The Financial Crisis - Part 3

To better understand the issues, let’s start with a very simple case and then move toward reality. In a basic lending relationship, a bank makes a mortgage loan to a homebuyer in exchange for an IOU. According to this IOU, the homebuyer owes the bank a series of monthly payments until some maturity date. If the homebuyer fails to pay, the bank may foreclose on the property, thereby assuming ownership. On the front end, the bank’s ability to foreclose in the event of default insulates itself (at least to some degree) from losses because it will have the ability to resell the property. In fact, the bank expects this process to take place in some portion of its loans as a normal course of business.

Now suppose that a large number of defaults happen at the same time. Our hypothetical bank would begin foreclosing on these properties and then trying to resell them. In contrast to a normal scenario under which only a few foreclosed properties are for sale, this case would result in a large shock to the supply of homes on the market. And all else equal, the extra homes for sale would depress prices and reduce the amount of cash the bank could get from any foreclosures that are resold. Combining this with the likely case that the defaults were driven by a slumping local economy, reduced demand for homes would drive prices down even further. One big loser here is the bank holding the foreclosed properties. Losses might be so bad that it would not have enough cash to pay its other liabilities such as its demand deposits, other deposits such as CDs or savings accounts, and any other longer-term borrowings that are coming due. This would result in bank failure and regulatory intervention (you know, when the guys in suits come and lock the bank’s doors).

While the above situation is undoubtedly bad from the perspective of the bank and its employees, it does not in and of itself warrant any type of bailout, nor does it necessarily threaten the vitality of our financial system. So let’s move now into what has actually happened.

After banks make mortgage loans, many do not hold on to the new IOUs that were created. Rather, they use some mechanism to sell them to other investors in the secondary market. That’s right, a lender can sell an existing IOU to another investor for cash. As a result, the homebuyer still owes a series of payments, but he owes it to a different party. The lender, on the other hand, no longer bears the risk of non-payment and now has cash that can be used to support new loans or other activities. In principle, this is a win-win situation. From a bank’s perspective, it is not holding a pile of IOUs from borrowers in the same geographic region. That way, it’s somewhat protected from a bad event that leads to a lot of defaults in its own geographic vicinity. Moreover, investors purchasing these types of IOUs are less exposed than the lending banks because they are also purchasing similar IOUs from lenders from many different geographical areas. As a result, non-performing loans from one area will be offset by performing loans from another. Finally, from the perspective of homebuyers, there is available credit to use in purchasing their homes. And everyone is happy.

Problems only really arise here if there are large negative shocks across the entire economy. And that’s exactly what has happened. In this unlikely case, everybody hurts. So who are these investors holding the risky assets? Lots of folks – including many banks and other financial firms, mutual funds, money market funds, companies such as Fannie Mae and Freddie Mac, and alternate investment vehicles such as hedge funds. I’ll devote the next installment to a more detailed description of what this exposure looks like and what can happen when these entities fail at the same time.

The Financial Crisis – Part 2

I had a really interesting experience at my dentist's office last week. For the first time – ever, I think – he removed his hands from my mouth and allowed me time to respond to one of his questions. Why? Because he's interested in the financial crisis, and he thinks I actually know something about it. It was flattering to say the least.

He's not the only one out there under the slightly mal-informed impression that I know something. In fact, I've been astonished at all the conversations I've found myself in lately. For once in my life, everyone cares about the same boring stuff that I think about every day and I'd like to milk that for all it's worth. So, if you're still reading, I'll assume that "everyone" includes you.

Over the next few days, I'm going to take a stab at explaining, in clear English, what's been happening. My intent is neither to create a panic nor to convince you that our financial system will make you safe. (If what ensues leads to either, we should probably have a discussion about idolatry.) Rather, I simply want to distill the situation in a way that educates and informs.

So without further ado, let's start with how we got into this mess in the first place. While there is no single reason for the crisis, most will agree that current problems stem from sub-prime mortgages. These are home loans that were granted to borrowers with less-than-desirable credit or financial resources relative to the amount borrowed (hence, the term "sub-prime"). In some cases, lenders were fully aware of the financial positions of their clients. In others, that isn't necessarily true. For example, some loans were granted based on stated income as opposed to requiring paystubs, W-2s, etc. Or worse, some loans required basically no documentation from the borrower at all – the dreaded "no doc loan". In all these instances, however, lenders did to some extent recognize such borrowers as less likely to make contractually-obligated payment and charged higher interest rates as compensation for the associated risk.

