The Financial Crisis In A Nutshell

Barack Obama has surged in the polls during the last three weeks, as far as I can tell because of the current financial mess that the country is in. While the fact that we're in a financial crisis is obvious, what I do not understand is why significantly more Americans say they trust Barack Obama on financial issues and saving our economy then they do John McCain. Also, most people still do not seem to understand how we got into this mess, nor the various proposals being floated around Washington to get us out of it. I don't claim to understand it all, but I think I have a better understanding than most and so I am going to describe what I understand and see where it leads.

First, a little background: for the past 7 years I have worked as a professional software developer, but for 15 years before that, I worked in the finance industry (I couldn't cut it as a Computer Science major in college so I switched to Finance). My first three jobs out of college were as an investment accountant. Every day, I spoke directly with bond and stock traders and handled the accounting for all investments for a number of large companies. In my first job, working for Executive Life Insurance, part of my job was to determine the market value of our $17 billion bond portfolio every month. In later years I was a financial advisor and was also trained to sell residential mortgages. I don't claim to be an expert, but my point is that I do have some experience and knowledge in this area.

Banking 101

We all need mortgages. The cost of a house is so large that thinking of buying one without taking out a loan to do so is beyond the imagination of most people. This is fine, because lending like this is part of what makes our economic system churn. People put money into checking and savings accounts in banks, and those banks have a responsibility to take those funds and lend them out to generate interest. For banks, deposits are a liability and loans are an asset (this is backwards from the traditional understanding). Banks are regulated by the state or by the fed's depending on their charter, and as such they are only allowed to invest in very safe investments. This is both to protect against actual investment losses and to keep the public confident in the banking system as a whole.

Confidence is critical because account holders could come into the bank and demand their money back at any time. Banks assume a certain percentage of their depositors will do this on any given day and keep enough cash and liquid investments around to handle this, and to give the illusion that all the deposits are available all the time. In reality, most of the monies are loaned out to businesses and homeowners in illiquid (i.e. difficult to turn into cash quickly) investments. If all, or even most, of the bank's depositors came in and demanded their money back (called a "run" on the bank), the bank would be in deep trouble, and would probably fail. It would fail not because the depositors' monies were gone, but because they were tied up in long-term investments.

Say the bank loaned $500,000 to a business for capital improvements, with monthly interest and principal to be paid back over 15 years. A bank run occurs and the bank now needs this money bank to satisfy deposit demands. How do they get it? The business has no obligation, much less ability, to pay the money back immediately. They might be able to refinance and pay the loan back that way, but this would take some time and effort, and costs would be borne by the original bank anyway since they are causing the problem. In the meantime, the bank fails.

Or the bank could be seized or backstopped by the government, which would gallop in on its white horse and pay the depositors back through the FDIC (bank insurance fund) or some other, similar, entity. In return they would take over the loan portfolio of the bank and probably sell it to another bank or work out some arrangement with the original bank to keep the doors open. But the key point here is that the depositors' money was never in jeopardy; it was just illiquid. Lack of confidence is what caused our hypothetical bank to fail.

Modern-Day Mortgage Industry

Back in the day, you'd get a mortgage for your house and make your payments to the bank that got you the mortgage until it was paid off. If you fell behind on your payments, you had to deal with your local bankers to get caught up. This still happens with business loans: Your local bank's commercial loan officers investigate your business and your collateral, and meet together to decide whether to risk loaning your business their depositors' money. After you get the loan, you pay them back until you're done. If you fail to pay it back, they take over your collateral and liquidate it to get their money back.

Today, though, at least on residential mortgages, your loan officer / mortgage broker typically gets you a "rate lock" not with his own bank, but with some huge mortgage lender instead, like Countrywide or Chase, or one of the pseudo-government entities like FNMA, FHLMC, or GNMA. He will collect from you the documents that lender requires, and his own bank's loan processors will do some level of underwriting based on that lender's underwriting standards, before ultimately sending the loan package off to the large lender for final underwriting and approval. His local bank, in the end, doesn't receive your monthly interest payment, but instead receives a fee for writing the loan.

