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1. It all began with cheap money. To prop up ailing economies early in this decade, central banks in the U.S. and Japan kept interest rates unusually low, which encouraged speculation. In the U.S., the Federal Reserve lowered the federal funds rate -- the rate that banks charge each other for overnight loans and a barometer for the cost of borrowing money on a short-term basis -- from 6.5% in 2000 to 1% by mid 2003. Cheap money quickly ignited a sharp rise in home values in virtually every corner of the country.
2. Financial magicians made subprime loans golden. Banks and mortgage companies fed speculation in home prices by offering cheap credit to all comers, including those who would not normally qualify. What to do with these subprime loans? Package them with thousands of high-grade loans to sell to investors. To make the subprime loans attractive, underwriters bought insurance policies guaranteeing that the loans would be repaid. With insurance on the loans, credit-rating agencies stamped such paper as triple-A-rated debt.
3. The global economy became infected with poisoned debt. The loans came to investors as collateralized-debt obligations, or CDOs. A CDO is a huge package of loans sold in assorted segments -- known as tranches -- with varying interest rates and levels of risk. Buried inside the least-risky tranches were those subprime mortgages masquerading as triple-A-rated debt because of their insurance policies. Companies that wrote the insurance policies on these mortgages assumed that default levels would be minuscule.
4. So much for those assumptions. Home prices tipped downward, setting off a chain reaction. All bubbles eventually burst. The Fed began raising short-term interest rates in 2003, eventually boosting the federal funds rate to 5.25% by the summer of 2006. As a result, adjustable-rate mortgages (particularly the subprime variety) began to reset at far higher interest rates, and in July 2006 the rise in home prices abruptly stopped. In fact, home values began a descent that continues to this day, in many communities averaging a loss of 15% to 30%. As borrowers realized their homes were worth less than the amount they owed on their mortgages, the default rate shot up.
5. Rating agencies lowered their assessment of those supposedly triple-A subprime loans to junk levels. The investment and commercial banks, pension funds, and other institutions that had bought the supposedly safe, triple-A-rated CDO tranches woke up to find their investments tainted by those poisonous subprime loans, which began to default at alarming rates. Holders of these CDOs found it all but impossible to know what they were really worth. And when they tried to sell them, there were few buyers -- the beginning of a seize-up of U.S. debt markets.
6. A wave of write-downs on the value of those loan packages commenced. Financial accounting standards require banks and investment companies to "mark to market" the value of their assets each day. If it's impossible to value a security because there is no market for it, too bad -- make a smart guess. Starting in 2007, one financial institution after another announced a series of quarterly write-downs of hard-to-value and unsalable CDOs that turned into a financial tidal wave.
7. Financial institutions were revealed as vastly undercapitalized. As the quality of their debt portfolios deteriorated, investment banks wrote off billions of dollars of bad assets each quarter, causing their reserves to shrivel. Commercial banks are leveraged with perhaps ten times as much in assets as capital. But some investment banks leveraged themselves more than 30 to 1, to the point that should anything go seriously wrong with those assets, their businesses could fail. The same held true of Fannie Mae and Freddie Mac, which own or guarantee more than $5 trillion in mortgage debt.
POSTED BY: Brian (October 27, 2008 09:06 PM)
This is to Tom from he who is "without a clue"....This theory, that the bad mortgages sold by Fanny Mae and Freddy Mac to stupid moneyless people that should have known better, is a false premise....It is so much more complicated than that....Back in the early nineties the total amount of money that was available for investment in the world (called savings) was about 35 trillion dollars. In six short years it grew to about 70 trillion. Please remember that this was at a time when wages of working people was flat or decreasing. Question: Who held this money? Answer: The nouveau riche; the benefactors of the “trickle up” theory....This money was so great that finding places to invest it became somewhat of a problem for those who had it... Someone from the investment banking community thought that mortgages might be the answer. They knew that these investors would not be interested in holding Joe the Plummer’s mortgage. That would be too much like work. So they devised a scheme with mortgage bankers to package mortgages into investment instruments. That took care of the messy landlord end. Then they got insurance companies to back them (AAA). This took care of the need for security. The end result was that they were selling like hot cakes. Rich greedy investors couldn’t get enough...There was so much demand for these products that greedy bankers and mortgage brokers started making mortgages more available to more and more people. This created a sellers market which drove up the value of homes across the country. The bubble got so big that, like all bubbles, it eventually burst. At this point insurance companies backed out, leaving the investors holding the bag....Let there be no mistake, this problem was caused by greedy bankers and investors and had nothing to do with liberals, socialists, commies, tree huggers, gays, pro- abortionists, anti-gun people, peaceniks, less fortunates, minorities or the poor sap trying for the American Dream. It had all to do with Reaganomics, deregulation, free market capitalism, and smaller government.
POSTED BY: Coop (November 08, 2008 08:48 AM)
A problem over looked is not government but the leaders in goverment. We have elected irresponsible leaders due to the fact that we Americans are irresposible when it comes to personal finaces.
POSTED BY: mike (November 18, 2008 07:49 AM)
Brian - Although many factors contributed to this Perfect Storm of Financial Chaos, the spark that started all of this was the Community Development Act that good ole Janet Reno and Bill Clinton imposed upon lenders across the country, forcing them to make sub-prime loans to people who in the end could not afford them.
With backing from Fannie Mae and Freddie Mac, the lenders went hog wild and and the rest is history. Corruption, lies, and greed in the private sector, you bet, but let's not forget the root cause of all of this: "Social Engineering," which was the brainchild of the Democrats.
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