In an effort to distract me from my card play, someone at our home poker game asked me what I thought about the "bailout" that passed last week. After the 2nd sentence of explanation, it was obvious that they either didn't really care or just enjoyed taking my chips while I tried to explain how we got here and why I felt something, "bailout" or something else had to be done. It was also obvious to me that I don't have an easy answer that connects. So for those interested in why it seems all hell has broken loose economically, I will try to give the old college try.
Everything starts during the real estate bubble. Remember that? Real estate was suppose to be where the money was to be made. You turn on a cable channel and watch, "Flip my house" or "What's my house worth?" That these shows were even green lighted, much less popular should have been symptom number one that something was going awry. When you watch a "realtor" show a house for entertainment, there is a problem..
The fact is everyone wanted part of the action. After all, you would hear of people making eye popping profits and with interest rates low, real estate going up (after all they don't make any more of it, you know), people of all financial levels were catching the American dream.
With so many people buying houses they really couldn't afford and the mortgage business being an extremely profitable venture, there was fierce competition to originate loans despite the ability of the borrower to be able to repay. That coupled with the fact that most mortgages could be sold off, there was little reason to be concerned about the risk because the agent could get his fat commission, sell the loan off for someone else to worry about. These loans were then bundled together with other loans in instruments called CMO (Collaterialized Mortgage Obligations) or CDO (Collaterized Debt Obligations). The higher the average risk of the loan in those instrument the higher the yield. Which leads us to what should have been a second harbinger of things to come. When you are getting 10-12% returns on securites that are considered "fixed income" you should know something isn't right. You don't buy fixed income securities for "return" but rather for security and income, not growth.
Okay, back to the borrower. Here is what a conversation may have sounded like in a typical mortgage office.
AGENT- "How can I help you?"
BORROWER- "Um, I want to move into a house with a better school for my kids (notice we always justify our greed with our kids."
AGENT- "Great! How's your credit?"
BORROWER- "Well, that's the thing, it isn't that great, but I think this home will be a great investment and, you know, my kids can go to this great school. I may even sell this home to fund my retirement. Can you help people with crappy credit?"
AGENT- "Oh sure, that's why we are here, to help people...."
BORROWER- "Well, I make....
AGENT- "No, no, no, don't worry about that, we can get a loan that you can afford. How much a month could you pay?"
BORROWER- "Uhhh, I don't know, maybe $800 per month, but my credit.....
AGENT- "Hey, like I said, don't worry about. I am here for you. Here's what you do. We will put you in an Adjustable Rate Mortgage, you will only pay like 4% interest for 2 years. That will keep you monthly payment at $800. By paying it, you will improve your credit, and with this great investment going up, you will be able to use the equity to refinance into a fixed rate loan and get a good interest rate because your credit will be all fixed."
BORROWER- "Wow! That's sounds great, but you said something about 2 years, what happen when...."
AGENT- "You come back to me and we will refinance! It's a win-win for everyone."
BORROWER- "Oh, thank you, thank you. This is a dream come true."
The agent gets a huge commission, the borrower get's his kid into THE school system, and some investment bank gets another mortgage to bundle up to sell to pensions, institutions, and individual investors. All is good.
The poor insurance industry however was missing out on this orgy of money, so they decided to get in on the action. They recognized that many of these bundled securities are being sold to people who like safety. So they decided to sell an insurance equivalent on those securities. The idea being that they would insure these investments should they blow up. They called these "credit default swaps." Notice the name. They will swap the risk should the credit represented in those loans default. These proved to be extremely popular (and profitable). It has been estimated that there were about 62 trillion in credit default swaps issued. That is trillion!
You will also notice that I said estimated, because no one really knows. Why? Because, notice that credit default swaps are not called what they are, insurance. Insurance in not in the name. Why? Because insurance is regulated by the states and we know that regulation is ultimate evil. If you deregulate, the free markets can rule and we do love the free market (as if it really existed).
So what you have is billions if not trillions of dollars in risky loans made with the belief that real estate would increase forever, insurance on those loan, predicated on the fact they would never have to pay a claim.
Then the bubble burst. Real Estate values fell, that home equity the borrower was planning on using to refinance was nowhere to be found. His mortgage payments went up after two years and all of a sudden his home was facing foreclosure. Again and again this happened. Which means all those CMOs and CDOs were blowing up, which meant that all those credit default swaps were being called to pay out. Since the insurance companies weren't regulated, there weren't required to keep any capital liquid to payout on the claims. Instead those used those huge profits to pay extraordinary bonuses and commissions to executives.
Hence, what we know as a credit crunch. That simply means that institutions no longer trusted other institutions to lend them money because they didn't know if they would be able to pay back those loans. Why no trust? Because no one could determine how much bad investments, or bad swaps a company held. All of sudden risk mattered again and the pipeline of credit ceased. No credit, meant that businesses couldn't continue their business, which meant, a collapse.
Hence the so called "bailout." Which essentially is the government, using taxpayer money, to buy these endangered investments, to get them off their book, so that banks and institutions will feel better about lending them money again. The idea is that this will free up the offering of credit and business can continue.
If it doesn't work, or if nothing was done, the mom and pop store on main street wouldn't be able to keep their inventory up to date, couldn't make their payroll, couldn't pay their bills. That would lead to layoffs, and layoffs would lead to rapid decrease in consumer spending which makes up 2/3rds of the the American economy. That my friends would be a depression, not a recession. It is a perfect financial storm. And that is as simply as I know how to put it.
