The "Credit Crisis"

Intro

A few people have asked me what this "credit crunch" is, and what the big deal is over subprime mortgages. Let me explain briefly.

Terms

A mortgage is actually just a document that says the bank can take your property if you default on your loan. So I'll be using loan throughout this little essay, not mortgage.

A "subprime" loan is simply a loan with a higher risk of default - e.g. a loan to someone otherwise not qualified for this loan. A loan may be subprime for a number of risk factors - bad past credit history, low/no income relevant to the size of the loan, you get the idea.

The Old Way

When you get a loan for your house, your lender (almost always) immediately sells the loan to a big broker. This is to allocate risk. If a small lender sees 5/10 loans go belly up on a freak thing, the lender might go belly up too. This is unlikely, but it is even less likely for 50% of 1000 loans to go belly up.

This broker bundles lots of similar loans together and sells basically sells parts of the income. They basically sell sections of the revenue stream. This way the big broker doesn't even have to take all the risk himself, and the big broker doesn't need to have all the money it lent out, since the broker can borrow the money to lend, from investors. See this isn’t hard right?

The New Way

Brokers figured out a new way of selling investments. The old way was selling sections of the revenue stream. For instance, they might sell 2% of the loan payments, for a certain bundle of loans, to Jon in exchange for $1,000 now. Got it?

The new way breaks down the payments into "traunches." Lets say we use 3 traunches. The 1st traunch gets the 1st 1/3 of the loan payments from a bundle. Got it? The 2nd traunch gets the 2nd 1/3 of loan payments. The 3rd traunch gets the last 1/3rd of payments.

Naturally the 1st 1/3 of payments is very safe. More than 2/3 of the loans would have to go belly up before the 1st traunch failed to fill completely. So these assets sold at nearly face value. For example, if income is expected to be 1k/month, a 12 month asset would cost just under 12k (due to time value of money, and very very minor risk). These brokerages got these "1st traunch" assets rated as very safe. Safe for stuff like teacher's pensions.

Naturally the last 1/3 of payments is very risky. If anyone defaults, the revenue is coming out of there. So if loan payments were expected to be 1k/month with this traunch, a 12 month asset would cost much less than 12k. These assets were rated very risky, suitable only for hedge funds and other speculators . Still with me?

Complications

Ok with that setup lets do a small amount of history. Remember the early 2000s, and the pseudo recession? Remember what interest rates were? They were low. Like 1%, maybe lower. What do low interest rates encourage? Not saving, but borrowing & spending. That's how we "boost" the economy.

So lots of people got new houses they could only afford at 1% interest rate. Which means lots of people got loans who shouldn't have. And lots of these same people got "variable" interest rates, so the rates change with whatever is current. Lots of "subprime" loans were made. Some predatory lenders were involved, and some greedy stupid home buyers and brokers were involved, but the end result was lots of people got home loans they weren't going to be able to pay back.

Result

Ok now fast forward to today. What are interest rates now? Not high, but higher. And high enough a lot of these subprime loans are going belly up. Which means brokers are losing their shirts and borrowers are losing their homes.

The loss of these loans basically saps money from the economy & causes constriction of money supply since loans create more money than anything else. The reduction of the money supply makes money, and thus –loans, harder to get. And so we have the “credit crunch.”

Concerns

One big fear is that so many of these loans will default that all the derivative assets (remember the traunches & streams?) will be worthless. Since some of these traunches were rated AAA, this means teachers losing retirement pensions, old ladies losing nest eggs, and general instability in the investment market.

The next concern is with deflation. When these loans default, the mortgage permits the lender to seize the house & sell it. This can result in an auction, an empty house, and other things that drives down housing prices. Problems with the investment market & dropping prices may discourage buyers from looking, thus further depress prices.

The reduction in the money supply makes money harder to get. Which would drive up the interest rate, if the fed wasn’t pumping lots of cash into the market. Deflation increases saving rates (which is important since Americans have a net negative savings rate), but decreases investment. Decreased investment weakens job growth, production, and the economy as a whole.

The concern with low house prices is this: if you have a $250,000 on a house worth $200,000 - you may be better off walking away from the house & the loan & letting the bank seize the house. This is very bad for you: you've already invested in the house, and you lose that. This is bad for the bank: they must seize & sell more property, and lose money on the loan. This is bad for other homeowners: prices will fall further. Et cetera.

One last concern is with huge brokerages like Fannie Mae & Freddie Mac. These firms were created by the government, and carry with them an implicit federal bailout safety net. If one or both of these go under, it could cost us a huge amount of money to bail them out. Not that we ever pay off what spend anyway. Clear enough?

Non-Issues

Brokers are learning their lesson. Brokers Lost profit is the slap on the wrist the brokers needed. With the massive amount of money being lost, it is actually much more than a slap on the wrist. Maybe more regulation is necessary to prevent this from recurring, maybe less - I don't know.

Bad loans are getting weeded out. When someone defaults, the broker takes a loss, takes the house, and dissolves the loan. If a broker takes too many of these, they may go out of business. When this happens, they sell the remaining good loans to another broker. Purging bad debt is good, carrying it longer with us is bad.

The market will correct itself. Not everyone losing $250,000 homes is going homeless - they're renting or buying a cheaper place. Borrowers are losing their homes, but these homes aren't disappearing, and the depressed prices are permitting new home owners to buy places they couldn't have afforded 2 years ago. So no one is losing anything they should've had in the first place.

Summary

A confluence of factors came together to make too many people get too many loans they couldn't afford. The loans came due and these people started to default & lose their homes. This potentially affects us all. See, easy to understand.