Tuesday, September 30, 2008

How Did We Get Here? Part 1

Last week, we tackled the rather convoluted history of financial speculation, recessions, depressions, the business cycle and other background information.

Now, let's move on to the roots of the present financial situation.

Actually, if you want a great primer and clear explanation of these complex economic interactions, I found one at a somewhat unlikely source. On a May, 2008 episode of the usually gut-wrenchingly smug NPR program This American Life with Ira Glass entitled "Giant Pools of Money," an excellent summary and explanation of the roots of the crisis was given. Maybe it was so easy to understand and accessable because Glass had nothing to do with it. NPR's business and economic correspondent Adam Davidson and NPR producer Alex Blumberg teamed up for this piece. While there are a few liberal jabs at evil capitalists, it is no more than one would expect for NPR; furthermore, these do not detract from the sound analysis offered in the piece.

Listen to "Giant Pools of Money" here.

If you listen to that, you could probably skip everything that I say below and still have a good picture of the situation. If you desire some more detail, links to relevant information and my perspective, read on...

The current "subprime mortgage crisis" and subsequent "credit crunch" has its immediate roots about eight years ago. In 2000, the sexy investment of the day, high tech and Internet stocks, began to falter. Falter is perhaps too light a word. The train came off the fucking rails.

With nothing cool like pets.com to invest in, the investing community (which encompasses everyone from ordinary individuals to global investment banks to governments) executed a classic "flight-to-safety." They were all looking for a place to put their money that gave reliable returns and had some assurances all while sacrificing sexiness. In other words, people were looking for nice, boring investment vehicles.

The nicest and most boring of all investment vehicles are U.S Treasury Securities. These securities, which are basically loans to the U.S. Government, are not risky, have low rates of return and are backed by the full faith and credit of good ol' Uncle Sam. Sounds pretty good, right?

Well, for a short time, it was.

Then the events of September 11, 2001 happened.

The economic nosedive after 9/11 coupled with the then still unravelling tech bubble made these boring investments even more boring. They became downright dreadful.

Why? Well, basically, it was because of what happened to that low rate of return...it got even lower. So low that treasury securities were not an attractive investment for anyone. You see, the rate of return on treasury securities is tied directly to the interest rate at the time the bond is issued. The people who control the interest rate in the United States (the Chairman of the Federal Reserve and the Federal Open Market Committee) decided that with the attacks of 9/11 and the bad stock market, the economy needed a little boost.

So the Federal Reserve, led then by Alan Greenspan, lowered the interest rates (which are several different numbers actually, but we needn't discuss this here) and kept them low for quite a long time. In fact, the Fed kept the rates so low that, in effect, the boring treasury securities became even too boring for people who wanted something that was pretty boring.

What happened next? Well, investors are not a crowd to sit around and let their money sit idle (hell, that goes against the very idea of investment itself). They then began the search for something that would pay a decent return and they were beginning to run short of options. These investors will return later. Now, another part of the story...

Another effect of lower interest rates is cheap credit. If the interest rates are low, this also means that the cost of borrowing money is also low. This means that anything that people usually buy on credit was now available at almost-giving-it-away prices. In other words, people could almost borrow money for free.

If people can borrow money for free, the natural inclination (which would prove unnaturally disasterous later) is to borrow more. For most people, what is not only the most expensive thing that they will ever buy but also a thing (more likely than not) that is bought on credit?

That's right: a house (or real estate, more generally).

The type of legal/financial arrangement in the US that involves real estate is called a mortgage (I won't explain this here, but click the link for definitions). So, with cheap credit, anyone could get a mortgage, right?

Well, sort of...

You see, once upon a time (until quite recently, actually) getting a mortgage was not as ruinously easy as it became in the years after 2001. If you wanted a bank to lend you money to buy a house, you had to prove all sorts of things to them. You had to prove that you had a job, that you had some liquid assets, that you didn't have a really horrible credit history...generally, you had to prove that you were a good risk and that you would eventually pay the loan back in full.

In the early days of low interest rates in 2001 and into early 2002, these policies were still pretty standard fare. Yes, the credit was cheap, but you needed to show your financial responsibility before the bank would let you at all the lovely money.

This went on apace until we reached a point, most say sometime in 2002, that everyone who qualified for a mortgage and wanted one could get one. Fine, you say, responsible people should be able to have access to such arrangements.

Well, it turns out that lots of irresponsible people wanted access to this cheap credit and there were other irresponsible people who were all to ready to let them have at it...

For Next Time

We will contiue to follow this story and try to draw the connections that eventually led to the state we are in today. We will see how cheap credit, irresponsible borrowing and lending, possible fraud, financial ingenuity, government stubbornness and some really mistaken assumptions began to lead to real trouble.

Stay tuned...it only gets more interesting from here.


the iNDefatigable mjenks said...

One thing that you didn't touch on, but I thought sure you would when you were talking about "back in 2000" is that Y2K panic actually helped to start the whole instability of the economy when people were afraid that they wouldn't be able to get their money, so they started pulling it out of banks and investments and such. While not the severe blow that 9/11 was, Y2K kind of helped kick this whole thing off.

Will Shannon said...

Good point, Jenks.

I rather think that the Y2K issue and the panic therein was more of a secondary level cause.

What I mean by that is that while it may have led to a general uneasiness leading up New Year's 1999, I don't really think that it could be linked in any direct way to the tech unravelling.

The causes of that event are complex enough, so I just tried to keep in the parts that relate to the situation at hand.

Having worked in the financial sector, it seemed to me that the tech bubble began to burst when it did simply because the wider investing public realized what the pros did: these companies were grossly overvalued, were not showing any sort of profit and were unlikely to do so for some time; hell, it took Amazon eight years to finally make money overall.

Thanks for the comment, as always.

Anonymous said...

i hope you really lay into greenspan more. he deserves everything he gets.


Bruce A. Sullivan said...

Thanks Will - I am making my way through the swamp. Great pools of money enlightened me and made me sick at the same time. I almost thought it was yacht rock.

Will Shannon said...

Greg: Don't worry. Greenspan will get his next time.

Bruce: If only this was as smooth as YR...I wonder what Michael McDonald and James Ingraham could do about this problem. Maybe they could do a great smoothing over...

Lost A Sock said...

I've actually had this entry saved in my feed reader for two weeks, waiting for a quiet moment to read it. (This is bad, that it has taken me two weeks to grab a quiet moment.) All that being said, well written, and I look forward to reading the next installment. As always, I like how thoroughly you explain things.

Also, I thought of you when I read this: http://momocrats.typepad.com/momocrats/2008/10/justice-departm.html