FINANCIAL MISCONDUCT: How did the credit crisis develop?
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Jonathan Jarvis has created a slide show that explains in simple terms how the credit crisis developed. To understand about the credit crisis you have to understand the components known as prime mortgages, sub-prime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps.
Homeowners and investors were brought together. Homeowners are represented by mortgages and investors by the money they invest in the stock market. The mortgages are represented by houses and investment money by institutions that invest our money in ventures that are supposed to make a return on the investments. These include pension funds, insurance companies, mutual funds and other companies that invest our money for a fee.
In the middle of the homeowners and the investment companies are the financial markets that are housed on Wall Street. When Alan Greenspan as the head of the Federal Reserve lowered the interest rate to 1% it caused investors to look for alternative investments to beat a 1% return that they would receive on T-Bills.
Traditionally when investment institutions had extra money they would buy government bonds or T-bills. After the dot.com bust the government began doing something different that caused investment institutions to look elsewhere for a return.
On the other hand banks can borrow from the Federal Reserve for 1%. The banks said yippee kayay! With oil prices climbing many foreign investors/governments had extra cash on hand; making credit abundantly available. The more money that was available the easier it was for bankers to borrow.
A zero leverage is when a person has $1,000 and buys a $1,000 item; then turns around and sells it for $1,100. You make a $100 without any borrowing or leverage.
It was at this point that leveraging starts to rare its ugly head. Some leveraging is good and some is very risky. If I have $200,000 to invest in a building and can borrow $2 million more I'm leveraging my investment money 1:10. The borrowed funds are backed up by collateral. In this case the commercial real estate. Assuming there are good solid leases in place with honest tenants, then this is a safe leverage for everyone involved.
Here is where it can go wrong. The person who sees the $1,000 item with $100 to make in profit heads to the bank and borrows $990,000 when they have only $10,000 of their own money to invest. The investor or businessman now has $1 million dollars to go out and buy 1,000 of the same items estimating a $100 profit on the sale of each; or a total return of $100,000. Subtracting his initial investment of $10,000 he's made $90,000.
So long as this guy is paying back his loan the banks are making money through loan interest payments. In a low interest market banks will line up to cut each other's throats to get this guy to borrow from them. Hey come to our bank we will give you a better deal; a lower interest rate, we will require less collateral and/or no prepayment penalty.
Wall Street sees deals everywhere. They see deals in putting together a hostile take over, IPO's, stock sales, stock purchases, indexing and a whole host of legal investment schemes. Wall Street borrows money by the billions. As a part of this process banks make a ton of money in fees from mergers and acquisitions, loans and structuring deals for Wall Street.
That's where you and I come along, remember we are the investors. We have money saved for retirement and want it busy earning a return on investment.
Wall Street sees us on the side lines clamoring for a piece of the ROI rally and that makes them think up ways to get our money busy. Here is their idea: Let's connect the investors to the homeowners through the mortgages that are being written.
In come the mortgage brokers who take the homeowner's loan application, then locate a lender who will underwrite the paper. (Mortgage = paper) The broker gets paid a commission and that's how the broker makes his living; by connecting the dots between home buyers who want a mortgage and lenders who lend the money. The more loans they broker, the more they earn.
Homeowners see buying a house as an investment. That has historically been true. Buy a house, make the payments, pay down the principal amount, and maintain the house and when you sell it you walk away with the equity.
Wall Street hasn't gone anywhere and those on Wall Street see these mortgages as something to invest in. Wall Street wants to buy your mortgage from your lender bank. The lender can earn a fee if your mortgage is sold to a Wall Street investment banker.
Now flip back to the guy borrowing $990,000 and turning his $10,000 of cash into $100,000. The investment banker does the same thing. The investment banker borrows hundreds of millions of dollars to buy thousands of our mortgages. These portfolios of loans are then packaged as securitized mortgages. Meaning investors won't see a single mortgage but a group of mortgages that have been grouped together and rated for risk. Risk is associated with which borrowers are more or less likely to be able to make the mortgage payments.
With the ownership of all these mortgages go all those mortgage payments. Though leveraging the investment banker is dramatically increasing the amount of cash flow coming in each month.
