Understanding the Financial Crisis – Part 1 – The Problem

The Base of the Problem

The crisis is primarily one of credit. A constriction of credit caused by the turn in the housing market and causing the current mild recession.

With losses adding up at financial institutions due to home loans, they’re less inclined to lend money. This means that any money that is loaned must pay a higher rate of interest to entice such institutions to do the  lending. This is also the reason why its harder to get higher credit card limits, lower rates, obtain cheap student loans, or easy home loans. Each of these markets was driven by the availability of cheap credit, is now facing losses, and has reduced business to all but the highest quality borrowers.

Brief Background on Mortgage Backed Securities

Mortgage backed securities combine a large number of mortgages in to a large pool, usually purchased with additional borrowed money. Ownership of this pool is split in to slices called tranches. These are rated from investment grade to junk status based on how many  or much of the mortgages have to default to see losses. The lowest grade tranches see losses early, but the highest grades only see losses if there are high levels of defaults. Computer models are used to price, risk evaluation, and ratings for the tranches as designed.

Everything works unless there are historically unprecedented default rates. (More on that in Part 2)

The Commercial Banks

The failure of several investment banks and insurance companies is driven by losses in their mortgage portfolio and the lack of credit to finance these losses. These companies operate by borrowing money in the open market and using it to finance their loan portfolios. This works since the grade (or rating) on the mortgage tranch equals that of the debt issued by the investment bank but yields more. The investment banks make money on the spread between their debt and the mortgage instruments they’ve purchased.

Additionally, several of the investment banks were responsible for creating and selling mortgage backed securities. They had to hold many, many loans on their books during construction. As the market dried up for such securities several firms ended up with large number of loans with high default rates that they couldn’t package and sell.

These banks are being squeezed because they cannot borrow enough money at a cheap enough rate to shore up their balance sheets while taking the mortgage losses. Since they borrowed money in the first place to purchase the mortgages, in some cases up to 30x their cash on hand, it doesn’t take many losses until you run out of cash and have to start borrowing more. The credit issue constrains their ability to borrow.

The Home Front

While there is more media attention being paid to Lehman and AIG the real credit problems are hitting the home front. The commercial failures affect their employees and will affect the business environment when the economy rebounds, but don’t materially affect the home front.

The credit problem hits Main Street in a number of ways. Home loans are the most obvious since the high number of defaults have caused mortgage products to be withdrawn and lending standards to be highly tightened. Second to that are other types of loans, such as car loans and credit cards. Each of these use a similar securitization system and are affected the by the lack of willing money lenders. This leads to a similar raising of standards and rates for these products.

Additionally, the cheap credit and housing boom lead to huge numbers of unnecessary stores, restaurants,  and new construction projects. As credit is constrained consumers cut back on the dinners, decorations, and shopping Saturdays. This and the construction cut backs are closing hundreds of stores and putting thousands of people out of work. People who themselves most likely have mortgages and credit card bills they suddenly can’t put off.

A good bit of economic progress in the last few years was driven by cheap credit including the ability to obtain home equity loans and credit cards easily. With the tightening of the credit markets people are now having to pay back money they might have floated from credit facility to credit facility for years. This redirection of productive growth in to paying down debt must happen, but it means we do not get the benefit of that productive behavior today. In effect, we’ve already used it to create a housing & credit boom and must now pay it back.

In the next part of this series I’ll examine the cause of the problems described before and how we got in to this mess.