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.