Making Sense of Our Financial Mess

Really, what the general public has got to be asking after the financial news of the last week is "wha' hoppen?" -- accompanied by grogginess, head shaking, and animated birds circling their heads, chirping.

It started ten days ago, with a series of events that had the result of "freezing" the credit market. What that means is that banks and other financial institutions stopped lending one another money and people started moving away from money markets and similar kinds of accounts -- the savings accounts of really big companies -- and moving their money into Treasury bills. They were so frantic to get out that, for a short while, Treasury bills were down to zero yield. This is pretty much the definition of fear on Wall Street: they were so worried about losing money that they were willing to lose money.

If this goes on, here's what could happen.

We depend on credit lines more than most people realize. Credit lines dry up: businesses that depend on them grind to a stop. That means: grocery stores start to empty -- they depend on short-term credit to buy food for the shelves; paychecks bounce, or aren't delivered at all -- many companies, especially very big and very small ones, use short-term credit to pay payroll against receivables. People will be out of work.

When something similar happened in 2000 in Argentina, within a few months Argentina had 25 percent unemployment and middle-class people were reduced to recycling cardboard and picking rags in order to get money to eat. We're talking Great Depression here: bread lines and soup kitchens.

Now, that hasn't happened yet. Faced with the possibility of a new Depression, Ben Bernanke, chairman of the Federal Reserve, and Hank Paulson, secretary of the Treasury, got their attention wonderfully focused; the last weeks have been spent laying out a plan and attempting to sell it.

Before we talk about that, though, let's talk about what did happen.

Basically, it was a run on the bank, like happened at IndyMac a few months ago, like the one in It's a Wonderful Life. People started asking big financial firms for cash, until they ran out of cash; because the markets weren't working and credit wasn't available, the big financial firms didn't have it. This frightens people, and markets don't like fear.

So how did it happen?

The history of this really starts back in the '70s. For various apparently good reasons, Congress in its wisdom decided that banks and lenders should sell mortgages they would not have ordinarily done. Sometimes, the reason they didn't sell the mortgages was very possibly racial prejudice; sometimes it was the bank's observation that some neighborhoods seemed to do better than others (so called redlining); and sometimes it was for reasons of creditworthiness and income. In any case, the Community Reinvestment Act passed in 1977 during the Carter administration and was revised in 1995 during the Clinton administration. Whatever the desirable qualities of these laws, the net effect was to make home mortgages, over all, more risky.

As Wikipedia correctly says (as of September 25, 2008, at least):

Part of the increase in home loans was due to increased efficiency and the genesis of lenders, like Countrywide, that do not mitigate loan risk with savings deposits as do traditional banks using the new subprime authorization. This is known as the secondary market for mortgage loans. The revisions allowed the securitization of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997 by Bear Stearns. The number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent.

The 1995 revision of the Act allows lenders other than banks to get into the business of offering home mortgages, and allows both banks and these other lenders to offer these subprime mortgages while securitizing them. "Securitizing" means the loans were collected into a financial instrument like a bond and sold on an open market. These collections of securitized loans are called mortgage-backed securities, usually abbreviated as "MBS."

Why would you do that? The answer is that it was an attempt to reduce the risk: a single mortgage could fail or not, but a lot of mortgages collected together should always be worth as much, or nearly as much, as the face value of the bond. If a few mortgages failed, it didn't matter to the bond, because the face value included an allowance for some failures.

Still, some people felt the risk was too high, so another "innovative financial instrument" was invented, called the credit default swap, or "CDS." In a CDS, I insure my MBS by finding another company, like AIG, to effectively write me an insurance policy: if certain things happen to my MBS that make it have less value, AIG promises to pay me the full value of my MBS in cash, swapping it for the MBS itself. (A "credit default swap" works like this: since I believe in the good credit of the issuer, I'll let you pay me a small fee, with the promise that if the issuer defaults, I'll swap the full amount in cash for the security.  In other words, if something bad happens to the bond, I'll buy it back from you, paying cash for it.)