The Current Financial Crisis – What the Heck Happened? (Part 1)

Alright, my first real post! I figured I might as well start out in an area where everyone is probably interested in, the current financial crisis and how we got here. There's been a great deal of coverage on this topic through various news channels outside of the financial-specific type. I even saw a documentary on it on the History Channel recently titled with something like 'The Next Great Depression'. Although I strongly disagree with too closely aligning this crisis with the great depression - there are some very important differences - I did find it an interesting and easily understandable piece on the origins of the crisis.

What I'll do here is to try to give some context as to what's going on while also giving my take on where we go from here.

The Way Things Were and Where Things Went Wrong

To understand what's going on, it's important to understand what changed in order to set the crisis up. It all really boils down to mortgages...and how they're created, who gets them, who owns them. Back in the old days (meaning 10+ years ago), getting a mortgage would be more like building a relationship with a bank. The banks wanted to know who you were as a person, as a borrower, and as a money spender. They wanted to know these things because that's how they would evaluate their risk when you asked them for a mortgage. If they decided to loan you money, they would own a mortgage (which is like any other asset a bank or company can have), and they wanted to make sure that you wouldn't default on this mortgage.

The system worked in this basic manner for decades, and the banks were able to build highly refined risk models to accurately predict a person's profile. In the end, they became very good at assessing risk because they needed to be good, otherwise it was them who would lose out if the borrower defaulted.

So, what changed?

Now things start getting a little tricky. The government began a long term political quest to promote home ownership in every person possible. To do this, they created new enterprises (Freddie Mac and Fannie Mae) to essentially share the risk of mortgages that were given to people that banks would normally not lend to. The aim was to help people generate wealth through the biggest single asset a vast majority of Americans will ever have - their homes.

Well, although this was a novel and highly regarded endeavor, it had some not so fun consequences. See, now that it was common to share mortgage risk with other banks, these banks started getting a little creative. They found ways to not only share the risk with the government, but with other investors. What they did was take the mortgages they created and packaged them into securities. Essentially, these mortgages turned into mini-stocks and they traded like those stocks. They came to be called Mortgage Backed Securities or MBS. Now, the banks could issue loans and makes money from the fees associated with those issuances, but turn around and sell part or all of the mortgage to investors as MBS's. In essence, they no longer had to worry as much about the risk associated with these loans since they wouldn't have them on their books. It would essentially be up to the investors who bought the MBS's to figure out what their worth was.

But here comes another problem, although these MBS's looked like regular stocks, they didn't trade like them as in, they don't have a market like the NYSE or NASDAQ where all the buyers would come in and the price was determined by the amount buyers were willing to pay and sellers were willing to sell at. Instead, the MBS's traded over-the-counter (OTC) meaning there were direct trades between buyers and sellers. This direct trading method made pricing the MBS's more difficult since there was no central market place and, again, put more onus on the investors to price the MBS's appropriately since they would have little reference as to the market value like they would on an exchange listed security.

The Rise Up

So now the train is leaving the station for what will eventually turn out to be, for lack of a better term, an economic wreck. Initially this worked out great for everyone involved when this risk sharing model was created. The economy was coming out of the dot-com bust. Interest rates for mortgages were historically low and the government promotion for home ownership was still going on. Banks were lending out more and more money to people that maybe weren't qualified for the mortgages they were receiving. New types of mortgages came out (option ARMS, Alt-A, etc.) that gave people the ability to afford homes that were way out of their usual price range with little or no money down. The banks realized that there was a virtually infinite demand for homes, and, with MBS's, they could loan out money beyond their usual risk tolerances. Consequently, home prices kept on rising, further increasing the level of indebtedness for Americans. People could easily refinance their homes to pull the equity out and buy more things like cars, LCD TV's, pools, all the good stuff. Eventually, Americans were more in debt than ever before. On the other side, investors kept on buying those MBS's, and as home prices kept on rising, they were still making money.

Everyone was happy. Money was being made. And then things got ugly...and that's where I'll pick up my next post!

Hope you liked my first one.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.