And it doesn't end there. The large lenders have, for years, "securitized" these mortgages by pooling similar (i.e. maturing in the same year) ones together into what's called a "Mortgage-backed security," or MBS. When they are turned into securities in this way, the pools can be traded on the "secondary market," such as a bond exchange or among institutional investors. So the large lender pools together 100 mortgages that are due in 30 years, names the pool "FNMA MBS 5.5% 10-2038 POOL A" or something similar. Then other companies can buy and sell that pool.

The Market for Bonds

Mortgage-backed securities are essentially bonds, or "debt instruments." You have a bunch of people – homeowners, in this case – who need to borrow money and agree to pay a stated interest rate and some capital every month for some period of time. As an investor, you are providing some of the money for those loans and are receiving this interest back as profit. Buying bonds is as old as investing itself. It's simple to understand, profitable and relatively safe, and vital to our economy.

Determining the price/value of a bond is both classic and elegant. Classic, in that it's one of the first things a Finance student learns to do after he learns about present value calculations, and it's exciting to work through your first few times (I think, but I may just be being silly). It's elegant in that it's so simply laid out – it's not rocket science. Pricing a bond involves putting 3 elements together: The term of the bond; the rating of the bond; the interest rate, or coupon, of the bond. Without going into all the gory details about par value and interest rate risk, nor a specific example, suffice it to say that these 3 elements alone make up the value of a bond. Two bonds that have the same maturity, coupon, and rating will be priced the same on any given day.

How MBS's Fit Into the Bond Markets

If you've persevered this far, I thank you from the bottom of my heart and hope this is helpful.

Mortgage-backed securities are bonds, but they are very strange ones. Most bonds have a stated coupon and maturity date, neither of which ever change. In addition, they typically pay the interest every six months, and they don't pay any of the capital back until the maturity date, at which point they pay the whole thing off at once (think of it as a balloon payment). MBS's, on the other hand, pay interest monthly, and pay down part of the principal every month, too. What's more, they almost never survive to maturity because most of the mortgages in the pool will wind up being paid off prematurely – how many people, if any, have you heard of who take out a mortgage and hold it (not even refinancing) the whole 30 years? So you just can't fairly price these things based just on the stated term and interest rate. Clearly some allowances must be made in these areas, and they are made.

The rating is now where we arrive at. And for the first time, we're now touching on something that has directly contributed to our current financial crisis. There are several firms that provide bond ratings, but two stand out as the classics: Standard & Poors (S&P), and Moody's. Each has a similar rating system, using letters or letters/numbers to communicate the safety of a given bond. I'll focus on S&P since it's the most prominent and the one I can actually remember without having to look it up. S&P's highest rating, also known as "risk-free," is "AAA." As a bond is considered more risky, the ratings change to "AA," "A," then "BBB," "BB," "B," "C," and then "D" meaning "Default." Default is bad, by the way.

Bonds that are rated "AAA" would include all Treasury Bonds, and those primary debts of large companies like IBM, Exxon, etc. Since there is no real risk, these bonds typically have the lowest coupons. As you go up the risk ladder with lower-rated bonds, the coupon rates will get higher (assuming the same issue date).

Rating MBS's – AKA Getting Into Trouble

So what would you think that MBS's would carry as far as rating goes? Well as best I can remember, all MBS's I saw were rated "AAA." This I think was obviously not a comment at all on the underlying quality of the mortgages, but because everyone knew that FNMA/FHLMC/GNMA MBS's were ultimately backed by the federal government. As such, there was no risk, thus the AAA rating.

And what expertise, truly, would a bond rating professional at S&P have in determining the actual riskiness of those underlying mortgages? These guys are used to looking at a company's balance sheets and income statements, evaluating actual collateral and income in assessing a rating for a bond. How were they going to go in and tear apart these MBS's to really do a thorough rating? And why should they anyway? Again, although those agencies are not backed in writing by the fed's, everyone knows the fed's will step in if necessary to bail them out. "AAA for you!"

