As you might have noticed, there’s been a little bit of trouble with the economic markets lately. Maybe you noticed your 401K being decimated, maybe you noticed investment firms going out of business, and if you (were) a Washington Mutual customer, maybe you noticed when your bank was sold to J.P. Morgan-Chase.
One of the big questions that everybody is asking through this, the “greatest financial crisis since the Great Depression,” is… what caused it?
Not that there’s a shortage of people to blame, but the most popular culprit is, as always, “corporate greed,” followed closely by “failed Reagan-era economic policies.” Well, I actually am an accountant, which makes my commentary here almost legitimately qualified (more than your typical Journalism major’s at any rate), so why don’t I join in the blame game?
Who do I blame for the current economic crisis?
You see, here’s the thing. There’s no one thing, or one aspect, that caused this. It required a perfect storm of new regulation, market conditions, political expedience, and human panic. Like the last economic disaster, it required poor long-term investment strategies, the lemming-like tendencies of investors everywhere, and just a soupcon of fraud.
First, a little terminology… or, as I like to think of it, our Usual Suspects, straight from central casting.
- Bonds – long-term securities typically sold on a 10-30 year term that pay a modest interest rate over that period. You buy a bond, you collect your interest, and when the bond comes due you’re given back the face value of your bond. Bonds are often backed by some sort of collateral, just like your mortgage is backed by the house you buy with it.
- Stocks – also known as trading securities, stocks regularly trade hands and are generally considered practically the same as cash. You buy a stock, usually hold onto it for a little while, and then sell it on the uptick. The exception, of course, is in some companies which are more long-term investments – Microsoft, for example.
- The SEC – the regulatory body for American financial markets, the SEC does most of the final regulating on who says what about their financial condition.
Now, here’s what happened. Banks started selling bonds, backed by mortgages that they had given out. Many, many of these mortgages were (at one time or another) owned by Fannie Mae and Freddie Mac. While housing prices rose, these mortgages were as good as gold. Traditional wisdom holds that mortgages are the last thing people will default on and, even if they do default, you’ve got a house you can go out and sell to make back the money. Therefore, the mortgage-backed bonds should be incredibly secure securities – and were rated as such. They sold at a premium, and everybody was happy.
Except that traditional wisdom only holds out over the long-term. Over the long term – the life of the mortgage – housing values will rise. But over the short term, they fluctuate. Once in a while you hit a dry spell in the housing market – especially if a lot of new homes have been built and sold and flipped so many times that the value has inflated beyond reason. And that’s the situation we’ve found ourselves in. Low interest rates and sub-prime mortgages were originally meant to let people who couldn’t buy a house buy one for the first time, or let people who already could afford one afford a larger one. But, since credit was easier to get in larger and larger amounts, people got a little bit greedy – why should they sell their $100,000 home for a ‘lousy’ $110,000 when they could get $125,000 instead, because the guy who wants it can get that much and there aren’t enough other places in the area he could buy instead?
So you sell the home at a markup… and then *he* sells the home at a markup… and then somebody can’t make their mortgage payment and the *bank* sells the home at a more modest markup, to a guy who fixes the place up and sells it as a *big* markup.
This was confounded by the fact that people were taking out second and third mortgages on their homes, sometimes to fund investments, sometimes to fund home improvements, sometimes because they wanted to buy something big and flashy. A lot of people treated their homes like credit cards with better interest rates. This helped fuel the economic boom of the last two decades… but like all booms, it slows down, and nobody was thinking about what they would do if housing values started to drop. When housing values drop, you can’t take out another mortgage because you already owe more money than the house is actually worth. Without the steady flow of multiple-mortgage income, the consumer-goods economy slows. When the consumer-goods economy slows, profits and salaries start to slide back. When they start to drop, people can’t afford the mortgages they have out, and the banks have to foreclose on the house. When they do that, the *bank* can’t get all of their money back… and they can’t back their bonds. Nobody wants to buy bonds that can’t be backed, and to be honest, nobody really wants to sell them, so bond prices stagnate. But if people have to sell them, then the prices plummet (more on that later).
Now, normally, this all would have taken a long time, probably long enough for housing prices to start ticking back up. But a time bomb had been set in the mortgages. Back during the 90’s, under the Clinton administration, the Democrats started pushing groups like Fannie and Freddie to give out more loans to low-income families. They pushed to expand what could be considered income. This gives our our little bit of fraud – people were listing unemployment benefits as income to repay a home loan, and welfare checks. Not the sort of things you want to base a 30-year mortgage on, are they? But the Democrats actually sued to let them be included. What this did was that it accelerated the process listed above. When your income is already on shaky grounds, any hit can endanger your mortgage. If you already couldn’t afford it, and were counting on ‘flipping’ the house to make some money, dropping prices are disastrous. And, if you don’t have many roots in the area because you don’t have a job you’re particularly fond of or family and friends you’re especially tied to because you just moved into the area, you might find it more to your advantage to abandon the mortgage *first*, not last.
