"The most serious financial crisis since the Great Depression"

[unforth]

Lehman Bros File for Bankruptcy, and Merrill Lynch Purchased Bargain-Basement by Bank of America

I'm scared.


I know I've found it helpful recently when friends exploring complicated issues have shared that exploration in their LJs (guiniveve's recent exploration of the presidential candidates education background, skygawker's long discussions of the election, and others).

Subprime lending is one of the main causes of the current problems facing investment banks. See also the subprime mortgage crisis. Maybe there was a reason that those with poor credit shouldn't have access to major loans, even if it is rather unfair and biased. I've seen (and been personally hit by) the results of this kind of lending first hand, and it truly sucks - when someone is broke and can't afford to pay their credit card, the last thing they need is late fees and over limit fees that make it impossible to get ahead. It would have done me a favor if the bank had just said "NO, you can't have the credit."

"About 21 percent of all mort­gage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market." Furthermore, they represent a much higher percentage of the foreclosures. As a result, since 2006, around 100 subprime mortgage lenders to fail or file for bankruptcy.

So why is this destroying the international economy? I'm still trying to figure that part out. The one-sentence implication is that "tranches of sub-prime debts were repackaged by banks and trading houses into attractive-looking investment vehicles and securities that were snapped up by banks, traders and hedge funds on the US, European and Asian markets." A "tranche" is "a term often used to describe a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. For example, a CMO offering a partitioned MBS portfolio might have mortgages (tranches) that have one-year, two- year, five-year and 20-year maturities. It can also refer to segments that are offered domestically and internationally."

So, if I'm understanding this right, which I might not be, banks and trading houses have the ability to offer bonds on the open market, bonds backed by their sub-prime lending debt, and that these bonds were at one point quite valuable, and were bought by others in large numbers with the expectation that they would accrue in value - which they would do as long as the borrower continued to pay their loan - and presumably the bond would mature at some point and be totally awesome - but ONLY if the borrower pays. Thus, when the lendee defaulted on their loans, the bonds became suddenly worthless. Of course, the bond owner had already paid for those bonds, and while I'm not clear on what happened to that money, I suspect it was reinvested in the lender's company - companies which are now failing en masse - and as a result all of the money went "poof!". The borrowers lost their homes, or filed for bankruptcy to absolve credit card debt, or had their cars reclaimed. The lending agencies folded because they weren't getting paid back, and the housing market was (is) so poor that people aren't buying foreclosed houses - and even if they were, foreclosed houses don't sell for all that much. The bond owners now possess valueless pieces of paper - bonds that were probably the basis for other loans and investments which are now also crashing as a result. Is that about right, ultimabaka? You're probably the only person I know who knows enough about this stuff to tell me if I've got it all wrong. :)

While my initial instincts suggest that this is in part a direct side effect of the economic boom of the 90's, that doesn't seem to be the whole story. The initial cause of the surge in subprime lending was the relaxing of certain usury laws in the early 90's (1993, apparently). I can't find much information on this, though, which is frustrating - the most recent change to usury law appears to be in 1980 ( Marquette National Bank of Minneapolis v. First of Omaha Service Corp, 1978; also, Smiley v. Citibank, 1996). These rulings prevented the states from limiting the interest rate and credit card fees on national bank credit cards. From what I can gather, the implications of these rulings were that national banks could issue credit cards much more easily, and as a result, the use of credit cards exploded in the 1980s and 1990s. It also completely undermined the old usury system, which was state-specific - national banks could move to states where the rules were relaxed and then just issue cards nationally with whatever interest rates and penalties that they wanted to. However, it's particularly in the 21st century that subprime lending has grown, and I'm not sure why. It clearly has something to do with the housing bubble, though - where housing prices rose rapidly until they ceased to have much relationship to the actual value of the property, and are unsustainable in relation to the income of the people buying and living in the houses. Whether or not this is related to the dotCom bubble seems to be up in the air. However, the collapse is definitely related, and is likely to get worse. Many subprime mortgages were done on a "low introductory interest rate" system - with 2, 3, or 5 year periods of low payments followed by 28, 27, or 25 years of much higher payments. It's when the introductory rate goes away that people start to default on their loans. Since the housing boom was in 2005 - 2006, we're starting to get the early defaults now. It's likely to get worse before it gets better, if I'm reading all of this correctly.

