In just a few short weeks, the most powerful financial cornerstones in the world have been reduced to rubble. But has the carnage ended? Or is there more on the horizon? And dammit, how did we get here?
Lets get one thing straight, first. This is *my* take on what’s going on based on information gathered from news outlets on the web. I am not a financial guru, economist, or really anyone who should be trusted with investing money at all. I’m writing this because I can, and I’m trying to make sure it’s as accurate as I can. I will come back and edit if need be. That said, lets move on.
Since about 2000, the housing market has been booming. Prices have been rising steadily, reaching all-time highs. Mortgage lenders offered subprime mortgages, a truly stupid way to make a quick buck. Subprime mortgages worked something like this :
Joe wants to buy a house, but Joe doesn’t have very good credit. This could be because Joe is new to the financial world, or because Joe made some bad choices in his past. Either way, he doesn’t fit the criteria to be offered a standard loan. But, not wanting to turn a potential customer away, the bank decides to offer Joe a subprime loan. Subprime loans are great, says the bank, because they allow you to buy a house today and help fix your credit over the short term. Then, in a few years when your credit is better, you can re-apply for a normal loan!
So, Joe opts in for the subprime loan. The bank will give him a loan for his new home, and all he has to do is pay interest payments for the next 5-10 years. Of course, since the bank is doing him this huge favor, at great risk to themselves, there are some conditions. If Joe is late on a payment, he’ll pay a pretty hefty fee. And in 5-10 years, the subprime interest rate he’s enjoying today will be switched to an adjustable rate. But that’s 5-10 years in the future, plenty of time to deal with that later.
Ok, so what’s the problem here? Joe will surely fix his credit and be able to get a better loan in 5 years, right? Well.. maybe. 5 years go by and Joe is still having some financial trouble. Nothing huge, his mortgage payment is always on time, but those damn credit cards are killing him. Oh well, no way to get a better rate and re-finance his mortgage. And suddenly, Joe’s mortgage payment jumps up by a pretty hefty sum. Why? Because he’s past the interest-only payments, and needs to pay on the actual mortgage balance now.
Now we have a problem. Joe can’t afford all of this, so he delays paying the mortgage until he has the full amount. Of course, this makes the payment late, which then adds a late fee. More money that Joe doesn’t have. This starts a rather vicious cycle which typically ends in Joe’s credit being completely destroyed, the mortgage defaulting, and the house being foreclosed upon.
This started to happen quite a lot in about 2007 causing the mortgage industry to start a slow collapse. First to go was New Century Financial which filed for Chapter 11 bankruptcy in April, 2007. In the months following the initial collapse of the subprime market, the heavy hitters of Wall Street, who dealt in mortgage-backed securities, started trying to sell off their subprime mortgage assets. Of course, noone wanted them because they were now worthless, a horrible investment guaranteed to lose money. CNN has a great definition of a mortgage-backed security:
Banks lend money to homeowners through home mortgages; these loans are then bought from the banks and sliced up and repackaged into securities that investors buy and sell just like stocks. Those investors make money off the homeowners’ monthly interest payments. The nation’s housing crisis has forced many Americans to skip payments, or worse, foreclose on their homes, so investors don’t get the interest payments. That’s why the securities become toxic assets to have on a company’s balance sheet: nobody wants to buy them, and there’s no market for them. Thus, all those institutions that hold these mortgage-backed securities — and they’ve got a lot of them! — are in big trouble.
So the investment bankers start feeling the heat and are unable to get rid of these so-called “toxic” assets. The value of these assets begins to plummet causing the value of some investment banking companies, who had a large stake in the subprime market, to drop. Bear Stearns, one of the largest, was particularly hard hit and had to apply for an emergency loan in March of 2008 in order to stay afloat. Later that month, they agreed to merge with JP Morgan Chase, effectively ending the existence of Bear Stearns.