(Those looking for another voice saying much the same thing, if somewhat more abrasively, may find Ann Coulter’s rant on the subject enlightening.)
So the banks are left stuck holding the bag on a bunch of houses that aren’t worth as much as they used to be, and the people who owned them… well, they didn’t really have all that much equity in them in the first place, so they’re not out too much, just the roof over their heads (not to make light of not having said roof – hopefully they were able to find new accomodations, ones within their current income levels.) Why is this really a problem? The banks can just wait until prices rise, which they inevitably do, and then they’ll be fine.
Well… remember what I said about people having to sell their securities that nobody wants? Banks and investment firms are required by the SEC to maintain certain asset levels. Not just houses or long-term securities, but liquid assets. Cash and tradeable securities, things they can use to cover withdrawals. They also have to hang on to a certain level of combined assets, but the liquid assets is where the dominoes start to fall.
Houses are all well and good, but when I go to the bank I want cash, not a chunk of window moulding appraised at the cash value. Not only is it easier to spend, it fits in my wallet much better. So the banks have just traded massive amounts of cash for massive amounts of real estate. They need to get cash to stay in business, or else the government seizes them and sells them off to J.P. Morgan-Chase at fire-sale prices. To make matters worse, they already had this problem when they were extending the mortgages – they packaged them up into bonds and sold *those* off to make back cash so they could give more people mortgages that could be packaged up and sold to make back cash… lather, rinse, repeat. So now they’re stuck with houses. They’re stuck with interest payments on these bonds. And, eventually, they’re going to have to pay those bonds off… but the houses backing those bonds, *right now*, won’t make much cash. The banks start getting nervous and calling in a lot of those mortgages they put out that were ‘interest-only’ – now they want principle, and they want it fast. Well, that just results in them getting even more real estate, which they can’t sell at a profit, so they sell them at whatever price they can get, pushing the housing prices down even faster (though not *that* fast… funny how they always go up faster than they go down, isn’t it?) But since the banks were stuck holding the highest amount of paid value on the houses, they also eat the largest losses when they sell at actual market value.
And losses make the market-lemmings start searching for cliffs. They sell the bank stocks. They want to sell the bonds, but they can’t get anybody to buy them, so they’ll hold those. The bank stocks drop, equity in the bank drops, they need even *more* assets… and the death spiral begins.
As for those bonds… allow me to introduce you to the SEC’s latest new regulation related to this. Last year, they required that investment firms list all their securities at market value. Even if there’s no actual market out there. Before this ruling, you could’ve tightened your belt, looked at the execs who chose to invest in these, and said “Bad doggie, no biscuit for you!” You’d wait until the housing market started to come back up, your assets are worth more than you paid for them, and sell them at a profit. Now, you have to estimate a price for bonds that nobody wants. Being good little accountants, you follow the SEC’s rules, and devalue the bonds, despite the fact that they’re backed by assets which will eventually be worth more than the bonds themselves. This makes your balance sheet look bad – like banks, you have to maintain a certain asset level, and now your assets are on the line. So you *have* to go out and try to sell these “worthless” securities that nobody wants right now… right now.
“Two moths and a wad of camel spittle” looks bad on the balance sheet, no matter how you slice it.
The bonds are devalued down to pennies on the dollar. Your assets, formerly on the line, are now well under it. And… you have to declare bankruptcy, or sell, or otherwise go through a company catastrophe. The death spiral steepens.
All of this comes back to the market-lemmings. They see even bigger losses and disasters. Rather than take a leap off the edge of that nice little table they’ve been eyeing, they decide that it’s time to go for broke and take a swan-dive off Angel Falls. They sell financial stocks. They sell bank stocks. They sell everybody’s stocks. The stock markets begin to plunge – the lemmings start building platforms on top of the peak and jumping from there. The markets drop even further. Finally, you’re at the point where the lemmings are putting on tiny little space helmets and sky-diving from orbit, the regulations in place devalue vast amounts of corporate real estate, and the entire economy tanks.
That’s where it could end up, at any rate. Fortunately (and this is one of the only times you will ever hear me say this), the government has said they’re going to do something. They’re going to give the banks and investment firms with these ‘toxic’ bonds cash in exchange for them – the government can hold them until they come due, and make a profit on them. It might cost $700 billion dollars, but in the long run these actually are safe investments… it’ll just require tightening up the belt, giving the execs stern looks, and saying “bad doggie! No biscuit!” for a year or two. Exactly what the companies should have been able to do. Exactly what they would have been able to do if the SEC, with the best of intentions, hadn’t paved the road to Hell.
And if the lemmings hadn’t stampeded right down it.
So, who’s to blame for the current crisis?
Which means that, just maybe, it’s not that unfair if everybody shoulders part of the cost.