In a better world, every MBS would have the proper research applied by the bond analysts, and would receive a rating based on the collateral value. With the appropriate rating applied, the pricing would naturally be higher for riskier mortgage pools.

Unfortunately, that is not how things have been done up until now. With AAA ratings across the board, most mortgage pools are assumed to be risk-free in terms of principal losses (and priced accordingly). For the longest time, this worked out fine because banks are naturally conservative, and demand homeowners either put down at least 20% of the size of their mortgage down in cash before getting the loan. They could put down less, but would have to then buy mortgage insurance (PMI) to protect the bank in case they quit making their payments and the value of their home decreased, putting the bank at risk. The bottom line is that all mortgage loans were "secured" with capital: the house, and cash, and possibly insurance.

Sub-primes Foul the System

The problem we're facing today is a result of lowered standards by banks as to who they're willing to lend money to. Somewhere along the line they seem to have thrown their lending standards out the window (these less-than-ideal loans are referred to as "sub-prime"):

1. They have encouraged dangerous "interest-only" loans and adjustable-rate loans so people could get as low a payment as possible (and thus afford to buy). In a low-interest rate environment, this is fine, but as soon as rates start rising (and they always do eventually), these homeowners are the first to go into default.
   
2. They've also allowed people to apply for loans without verifying their incomes ("no-doc" loans), which encourages fraud.
   
3. Lenders also allowed people to borrow money with nothing down, or even borrow against 125% of the value of their home. If and when these borrowers stop making their payments, the bank can foreclose (seize the home and sell it), but whether they'll get all their money back is debatable because they didn't insist on the "cushion" of the down payment.
   

Without that cushion, the bank only has two other sources of protection left: The house value, and PMI. As long as housing prices go up, even lending practices as bad as these can be fixed through foreclosure. Since the house is worth more than the amount owed, the bank or investor does not lose money. In a "down" housing market, though, the sale of the home doesn't provide enough money to pay it back. If the homeowner carried PMI, as they would have had to without putting down 20%, that insurance should also kick in and protect the bank from the loss.

In our case, all three of these safety valves failed: Shoddy lending practices led to high default rates when interest rates began to rise. The resulting high foreclosure rates undoubtedly contributed to the decline of a housing market that had already peaked. And higher and higher losses on these foreclosures bankrupted the PMI system.

"So What? I Always Make My Mortgage Payments"

Why do we, the 95% of us who make our mortgage payments on-time every month, care about all this? Well, like another controversial issue of our day, gay marriage, we care because of "Unintended Consequences." That is, while the initial "action" doesn't really matter to the rest of us, it does set off a whole series of other problems that actually do affect everyone else.

Firstly, when sub-prime borrowers start defaulting, and the foreclosures start happening and housing prices plummet, and losses mount up, and PMI fails, etc., the lenders can only absorb so much of that before they have to file bankruptcy themselves. The problem is, these are banks, and you can't just let banks start failing all over the place. The banking system is absolutely at the heart of any economy; it has to be strong as a rock or that economy will collapse. Banks don't just lend to homeowners; they lend to businesses of all sizes so the businesses can expand their operations, build new buildings, or just meet monthly payroll. Trouble in one sector will have repercussions in other sectors of that bank's operations. Depositors, hearing about the lending losses, might run the bank. Other businesses that count on continuing lines of credit from the bank may have to divert energy to finding the credit elsewhere, and/or may see their operations damaged or killed by the loss of available credit. Serious losses like these are not supposed to happen to banks because the risks are just too great, and in fact that is why so many safety valves are in place.