A lack of confidence in the market is another major side effect of this whole problem with tranches and bonds and such. Because confidence is down, banks aren't offering credit or loans as much, and because of THAT, it's much harder for people to get access to more credit. Of course, in the long run that's probably a good thing, but for now, there's a massive readjustment as people who probably shouldn't have been granted much credit in the first place try to get more credit to bale them out of their financial problems, can't get it, and sink. And while I can easily say it sarcastically with easy aloof attitude when it's about "people," on the level of the person, it's much more serious, upsetting and difficult to deal with.

I'll admit that one of the things that I've been attempting to determine is whether or not this can be laid at the feet of democrats or republicans. So far, it appears to be more attributable to republicans, but like so many things it's not as a straight forward as that - in large part because it appears that the two main changes in usury law that allowed all of this to happen was in fact caused by Supreme Court decisions, which are at least nominally non-partisan.

Though this has seemed to come out of no where in the past 6 months to those of us who, like me, tend to ignore the financial news, there have been signs to those who know what they are looking at for at least a year and a half. At the same time, though, the real estate market has been dumping vast amounts of money into denying the existence of a bubble. And if there's no bubble, prices won't drop, and that people shouldn't worry about the fact that housing prices were rising at a fast rate than income. Of course, prices are dropping, precipitously, which makes it seem likely that they are very, very wrong. Indeed, others are now predicting that houses will depreciate in value by up to 50%.

Difficult times lay ahead. From an overarching view, it's probably for the best. From a more personal view, though, I think there are going to be a lot of personal tragedies ahead, and I fear that there is little that can be done about it. Still, I'm glad that I did this research. Now I know more.

Comments

[bakanekotoo.livejournal.com]

Yeah, my boss and I were just talking about it this morning... It is scary. I mean, if someone told me that Lehman Bros was going to file for bankruptcy 10 years ago, I would have laughed :-\

[sapphohestia.livejournal.com]

Thanks for the post!

[ultimabaka.livejournal.com]

As someone who understands this pretty much forwards and backwards, I'm still kinda scared. I'll be honest.

Most of what you hit on is pretty much correct, although trying to blame "the republicans" or "the democrats" is little more than misdirection. If you really want someone to blame, blame joe six-pack for lying on his mortgage application to get a loan for a home twice as valuable as he can realistically afford. Or blame the [now effectively debunked] mortgage broker industry, for, in essence, not requiring potential applicants to even so much as prove their net worth. A mortgage broker, just like any other, makes all of his money at the point of sale, and is exposed to no risk doing so - if the lender borrowing from the bank declares bankruptcy tomorrow, the broker still wins.

To be fair though, the late 90's - early 2000's were a time of some of the easiest credit in American history. For creditors to make money, they need to make business, and for creditors to make business, they need to lend money out.

For a (somewhat poorly drawn, if not highly) accurate description of exactly what went down, click here [Google Docs Powerpoint]

[Note that the "Liar's Loan" actually does exist, though it's not called that for obvious reasons]

This correction (and that's really what this is) is the simple end result of people being overly greedy and, to be blunt, setting themselves up the bomb. Those AAA tranches you speak of were garbage, and something tells me everyone knew they were garbage, but when you've got people like Fitch giving them the AAA's, other people are going to buy them anyway. The only thing really left to say is that I'm taking bets on how low this goes.

AIG going under will likely cause a worldwide response, but it's definitely not the end of the picture. Bank of America just shot itself in the foot in a way it may never fully realize with its inexplicable purchase of Merrill at this point...ffs, if they waited until the end of today, they could have bought it for 30bb instead of 50bb, and one can only imagine where it will be tomorrow...