Fannie Mae and Freddie Mac, both government sponsored enterprises, controlled upwards of 50% of the mortgage market at the beginning of 2008. When the floor fell out from under the subprime market, these companies found themselves unable to cover the resulting losses. Both Fannie Mae and Freddie Mac began to fail and were quickly placed into conservatorship by the federal government. The government will allow both entities to continue to guarantee all loans, as well as grow their loan portfolio in the coming months.
Following this, additional companies began to fall. Lehman Brothers, a financial services company, suffered greatly from the subprime collapse and filed for bankrupcy on September 15th. The next day, Barclays plc, another financial services company, agreed to purchase what was left of Lehman Brothers. Following this, the American International Group (AIG), an insurance company, began to collapse. Investors noted that both AIG and Lehman Brothers had similar mortgage portfolios, but that AIG had them valued much higher. As a result, investors began selling off AIG stock in an effort to distance themselves from the company. On September 16th, the Federal Reserve bank agreed to loan the company up to $85 billion to bail the company out. In return, AIG agreed to give the Federal Reserve a 79.9% stake in AIG.
On September 19th, the Federal Government announced a plan to avert the financial crisis. The government would make available a minimum of $700 billion to cover the purchase of mortgage-backed securities from failing companies. The government would purchase these assets, effectively saving the companies involved from any losses, and sell them at a later date. The intention is to save the market and make the money back later when the assets are sold.
But, the carnage doesn’t end there. The last two Investment banks, Morgan Stanley and Goldman Sachs, both saw their stock prices plummet. On September 22nd, they both agreed to convert from investment banks to traditional bank holding companies. By becoming traditional bank holding companies, they have easier access to credit, including the government-sponsored bailout, thereby increasing their chances of making it through the current financial turmoil.
And that is about where we stand today. Congress is currently debating the bailout proposal, weighing the options and determining a course of action. President Bush addressed the nation last night, explaining his position and the intended bailout. All said and done, this bailout may cost upwards of $1.8 trillion, which includes money already spent on bailing out companies like Fannie Mae, Freddie Mac, and AIG.
But is this the correct course of action? Should the Federal Government provide an out for these companies? Companies, I might add, that manipulated the system just to make a quick buck? Many economists disagree with the current proposal. Some of the reasons cited include a lack of oversight on the use of the bailout money, displeasure at the amount of control the government is asking for, and a belief that the government sale of the assets will be unable to cover the cost of buying them.
From my own view, I don’t see this as the domain of the government. These are private companies that made bad mistakes. The fault of these mistakes lies both on the companies as well as the investor. Simply put, if you cannot afford a mortgage, you have no business getting one. Owning a house is great, but do you want the own a house at the risk of complete financial ruin? While there’s always a risk, minimizing that risk is the job of the risk taker.
The banks offering these types of loans should bear a good bit of the blame as well. In some cases, loans were pushed on unsuspecting consumers without fully explaining the risks. Regardless, I still don’t see how a bank can justify offering a loan to a high-risk borrower. I understand the frustration of the high-risk borrower, having been one myself at one time, but blindly offering loans to anyone asking for one can only end in catastrophe, as we are seeing today.
So what can be done to fix this? Well, I definitely don’t believe the government should be bailing these companies out. If I understand the proposal, the companies that caused all of this will, in the end, take almost no loss and suffer no consequences. On the other side, the government assumes the burden of dealing with those bad loans, and the cost associated will eventually be put on the taxpayer. In the end, the responsible taxpayer suffers because the big financial players got greedy.
Personally, I say we let them suffer. Let them figure out how to fix the system. It’s often amazing to see what solutions will pop up when the pressure is great enough. They’ll likely lose a great deal of money, and much of the financial sector will feel the crunch, but those of us who are responsible will likely be ok. Sure, my 401K will take a hit, probably more than it has already, but in the end, I’m willing to bet it will balance itself out.
So let this be a lesson to you.. Making stupid decisions can lead to disastrous results…