It gets worse, though. Remember that these mortgages are not owned solely by the banks. The whole point of turning them into trade-able securities is to sell them to other investors in pools, or MBS's. With their AAA ratings, the mortgages are good financial instruments to trade around. The problem is, no one appears to have been paying attention to what the lenders were actually putting into these MBS's. They started putting prime and sub-prime loans into the pools (I don't know whether both types would have been found in the same pool). So now you have these risky sub-prime mortgages "polluting" the pool of highly safe "prime" mortgages. What investors think is a risk-free investment is actually fairly risky, depending on how much sub-prime it contains.

The institutions and individuals who buy AAA investments are, by definition, the most "risk-averse" investors out there. Retirees; high-safety bond mutual funds; insurance companies; banks. In other words, those who cannot afford (indeed, are not permitted by law to own) risky investments in their portfolios. Again, the bedrock of the economy. They buy safe investments because while their portfolios must generate profit from investments, it is even more important that their portfolios remain solvent. If you own life insurance and you die, your family must receive the death benefit. If you are a bank, you are investing other people's money – you cannot just say, "well we lost your savings" if depositors or investors come around asking for their own property back. With these investors, losses are not acceptable, period.

It still gets a little bit worse. These polluted pools of mortgages (the MBS's) were actually pooled themselves into still larger investment vehicles, appropriate for the largest of investors. These investments are called "Collateralized Mortgage Obligations," or CMO's. So whether or not sub-prime pollution inhabited the same MBS's as prime, at this level it didn't matter because they certainly were combined. CMO investors would not be individuals, but large institutions and overseas corporations.

At this point you begin to see why your sub-prime neighbor down the street who defaulted on his mortgage is hurting the entire economy. Sub-prime mortgages are like a contagion, a virus, that has infected otherwise healthy mortgage pools and been distributed around the globe, making those who can least afford to get sick, get very sick. The deaths or even near-deaths of these institutions has profound ramifications everywhere else.

The Effects of All This, Present-Day

So rock-solid institutional investors have been getting sick by buying these MBS's and CMO's. Many, like Lehman Brothers, Merrill Lynch, Bear Stearns – household names – have gone under or been bought-out. Some, like AIG, FNMA, or FHLMC, have gotten "rescue" or "bailout" money either as a loan or as a purchase of part of the company's equity in order to stay in business and not damage the economy further by failing.

Another effect has been that those investors, including overseas institutions, that survived this mess so far are now staying away from these kinds of investments in droves. Since they still don't know just what the heck is inside these CMO's and MBS's, it makes sense not to buy them. Properly rated, these investments might be A-rated, or B-rated, you just don't know. Thus you don't know what to demand in terms of price, given the level of risk you'll be taking. Who needs it?!

With no MBS/CMO buyers left out there, banks can't possibly write as many mortgages. They also have to clean up their act in terms of the lending standards – they have to start being picky about who they loan money to again. There's also less money to go around, which makes credit still tighter. Many are now saying that even good credit risks are being denied credit.

The result of all this will be a slowdown in the economy. Credit is the engine of expansion and growth. Without it we're just spinning our wheels. If we were not in a recession – 2 quarters of negative growth, or shrinkage, of the economy – we were close enough that this situation would certainly put us there.

Problems and Solutions

To be honest, this little blog post took on a life of its own as I wrote it and has gotten way bigger than I planned. I'm content, then, to just leave it here. Dennis Prager has several expressions I'm fond of and believe in. One of them is, "first present the facts, then give your opinion." The message being that too often we do it the other way around. I think that with this post, I've laid out the facts pretty thoroughly, as best as I understand them. There are a number of other issues surrounding this crisis that should be discussed, but they all fall into the realm of "opinion." Those should come next, as they're already being discussed in other places right now.

Some of those issues should include: Why did the banks lower their lending standards? Was de-regulation to blame? What, if anything, should the government have done differently in order to prevent this? Why did so many people default on their mortgages? What is the point of the bailouts/rescues and will it work? Should congress people have voted for those bailouts? How do we get out of this mess, and how long will it take? What will be the damage done in the end?