Many people don’t understand the fundamental reasons why the US financial system is failing and the reasons behind the day to day volatility. In this post, I try to explain to you how this mess happened.
It all started about a decade ago when banks started redlining urban centers which immediately disqualified people from obtaining mortgages in the hypothetical red areas. The problem began when banks thought the solution to redlining was with sub-prime mortgages. Banks deceitfully offered significantly discounted interest rates that would eventually skyrocket after an initial 2 year term. In some cases, the principal was higher after the two year period! The problem was that loans were being granted to people with very poor credit ratings, including to people with Loan to Value (LTV) ratios of more than 88%, compared to the maximum current cut off of 75% which is arguably also pushing it. Another problem was that people were able to provide their own income which was never verified. If you’re wondering why people would take the loans, we can generalize with these main reasons: the banks deceitfully didn’t disclose the teaser rate wouldn’t last, the loan seemed so affordable it was basically free money, and people wanted to own their homes and didn’t have another alternative to get a mortgage.
So, what did the banks do with all of these loans? They grouped the loans into Mortgage Backed Securities (MBS) which were bought by various investment banks who converted the MBS into new financial instruments called Collateralized Debt Obligations (CDO). The banks originally developed MBS because they are only required to hold 1.6% of capital for mortgage backed securities, compared to 4% to hold a mortgage. The CDO instruments were then setup in the Cayman Islands to avoid taxes where they were then artificially rated by credit agencies who received most of their income from structured finance products. The real problems were for firms that invested in CDO securities based on the artificial ratings. Essentially, as people began to default on their mortgages because of the new high rates after the initial 2 year term and falling home values, the CDOs failed along with the firms heavily invested in these securities.
In recent events, on March 5 2008, $20 billion hedge fund Carlyle Capital missed its margin call (its positions totaled less than the allowable threshold), and In June 2007, the Bear Sterns sub-prime hedge fund also failed. More recently, ex Bear Sterns executives Cioffi, Tannin and a third Bear Sterns executive are being sued in a civil case by the Bank of America for understating the hedge funds performance by drawing the bank into a $4 billion investment. There is also talk now that the Fed will buy $600 billion in troubled mortgages to avoid further decreases in home values. Furthermore, Lehman Brothers investment bank recently went under after a $3 billion loss, all because of the credit crisis that resulted from very risky bad loans that were made in hopes of high returns by banks. All of this also resulted in runs on backs (people rush to take their money out) which was further adding to the problem. As businesses and people could not get credit, these problems spilled over to the real economy. Companies such as GM who need cash cannot get loans and they are in risk of going under. So, we can expect now with the bailout of cash injections that the financial crisis will subside within 2 years as the peak of defaults end.
I hope you now better understand the events that have caused this credit crisis better and the reasons behind why the banks did this: which are clear, they gambled with extremely risky loans hoping to earn substantial profits (they probably even knew they would be bailed out because the positions would be too big to fail, which served further as an incentive to take on these risks).
In an upcoming post I will give a detailed analysis about GM, how its doing and where its going and how its being affected by the credit crisis.
If you have any questions about the financial crisis, please do not hesitate to post them in the comments and I will try my best to answer you.
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