And don't get me started on Citigroup and HSBC. The ugliness involved in the failure of either of those two groups is indescribable.

On that note, I'll get off my soapbox. *huggle*
-- Gerardo

[akashiver.livejournal.com]

Thanks for making this post. I wish i knew more about the financial crisis; now I feel a little bit more informed.

[schenker28.livejournal.com]

Nice writeup -- I don't know all the details of this stuff but the things I do know seem in-line with what you wrote. A good summary!

You mentioned something interesting at the start that I have thought about some:

'I've seen (and been personally hit by) the results of this kind of lending first hand, and it truly sucks - when someone is broke and can't afford to pay their credit card, the last thing they need is late fees and over limit fees that make it impossible to get ahead. It would have done me a favor if the bank had just said "NO, you can't have the credit." '

There's an additional "subprime" sort of thing going on that no one talks about, but I wonder if it has made things worse... or maybe it's really minor and doesn't actually matter; I'd like to know. This is the way that banks give much worse terms to customers who are a bigger risk. I sort of like what you implied about: you should either have credit or a "No". But when banks give someone credit on bad terms, the idea is that the bank needs the higher interest rate, or extra fees, or whatever, as compensation for giving a loan that has higher risk of default.

However, it seems to me that there ends up being a huge batch of home/car loans, credit cards, etc. to people in worse economic situations, so it's even harder for these people to make their payments. My hypothesis is that the banks are increasing the risk of people defaulting because they make the loan terms worse.... It should be fine because the risk to the bank is factored into the price of the loan, right?

... but when all these loans are defaulting at once, and banks start collapsing, then even all the high-interest loans to high-risk customers aren't enough to help out the banks. I wonder if the extra premiums banks put on the bad-credit customers actually help force these same customers into defaulting? Maybe they would do fine if they had loans with the same terms as customers with good credit?

Example: I bought this condo, but I didn't have 20% cash to pay up-front. However, it's cheaper for me to have a mortgage than to rent! This up-front thing is a random obstacle. Still, there's this option of paying < 20% and then paying for mortgage insurance. So I'm explicitly insuring myself for the bank, so they don't have this big risk with me. However, now instead of paying $x each month, I have to pay $x + $80 or so per month. So I have this extra $80 burden each month. It's still cheaper to buy than to rent, so it makes sense. But I'd be an even smaller credit risk if I had $80 extra each month. And even though I'm insured via this $80, I think the housing market as a whole is better off if I don't default on the loan and help cause housing prices to fall.

People with poorer credit get hit with tons of extra fees, higher interest rates, extra insurance payments, etc., and it seems that these penalties are attacking exactly the people in the economy who are most vulnerable. Banks do this, justifiably, to protect themselves, but maybe it has the opposite of the intended effect when people are defaulting on mortgages en masse. I wonder if this mass failure is sort of an emergent phenomenon brought on by banks trying to protect themselves? If banks/credit cards didn't jack up interest rates and fees for higher-risk customers, would a bunch of those same customers instead be able to achieve financial stability? Is there a portion of the "high-risk" credit market that is essentially a self-fulfilling prophecy? Does a bank transform a person into a "high-risk" credit customer simply by the act of categorizing that person as "high-risk"?

I suspect there is a real issue of mathematical Complexity here -- in the sense of chaos theory, emergence, and complex systems. Economists and accountants use a set of models in computing credit risk, but I bet that don't account for the complex large-scale, emergent factors that can impact the whole economy.

Hope I made some sense... this post is long because I'm having trouble describing this exactly right.

[skygawker.livejournal.com]

Thanks for writing this up! I found it really helpful, and in fact I'm going to come back and reread it tomorrow (when it's not midnight, hah) and look at those Google docs too.

And I'm so happy to hear that you've found my ramblings at all worthwhile, too! Thank you! :)