14 Causes of the Credit Crisis: A Recipe For Disaster

by Ry@SpillingBuckets on September 24, 2008

The Wall Street Financial Crisis
“A tart dish with a hint of it was only a matter of time
Serves 301,139,947
Submitted by Ryan from Spilling Buckets

Here are the 14 disastrous ingredients that have been thoroughly mixed, baked, and are ready to be served to each and every one of us. Check the cupboards, tie that apron, wash your hands and let’s begin.

Add 6 Cups – Unprecedented New Wealth: In 2000 the sum of all the world’s savings was around $36 trillion dollars. It had taken several hundred years to get to that point. In 2006, six years later, that global pool of money was now almost double at $70 trillion (many reasons but mainly countries that were once poor now made a lot of money selling TVs and oil to us: China, India, Saudi Arabia etc, and most of them banked it). All this money came with an army of nervous and twitchy managers looking for very safe ways to make that money grow.

Add 1 tsp. – Alan Greenspan: You know that safe investment all those nervous people invested in, that was mainly U.S. Treasury Bonds…..until one speech started a shift. (I quote directly from Greenspan and the This American Life transcript on this one)

Alan Greenspan: The FOMC stands prepared to maintain a highly
accommodative stance of policy for as long as needed to promote satisfactory economic performance.

Adam Davidson: You might not believe me, but that little statement: that is Central Banker speak for “Hey, global pool of money -screw you.”

Alex Blumberg: Come on, that’s not what he said

Adam Davidson: It is! I speak central banker and that’s what he’s saying.

What he’s technically saying is he’s going to keep the Fed Funds rate at the absurdly low level of one percent. It tells every investor in the world: you are not going to make any money at all on US treasury bonds for a very long time. Go somewhere else. We can’t help you.

For best results: Prepare 1 Cup Housing Bubble, sprinkle in the Community Reinvestment Act, and add to a Fannie Mae or Freddie Mac pressure cooker: Now we have all this money that’s sitting around with nowhere to go. It didn’t take long for the next best thing to catch everyone’s attention: U.S. residential mortgages. Here were these low risk and high return investments that everyone just knew couldn’t go down in value…. it had the world salivating, but, there was one problem. The last thing the global pool of money wanted to deal with was individual people and their health problems or divorces or other reasons that may stop their steady repayment… Where there is a need there is money to be made.

The American dream….Everyone deserves a home right? For many years there was a large push in government to loosen standards and allow more people to own homes. Banks, who at one time were afraid to lend to people with little or no assets and little or no income, were assuaged by the fact that two new buyers, Fannie Mae and Freddie Mac were in town and ready to buy up the sour loans immediately after sale. Not only was their pressure to lend, there was also pressure not to decline, as banks did not want to get tangled up in the appearance of discrimination or the violation of the Community Reinvestment Act.

While that is warming prepare a tart CDO sauce in a separate bowl. Combine 1/2 Cup Greed, 1 Tbl. Failed Compensation Structure, 1 tsp. Peer Pressure, a pinch of Bad Analytical Software and a dash of Faulty Credit Ratings. In an effort to cash in on a percentage of all that money out there (and they sure did) Wall Street designed a new product: The Collateralized Debt Obligation (CDO). Groups of mortgages were bought, packaged together, and sold as a single product.

Alex Blumberg: And they sold so many mortgages that there came a point in 2003 where just about everybody who wanted a mortgage and was qualified to get one …. had gotten one.

But the pool of money had just gotten started. They wanted more mortgage backed securities.

So Wall Street had to find more people to take out mortgages. Which meant lending to people who never would’ve qualified before.

Slowly one bank would loosen its lending restrictions, then others would be pressured to do the same, and so on and so forth, until there was really nothing left to loosen. A stated income, verified asset loan came out….then a stated income stated asset loan, then a no income, verified assets loan…then the mother of them all…the NINANo Income No Asset loan.

