What amazed me was the point when I finally felt I really understood what happened and why we are where we are. My goal is to present this in a simple narrative explanation and avoid condescending analogies (it is not like dominoes local news writers!). I'll finish the article with as many of the sources for this information as possible, although it really is just based off of scouring all the informaiton that's poured out over the past few months.
Economy Wars: Episode I: The Phantom Menace
In the beginning there were good times. Housing prices were rising and people were making money. Of key note were banks and anyone that was even remotely related to Real Estate. Times were so good, there was a momentum and competition for banks to maximize their profits and not miss out on what was essentially riches falling from the sky. That lead to everyone within the industry pushing to simply give out more and more loans. They gave it out to anyone that would sign a name. Each time they sold a house, it pushed the value of houses upward and meant they would be able to sign even more lucrative loans. We all saw this in every neighborhood as housing prices doubled (or in California more than doubled) in only four years. We all were there in those surreal moments when you spoke to someone you knew only made $50,000 a year talk about the $600,000 house they bought.
That was the beginning.
We inflated a balloon (my last oversimplified analogy, I promise.) Banks made bad loans and invented completely retarded and overly complicated financial devices to get around the few speed bumps of regulation we had in place. The PMI insurance was always meant to be a deterrant for people borrowing too much, but suddenly there was a way to get a loan and have a down payment financed by another loan and both of these were now adjustable meaning you don't really know what you're signing on for.... Bottom line was that the regulators including Allen Greenspan didn't want to stop the party and put the brakes on everything.
But here's where it get's complicated.
The houses are only the start of the problem. The crazy loans that only those with a knowledge of modern finance at the level of Star Trek obessessiveness could understand did the worst thing possible. They spread.
Banks, not happy simply getting a poor sap to commit to paying them millions over the next thirty years created even more complicated financial derivatives. They would sell batches of houses and allow people to buy shares in these (REITs) and they would use these as collateral for entirely new investment portfolios. Again, competition grew as everyone wanted to find the fastest way to make money off of this oil strike of wealth generation.
It spread everywhere. Everyone was buying in including local schools and unions, super banks called institutional investors that invested money for everyone saw the huge rise in value of these real estate investments. That lead banks to make more crazy things that investors could buy and it drove up demand.
All of this lead to a glut where these shady loans where everywhere. Freddy Mac and Fannie Mae, the closest to government oversight of these things were flooded with loans.
The Calm Before The Storm
So let's pause here. Pretty much doing anything in real estate was like a print money button so everyone was pushing it. That lead to the proliferation of investments based on Real Estate that flooded not just the US financial markets but around the globe.
The Lord of the Spiral: Episode II: The Twin Clusterf*&ks
So everyone is making money, no one is saving (mostly because we had to drain our savings account to make our downpayments). And that's when the party ended.
The first houses that called in the bets on the Adjustable Rate Mortgages pushed the first batch of folks into foreclosure. On top of that, after a couple years of committing over 60% of their incomes to housing, families went into foreclosure as they remembered they needed to eat. And that food costs money (shock and awe!)
This is the snowball (ok fine there was one more cliche analogy in me). This was the beginning of the death spiral.
1. Resident forecloses on mortgage
2. Bank loses a lot of money on the foreclosure (remember each single house was hundreds of thousands.)
3. Banks start to struggle as the losses mount up.
4. Banks began to try to make up for this by limiting risky investments to small businesses and to new home buyers that didn't come in looking like Mr. T (a slight exageration, but perfect credit and more cash on hand than a Saudi prince seemed like the minimum).
5. This either slowed the growth of new businesses that created jobs (key providers of cash for the people that had no savings to pay for their very expensive mortgages) or it slowed the continued momentum in the market for new owners to purchase homes.
Now this is the point of speculation. During a key frontline report (that you can view here: http://www.youtube.com/watch?v=hKiEF7A6mX4) they really present a compelling hypothesis that two key mistakes by Henry Paulson lead to the complete decimation of our world economy.
I find this thoery too compelling not to accept it as logical and plausible. However, I don't know if I would wholly blame Paulson for what occurred. He may have made mistakes, but he did it with only the weight of literally the world on his shoulders.
The first major issue: Allowing Lehman Bros to die.
