What started this bloody recession?

The New York times today provided one of the most succinct summaries of how the subprime contagion and ensuing credit crisis has caused the global economic mess that we are seeing today. The writer David Leonhardt has done a great job synthesizing a complex topic into a simple essay. So if you don’t understand why we are having the financial crisis or just want a quick re-cap, here are the key points from the article that explain it all:

- It all started at the beginning of the US economic boom in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

- The new competition brought down mortgage fees and spurred some useful innovation. As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages. Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s. Once bundled, different types of mortgages could be sold to different groups of investors.

- Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

- All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But the powers that be and American homeowners decided that the usual rules didn’t apply because home prices nationwide had never fallen before (people have short memories!). Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

- And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

- Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. [Recent statistics point to potential exposure that could run into the trillions, so you can only imagine how deep the impacts of these losses will be]

- This toxic combination — the ubiquity of bad investments and their potential to mushroom through leveraging — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Good-bye, Bear Stearns.

- The conservatism has gone so far that it’s affecting many solid would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Streets fears. A recession could cause credit card loans and other forms of debt, some of which were also based on over exuberance, to start going bad as well.

Many economists, on the right and the left, now argue that the only solution is for the federal government to step in and buy some of the unwanted debt, as the Fed began doing last weekend. This is called a bailout, and there is no doubt that giving a handout to Wall Street lenders or foolish home buyers — as opposed to, say, laid-off factory workers — is deeply distasteful. At this point, though, the alternative may be worse.

Bubbles lead to busts. Busts lead to panics. Panics lead investors to sell and markets to fall and that’s why we are in the situation we are in now. Got it?

The full article, which is definitely worth a read, can be found here.

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Tagged as: crisis, recession