It was pretty clear that there was a lot of risk in giving someone with little income and no assets a big loan, but it didn’t matter to them because those loans were quickly bought from the originating banks, repackaged, and sold to the global pool of money and Wall Street Investment Banks. Since the brokers made a percentage of the total loan amount in commission, there was a nice incentive (for some to a tune of $100,000 a month) to approve and lend the absolute maximum amount you could, regardless of the consequences for others down the road.

Now all those money managers were not stupid, they knew that not all mortgages were the same, so they placed their trust in the credit rating agencies rating of these CDOs (all made up of different tranches, or small collections of different mortgage types, pools of pools if you will, some good loans, some crummy loans, some subprime toxic loans, all mixed together).

The credit rating agencies gave most of the CDOs a AAA rating, painting them as safe as US government bonds. They thought that if you took a pool of thousands of different mortgages, some risky, some not risky, that it would result in a money good investment. It turned out these agencies relied on historic data that did not reflect the new, low to non-existent borrowing qualification standards. [example: they looked at historical foreclosure rates and saw it was generally below 2%. So in their minds, absolute worst case it might show a 8% or a 10% foreclosure rate......Today, some are expected to go beyond 50%]

Combine CDO sauce and financial markets mixture in a baking pan. Bake at 325 degrees for 4 years: Everyone was happy and the money flowed. Bankers and brokers made tons on commissions, investment banks and the global pool was happy with a higher return, homeowners were happy with their houses they couldn’t afford and many borrowed against their rising home values through a HELOC and used this to pay their increasing monthly bills. Sounds sustainable right?

Alternative: For those who may prefer a sweeter sauce, prepare a Credit Default Swap dressing to be added after baking. For truly phenomenal results, prepare and mix both..the taste is devastating. Some say ignorance is bliss and so too is the transferal of risk to some other schmuck. A Credit Default Swap is basically an insurance policy that pays out in the event of a borrower’s inability to repay the loan. Since there is no regulation in the CDS market, instruments are bought, sold, created, bought, created, and resold many many times, often with huge amount of leverage, without anyone actually having the money set aside to make good on their promise if something does default. In mid 2007 there were over $45 Trillion dollars in CDS‘s floating around, that was twice the size of the entire United States stock market. Tell me where is all that money to make good on the promises?

Remove from oven, let cool, Serve on a chilled plate with a garnish of an election season: When the housing bubble burst and people could no longer use the rising value of their homes to make their monthly bill payments, all heck broke loose. Homes in foreclosure killed the value of the CDOs that all these different organizations had plowed their money into hoping for a little better return. A greater detriment was now the fear and lack of confidence each financial entity had in one another, effectively freezing normal lending and borrowing financial activity.

Plating Suggestions: Drizzle plate with Mark to market accounting and Fear of Sovereign-Wealth Funds: A contributing factor to the severity of the situation may be a newer accounting regulation called mark to market accounting which places a value on a financial instrument (like a CDO) based on the current market price for that instrument or similar instruments. Hugely complex mortgage instruments that had a sick or non-existent market were forced to be marked down substantially, causing a quick and fatal blow to several big Wall Street giants like Bear Stearns and Lehman Brothers.

Normally international buyers would be easing the situation by snapping up US bargains but this has been slowed for several reasons. Political uneasiness and national security concerns regarding Sovereign-Wealth Funds, or state owned investment funds, has slowed and prevented international cash from flowing in and providing capital or ownership transactions (maybe rightly so).

Be sure to share this dish with your friends. All your friends. Heck, how about everyone. Serves 301,139,947 so there is plenty to go around. Refrigerate leftovers.

I have done a lot of research on the issue and am standing on the shoulders of some excellent summaries and journalism including The Giant Pool Of Money by This American Life, countless Wall Street Journal and CNN Articles, and many more. This recipe represents my ideas on the causes and makeup of the issue. Have a different view or heard something else, I encourage your comments below.

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