In response to the questions I've been getting from the market and clients, I've attempted to explain the course of events and processes that have led to the US credit crisis.

So how did we get ourselves into this mess?

Just like the stock market in the late 90s, the extreme price appreciation of real estate over the last 5-10 years has been stratospheric. It didn’t take an economist to sense a bubble.

What blew this bubble way up, though, was the reckless way mortgages were doled out so freely. Speculation was rampant; loans were taken out without verification of income or assets. People got in over their heads in mortgage debt, either looking for a quick buck or living beyond their means. 

Now, here comes the tricky part, which explains some of the problems we are seeing today. Historically, you took out a loan with a bank and the bank might hold/own that loan until the end.

But a process called securitization really started to take off on Wall Street over the past 10-20 years. But before I explain what securitization is, remember that a mortgage loan is DEBT for you the homeowner, but an ASSET for the bank or whoever owns the mortgage.

For simplicity’s sake, here’s how securitization works: a bank takes 10 loans and pools them together. These can then be split up into groups (or tranches in Wall Street parlance) based on the credit worthiness of the homeowner. Good credit loans are prime, in between are Alt-A and the poor credit loans are subprime. The prime group would pay a lower interest rate but be theoretically safer, while subprime would pay a higher interest rate but be riskier.

Now, Wall Street would buy this pool of ten loans (usually at a discount to make money) and then sell the tranches to investors (banks, mutual funds, insurance companies, hedge funds, individuals, etc.) as “mortgage backed securities.”

This was/is a way for banks to make money from originating the loan and then take the risk off their balance sheet by transferring it to other investors.

Now, with subprime loans, investors were able to sometimes earn a higher rate of return because those loans require a higher interest rate, while perceived risk was lower because real estate rarely declines quickly. But you can see where this is heading.

The subprime market was the first crack, and we saw the bankruptcy of New Century and other problems with subprime loan originators.

The problems, however, then spread to ALL loans (including the prime loans) as real estate values rapidly dropped over the last two years. Even the prime tranche, which was supposed to be safe, saw its mortgage-backed securities lose value rapidly.

Across the market there were seriously too few buyers for these investments. And many who thought they had a more conservative investment found out otherwise. 

So how does that affect these big companies I keep reading about in the newspaper?

Now, it’s important to understand how these big financial companies work. There were incentives in place to own/be involved in this market.

First, investment banks made big fees on putting these deals together. In addition, by investing directly in the mortgages they could earn a high yield. I mentioned that banks usually originate these loans, then hand them off to be securitized. But many banks still held on to a lot of loans.

You might notice perhaps within the first year of a home loan you get a letter informing you that there is a new “servicer” to your loan. That’s likely where the securitization of your loan took place. However, the bank still owned your loan for that first year or so, leaving plenty of mortgages on their books. 

At this point, it’s also important to note that banks and investment banks make money from leverage. So while they are doling out loans themselves, they take on more debt to make more loans.

For example, Bank ABC might have $100 in capital and then borrow $500 more at 3%, then loan out $500 at 6%. In that case, they have 5 to 1 leverage.

Investment banks are less regulated and in many cases use leverage of up to 30 to one! As a point of reference; commercial banks leverage ratios are about half that of investment banks.

Think of it this way: It’s like you taking out a $3 million loan out against your $100,000 home to fund a new start up business.

That brings us to Lehman Brothers, Bear Stearns, AIG and others. They were caught holding the bad paper. The bad mortgage investments that nobody would buy.

Not only that, they had used leverage to buy those investments. So as we think of bankruptcy as one’s liabilities being greater than his assets, and as those assets are trading at a value of 80 cents on the dollar, then 70, then 50, then 30…you start get the picture.

So what’s going to happen to all that bad debt?

Who holds the ugly, unwanted mortgage investments now? You and me, if a government bailout goes through. We already own AIG, Fanny Mae and Freddy Mac.

So bottom line, we should be disappointed. And any outcome will be disappointing. There is no happy ending to this mess.

As much as the media is playing chicken little, I don’t believe the sky is falling. We are in for some pain as an economy though.

While the data may not technically point to a recession currently, every piece of data that has to do with U.S. consumers does point to a major contraction in the economy. Manufacturing, exports, etc. are doing just fine. However, the U.S. consumer makes up two-thirds of the economy. And it’s the American citizen that can’t seem to make enough money to catch up with inflation.

And, when a large chunk of the assets that make up an economy are a house of cards, it makes trudging through the rebuilding process a longer process.

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navit - indonesia  - direct impact to the US currency ?   |2009-06-24 22:44:47 why the impact of the credit crisis create the risk aversion in stronger the US currency ?

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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."