So during the death spiral, as more and more foreclosures mounted, banks lost money. So much money that they were on the brink of going out of business. For those that may not understand this, the bottom line is that banks never really just have cash on hand (most businesses don't.) They try to attract cash and they immediately put it to use, so they put money into the gas station down the street, the monolothic evil empire (*cough microsoft cough*), or the house in construction on your block. When the money disappears, they suddenly can't afford to pay the loans they've made (to other banks, to people in the form of CDs, or to businesses in the form commercial paper). You suddenly starve a bank by changing the trillions of dollars they felt they were owed in these loans and replace it with a blood red zero and that bank doesn't look stable.
Paulson made a call at this point. He was afraid that if he just bailed the bank out, all the other banks would just cash in their "help me" chips too and avoid really fixing the problems in their businesses (they have now fully dived into what may be zillions of dollars of real estate investments). He should know because he secretly saved Bear Stearns by armwrestling JP Morgan into buying them. I'm sure he felt that Lehman was being opportunistic and that wallstreet would see a gravy train leading right up to his office.
So Paulson made a decision. He allowed Lehman to fail.
That was the first shoe dropping. The other banks reacted with complete panic. Banks loan to each other all the time meaning everyone owes millions to everyone else. Suddenly they all looked at each other with complete suspicion not knowing who will go out of business next. The main fear was that giving any more money to that bank would just disappear if that bank went the way of Lehman Bros. That lead to the slowing down of economic activit.
Now here I have to give it to all the stupid newscasts, money really is like blood. It is the heart of what makes economies function. Banks take money from folks like you and me that don't want to sleep on a pile of it and they invest it in towns, businesses, and new innovations. When banks stop lending all of that growth stops. As the banks slowed people started becoming scared and consumer confidence falls meaning people stop buying. Which means businesses don't prosper, so it's real self fulfilling prophecy.
Wow that sounds pretty bad right? Except things got much much worse.
The second major issue: Privatizing Fannie Mae and Freddy Mac
The largest owners of mortgage debt were the semi government owned Fannie Mae and Freddy Mac. Paulson saw the fear on the street and his advisors no doubt saw the possibility of a major economic recession. They knew that trillions would be lost as economic activity continued to slow.
Unfortunately this drove them to a desperate measure: They privatized these two banks that had essentially failed with immense amount of defaulted loans.
This proved to people already scared that their fears were founded. Instead of finding comfort by the US Government stepping in and promising everything to be alright, they knew that the action showed that the situation was as bad or worse than they expected. That lead slowing to complete freezing and economic panic. This went from uncertainty to stark fear. It went from "risk of failure" to "freefall".
A new super death cycle evolved.
1. Families stuggle under foreclosure
2. Banks lose money
3. Banks refuse to loan money to businesses
4. Businesses are forced to go under since they can't buy supplies or pay for employees
5. This causes more people to go on unemployment
6. Those on Unemployment wind up foreclosing on their mortgages
7. The businesses going under and high unemployment bring down stocks and slows spending, effectively slowing sales for virtually all businesses
8. This causes large major businesses to suffer
9. Large businesses layoff workers in large masses
10. Laid off workers go into foreclosure
11. Virtually all banks wind up on the brink of complete failure mainly stemming from the bad real estate investments (also called toxic debt.)
All banks saw their books fill up with bad debt. They all viewed each other with suspicion and fear. Banks that were critical to their own success were now seen as ticking time bombs or as that Uncle Sal that you know will never pay you back. That lead to the complete freeze of the largest economy in the world.
That triggered a global death spiral. International banks relying on US banks suffered, global conglomerates fell in to bankruptcy, entire countries were bankrupt, global stock markets dropped at dizzying speeds.
Even Bush giving the banks an unprecedented 350 Billion dollars failed. That was to ensure every bank that, hey, at least you know that other bank has the 10B we gave them. Unfortunately, 350B was nothing compared to what realistically could be trillions of dollars of bad debt. The banks took the money and maintained their positions staring at each other and waiting to see who will die off next. It's like winter at the retirement home. Ok, maybe that was excessive....
And that's where we are... in freefall.
There we have it ladies and gentlemen! Loss of jobs and collapsing banks, all our 401K shrinking causing people to spend even less! It's an amazing thing to see the underlying foundation of our economy falter.
I'll follow up with another blog on fear and why it's not easy to fix. Really it's this issue of calculating the bad debt and how just honestly displaying how bad it is could be the worst thing the banks could possibly do.
