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.