to get into a house they can’t afford, Freddie and Fannie for buying too much junkie subprime mortgages, investment professionals for putting too much trust in subprime backed bonds, and some other elements. Yeah, greed and the need to make the next quarter’s earning did drive some of this; but it is a bit simplistic to heap all of the blame on them.

Later,

B

Very happ!

So I got to have a great week with my brother. I got to hang with him, cut up with him, see the Dark Knight with him, etc. I am glad that he is enjoying his time Korea; but I sure do hope he comes home in April. Man, I hope he comes home.

Today is a good day

Like the poet Ice Cube says, "I have to say, it is a good day."

Today is the day that my little brother, Luke, comes home from Korea. I haven't seen him since April of 2007, so its been a while. I can't wait to hang out with him, shoot the breeze, play video games, etc. It is a good day.

Peace out,

B