The other day the Dow fell 777 points - the larget drop in its history; Washington Mutual, the largest savings and loans, went bust and its deposit base was sold by the FDIC to JP Morgan Chase. John McCain has lost all of his momentum coming out of the Republican convention and none of his silly ads and lies about Obama are being absorbed by voters in the past few news cycles - remember he was very successful, in my opinion, in controling the news cyle but with real news for pundits and newsman to talk about and to sensationalize being available. It drowns out McCain's political noise.
What happened?
Two words: Credit Crisis.
If anyone listens to "This American Life". They had a recent show that best explained the credit crisis and how it happened.
In this diary, I will try my best to paraphrase it and here's the link to the transcript for all of you to read and I do suggest you read it.
What is the root cause of the credit crisis?
Is it the government and liberals who forced banks to give loans to poor people?
No, I'm sorry this is not even a real answer. Banks give loans to make money. Period.
Is it conservatives and deregulation which allowed these Wall Street mondern day "Robber Barons" to make loads of money by loading up on debt and making risky choices?
Surprisingly, this is not the root cause.
Drum roll......the root cause is too much money. Huh? What? Too much money? Do I mean greed? No. There was too much money in the system.
Please allow me to explain.
The entire world is always saving money. Think of central banks like China and England. They are always saving money, in case they need to pump in cash into their economies or think of insurance companies, who save money for disasters. Think of yourself as well. Your probably putting money away in a 401 (k), Roth IRA, IRA or, your company is putting money into a pension.
All of this saved money in the whole world is around 70 trillion dollars.
Now, in 2000, this 70 trillion dollars was actually 36 trillion.
It took hundreds of years to get to 36 trillion and then it just about doubled in eight.
How?
Well, Poor countries like Saudi Arabia and China became really rich manufacturing and selling us oil and they saved all of this money and used the best financial minds in their county to invest it around the world.
Now, Alan Greenspan, at this moment in time, took one of the favorite investments of the world, the American treasury bond, and kept its intrest rate low. I think it was at one percent at the time.
And all of this money wanted better returns, so the world turned to a different bond. A low-risk and high-return bond called mortgage backed bonds.
So here is the chain: A man wants to buy a house so he goes and gets a mortgage from a broker. The broker sells the mortgage to a small bank, the small bank sells the mortgage to Wall Street. Then, Wall Street takes a couple of thousands of these mortgages and puts them in a big pile. The Wall Street firms are now getting thousands of mortgage checks a month and its expected to come in for about 30 years. Wall Street takes this pile and sells it to investors.
Now, there was alot of demand for this type of bond but now the problem is that you need lots of mortgages.
In the beginning, the broker in the beginning of the chain would only buy safe and standard mortgages but now the supply could not keep up with demand and so brokers started using looser guidelines and the demand still didn't stop and people are making fortunes, and so you finally get people with no income and no assets but a credit score getting mortgages.
Why didn't the banks stop this nonesense? Greed but more importently they were not holding on to these mortgages for 30 years so they didnt care.
Now, I forgot to mention these two very importent points. One, these thousands of loans given to people without credit, many were put into a special mortgage called Option ARMS. These mortgages have a higher rate of interest from the regular mortgage but you don't have to pay any of the mortgage for three years. All you had to do is pay the interest. Some people were duped into this loan because of its higher interest rate. On paper it was a better deal for investors and I'm sure that the commissions that the brokers earned for giving homebuyers Option ARMS were higher than the standard mortgage and some people weren't duped but thought they could afford payments down the line but couldn't.
The second importent point and this is VERY importent; These bonds are rated by Credit rating agencies like Moody's, Standard and Poor's and Fitch. They were given the best score possible even with the bad mortgages involved because the computer models used to analyze the data was faulty. The computer models were treating the bad mortgages like the good mortgages and assuming a low default rate.
So, where did the problem start?
Wages have not been keeping up with inflation since the 1970's and even though the housing market was going through the roof from 2000 to 2007, people's income had stayed flat.
People couldn't afford the houses they were living in. In fact, people would close on a house, sign all the papers and then default on their first payment. They just couldn't afford it.
Nothing could change this fact. So, how come the "house of cards" (cliche, I know) didn't come down sooner? Well, because, people were refinancing their homes and getting a new loan and using the increase value of their homes to pay for their current mortgage.
The first people to notice these were the boys on Wall Street. There returns were not performing well after six months and they stopped buying certain mortgages from down the line. This started a wild chain reaction.
All of these firms were highly leveraged. Everyone on the cycle was borrowing more money than they had to buy these bad mortgages and selling them. In fact, alot of these firms and brokers were borrowing 20 times the amount of money they actually had.
The small bank, in the chain, would borrow money from a big bank like WaMu or Citibank and once they sold these mortgages to Wall Street. They would pay the big banks.
Now, as you can see, once the investors stopped buying, everyone on the chain got burned.
So, whats the problem no big deal. Greedy Wall Street gets screwed. It serves them right.
Well, this affects you because no one is lending money.
If you want to go buy a car, you need at least a credit score of 700 these days to get a loan. Mortgages are hard to come by and business who rely on credit are being hurt.
For example,
According to reports from Bloomberg, McDonald's (NYSE: MCD) sent a memo to some U.S. franchisees telling them that Bank of America (NYSE: BAC) declined to increase lending and they will have to seek others ways to finance store improvements.
The news follows Bank of America's recent merger with investment bank Merrill Lynch (NYSE: MER) and last week's dislocation in the credit market.
Richard Adams, a consultant to about 300 of the company's franchisees, told Bloomberg, "This is the first signal that turmoil in the financial markets is reaching McDonald's."
This gets WAY more complicated because alot of these dealings involved very complex financial instruments called Credit Default Swaps or CDS.
CDS is a tool to reduce risk. These companies are buying insurance against defaults and investors are allowed to place bets on these CDS.
Anyways, I am exhausted, I hope you guys read and enjoy the recap and please read the transcript or better yet, listen to the "This American Life" episode The Giant Pool of Money.