In the good economic times of recent years, defaults (i.e., failures to pay) on sub-prime mortgages were not a pervasive problem. Part of this was because the typical borrower did in fact have sustainable income; part was because many loans had an initial period over which interest rates were quite low. But, more recently, many local economies have tanked, reducing or eliminating the once comfortable incomes of many of the borrowers in question. In addition, adjustable-rate-mortgages began re-setting to higher rates, thereby increasing required payments often times beyond borrowers' means. Given the voluminous number of sub-prime mortgages that were suddenly in default at the same time, it became clear that either we were in a very low probability state of the world, or that the risk of correlated defaults (i.e., defaults on many different loans happening at or near the same time) was vastly underestimated. Either way, lots of people weren't making their house payments, and anyone to whom they owed money was exposed.

That's enough for now. Next time, I'll discuss who was and is ultimately exposed to the mortgages that are either in our near default. (Hint: It's not just the banks that loaned the money.)

Let me also refer the interested reader to this article. It appeared in the NY Times in 1999. Prophetic? See especially paragraph 8.

The Financial Crisis – Part 1

Banks are failing. The market is down. The government steps in. The market is up. Banks are failing. The market is down. The government doesn't step in. The market is up. Banks are failing. The market is down. And the cycle continues...

Many have asked me what I'm doing in the wake of the current crisis that is upon us. My answer: "Start popping popcorn." You see, as a finance professor, I love this stuff. Not the panic and suffering and fear. But the mechanics - what is happening, how we got here, and what if anything can and should be done. I've got a lot to say, and the beauty of blogging is the fact that I can say it all and pretend that someone is paying attention.

So let's start here. I think it's interesting that anytime something bad happens in this world, there is a host of geniuses out there to claim foreknowledge of the whole thing. Just today, I read the following quote by financier Henry Clews...

As in every preceding crisis, the main cause was far too large a mass of credits -- that is, of debts -- for the amount of cash in which they were redeemable. Trade and speculation had long been so active, and too often reckless expanded, that this disproportion had become dangerous, and a menace to our safety...a serious reaction, a serious revultion, was inevitable unless we moderated our pace and mended our ways...I could foresee that this vast and growing disporportion between the volume of credits and cash would finally lead to collapse.

Here's the really interesting part. This was from a 1908 discussion of the Panic of 1907.

Don't worry...help is on the way

I just read this article about Boone Pickens' recent hard times. Yes, you read it correctly - his hedge funds are down about $1 billion, and approximately 25% of that amount is his own personal wealth. Interestingly enough, this was largely due to rapid declines in energy prices. You see, his funds were heavily exposed to energy stocks, and when oil prices fell, he got hurt. Now, I just don't think we should allow this type of thing to happen here in America. After all, there is an American Promise that must be upheld. So here's my proposal. Out of fundamental fairness, let's issue a windfall profit tax on Hollywood - you know, the likes of Angelina Jolie, Matt Damon, George Clooney, and most of all Lindsay Lohan - and subsidize Mr. Pickens to cushion the blow. Is anyone with me?

It's been awhile

I'm sure both of you are wondering why it's been so long since I've penned fresh words of brilliance. Well, the short answer is...um..."present."  (Thanks, Nate, for inspiring me.)

Seriously, though, I've got nothing right now. So I'll direct you here instead. Michael absolutely nailed it; this is worth taking at least a week or so to mull over.

Check this out, Clark

See that kid holding the sunscreen? He's mine. He isn't wearing clothes now because he was wearing them when he got in the pool. I objected to the idea at first, but Momma said, "Just let him do it. We'll be able to give him a bath and wash his clothes all at the same time." In light of the infinite wisdom, I conceded. The only real downside was that we had to waste a diaper since his old one weighed about 10 pounds when he got out. So much for foresight.

The real action, however, occurred between the cleansing and the scantily clad pose. Pretty Lady decided to strip him down outside the Winnebago and left him there to frolic in the breeze, thinking it was cute I suppose. Then, in an unexpected moment of both maximum nudity and extreme honesty, he claimed Mayah's car as his own.  Here's what we found.

Houseguest

Meet Ralf. He's been living with us for the past six days. He isn't here permanently though. We are his temporary caregivers while our friend Esther is away at Disneyland. Yes, she goes to the happiest place on earth to get her picture taken with a sweaty guy dressed up as a rat, while we keep her real one safe and sound back home.

But, honestly, it's really not that bad. He stays in is house pretty much all the time and all we have to do is feed him. The kids are warming up to him and occasionally even think about petting him.

The truly blog-worthy events, however, come from the enigma we affectionately call Mom. From the first night, Jenni has refused to touch him, feed him or so much as look at him with both eyes. But in spite of the negative signals, she has mysteriously become his greatest advocate. She talks about him all the time and is passionate about making sure he's comfortable and taken care of. I think there may have even been a hint of tear in her one open eye the other day when she said, "Awe, he looks hungry..."

So when I finally asked her to explain this love-hate relationship, Jenni's response made everything clear.  "I just don't want him to die.  Of course, if he were ours, it would be a totally different story."

Thanks, my dear Bride, for reminding me why I like you so much...