Investment bankers then get the idea they too can sell these packaged securitized mortgages by repackaging them. The loan portfolios are separated into three categories: safe, not so safe and risky. Not wanting to call them all by the same name the collateralized debt obligation is born. CDO.
You might ask why an investor would buy the CDO's with the risky mortgages. Well it has to do with the concept of risk and rate of return. (The riskier the investment, the higher the rate of return.) If you combine all three categories into one package the rate of return is averaged and is higher than just owning the safe mortgages. Investors are more willing to take at least some risky mortgages to get the safe and not so safe loans.
But this makes some investors nervous. They don't like the risk of buying mortgages where they haven't met the borrower and where risky loans are involved. Banks want the loans to be sold to investment bankers and so banks come up with loan insurance, called a credit default swap. Banks have the job of grading the loans and rating agencies get paid to put their stamp of approval on the loan packages. The top slice gets AAA as the best and safest of the mortgages underwritten. The not so safe mortgages get the BBB rating and the risky loans go unrated.
Hedge funds like the risky stuff because the return is higher.
With all these sales of mortgages the investment banker is making millions in commissions and fees. With the sales proceeds the investment banker repays the loans taken out to leverage purchases of securitized loans from the banks.
Investors are happy because they are making better than the 1% that Uncle Sam was offering on Treasury Bills. They demand more from investment bankers. "Bring us more CDOs!" they chant.
To fulfill this demand the investment banker contacts lenders saying, "Bring us more! Bring us more!” The banks want to earn more fees and commissions on selling these loans so they contact the mortgage brokers and say, "Bring us more! Bring us more!” The mortgage brokers need to create demand for more home mortgages and they in turn tell the bankers to lend more money to developers to build more houses. The loan brokers begin to look at the loan applications and identify questions that if not answered or answered little differently more applicants can be approved.
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Liar's loans are introduced. The mortgage broker doesn't really care about the application being less than perfect because he isn't lending his own money and he makes a commission on the loan being made. The lender looks the other way because this loan will be in the office only hours before it's sold to an investment banker.
Wall Street knows what is going on and of the risk involved. If the loan goes into default they will end up with the house; something they really don't want. Remember Walls Streets finest don't live on Main Street. To offset this risk of possible foreclosure Wall Street makes an assumption; even if we end up with the collateral our losses will be offset by the ever increasing value of homes in the U.S. market.
That assumption underlies investment bankers buying even more risky loans.
They yell louder "Bring us more! Bring us more!” We don't care about down payments (the borrower having some skin in the game.), no proof of income (liar's loans) or documentation of anything on the application.
To fill this demand for more home loans banks begin selecting appraisers that are moldable. Lenders hire appraisers whose opinions about the home's value makes the same assumption as that of the investment bankers: Homes in the U.S. increase in value every year. That allows refinancing of existing mortgages, HELOCs (home equity loans) and new home owner loans with borrowers who traditionally would not qualify for a home loan.
Prime mortgages are to responsible and honest people. Sub prime mortgages are to those looking for a participation trophy. Sub prime borrowers are looking for something for nothing.
Pretty soon everybody in the chain from mortgage brokers to investment bankers are looking the other way and doing deals that should have not be done because no one intends to hold the paper or those that do are relying on one false assumption; that homes always increase in value. That false assumption is one that Harry Dent predicted more than ten years ago.
Meanwhile the SEC exacerbated the situation by allowing the major investment banks to bet the house on leveraging our pension and investment dollars to buy more risky packages of mortgages. On April 28, 2004 at 2:30 p.m. the SEC held a meeting and changed the net capital requirement for Wall Street allowing them to remove any semblance of common sense in prudent investing. And as we saw the temporary reduction in value of our homes toppled the major investment banks when they found themselves undercapitalized.
So ask yourself does deregulation as the Bush Administration proposed work? No some regulation is necessary to curb the natural tendencies of a free economy, greed. Now mind you wanting to accumulate wealth isn't bad and that's not what I'm saying. But what I am saying is greed is not good and without the right checks and balances human nature being what it is will always push the economy to those ends. What we should be asking ourselves is why didn't anyone in this chain just say stop you're selling a dream that doesn't exist for this person. This is bad business.
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The Crisis of Credit Visualization, by Jonathan Jarvis.