Layman's Guide To The Credit Crunch

So you understand how homeowners took out risky mortgages and such, but what about C.D.O’s, liquidity puts, and how they all play into the global credit crunch? If you’re still scratching your head, this article breaks it all down and puts it into perspective.

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 I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything.

Just picture a collapsing Jenga tower and you’re just about there.

Can’t Grasp Credit Crisis? Join the Club [NYT] (Thanks to C-side!)
(Photo: giuvax)

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  1. Orngbliss says:

    Is this article talking about PMI – private mortgage insurance?

  2. RobinB says:

    Well if it is, I can confirm that the private mortgage insurance companies are all suffering losses too.

  3. landsnark says:

    Informative, but the stick figure primer you posted was way funnier
    [docs.google.com]

  4. Orngbliss says:

    What I don’t understand is why people fell for the whole PMI thing to begin with? I understand that some people were required to have PMI at their lender’s request, but that just seems shady to me.

    Let’s see, you have defaulted on your loan, thereby causing a negative reporting on your credit.Why on Earth would you pay for insurance that protects the mortgage company? It doesn’t protect you or your credit.

  5. B says:

    @Orngbliss: PMI allows people to get a mortgage for a house without putting 20% down. Since most people don’t have 40-60 grand laying around, it’s the only way many people could qualify for a mortgage. It’s only shady when the lender continues to charge for PMi after the borrowers have payed off 20% of the equity.

  6. Orngbliss says:

    Um, there is one flaw with the stick figure diagram. If a company created another or “shell” company, the company would have to file consolidated financial statements. Therefore, the “bad” mortgages would go on the balance sheet and would be disclosed.

    The SEC requires that companies that have subsidiaries or other companies in foreign countries, to file consolidated financial statements for this very purpose. This was all part of the Sarbanes-Oxley Act.

  7. Orngbliss says:

    @B: Thanks for the clarification!

  8. @Orngbliss:

    Correct. It was a direct result of Andy Fastow’s ingenuity with regard to subsidiary shells that he traded balance sheet items to in exchange for…nothing, really.

    However, these mortgages were still recorded as L3 assets, which does have similar implications for filing and reporting.

  9. Also – this does a good job of describing the collapse of the SIVs, but that’s really the GENESIS of the crisis. Operationally, it’s the result that’s important – the presence of these L3 assets on bank balance sheets have made them reticent to lend to each other. This makes the market less liquid, and subsequently less efficient, which has created an irrational mispricing of money. The fundamentals of interest rates at the Fed indicate that loans should be much cheaper, and they’re actually increasing in price due to an irrational fear of interbank lending.

    These banks have to demonstrate solvency for lending to resume and market function to improve. That will mean a few quarters of good financial results and a demonstration that revenue streams at these banks were diversified enough to absorb the impact of horrible capital losses in their SIV, CDO, and institutional lending desks.

  10. B says:

    The collapse reminds me of the Junk Bond scandals back in the 80s. Once again, investors convinced themselves that a risky investment somehow has no risk if you invest in a lot of it.

  11. Orngbliss says:

    @ADismalScience: Great breakdown! So, how long before we head into a depression……?

  12. humphrmi says:

    @ADismalScience:

    These banks have to demonstrate solvency for lending to resume and market function to improve. That will mean a few quarters of good financial results and a demonstration that revenue streams at these banks were diversified enough to absorb the impact of horrible capital losses in their SIV, CDO, and institutional lending desks.

    And, as Bernanke says, “Real estate must rebound.” I’ve got to find the quote, maybe you’ve seen it, but Mr. B this week basically pinned credit recovery on real estate values resuming their climb.

    I’m not sure if I agree with that.

  13. jimmycaynesbluntashes says:

    @humphrmi: I tend to disagree with the all encompassing Bernanke statements. For the general public yes, one of the only ways they will stand to see any real changes in the markets is through real estate, as the purchasing power of the dollar is not exactly the most obvious indicator for the average consumer. Considering how they spend already I don’t think it will make much of a difference. I ‘used to work’ in the Credit space and can tell you the average consumer won’t care if the leveraged CDO investor loses money, there are plenty of qualifiers before you could ever purchase anything as opaque as these securities. As DismalScience points these banks need to prove they’re solvent before the liquidity returns, and that is pretty much the endgame at least for the current situation.

  14. humphrmi says:

    @jimmycaynesbluntashes: Right, so if I follow you, that means before things stabilize:

    * A few quarters with no multi-billion dollar write-downs of off-the-books assets,

    * At least a quarter, maybe two, of profits

    Anything else? Does any consolidation have to happen or can the current mix survive? And, until that happens, are we doomed to a continuing bear market?

  15. ChuckECheese says:

    @B: And don’t forget the S&Ls and commercial property in the early 90′s!

  16. Kevin Cotter says:

    Here’s another good writeup explaining the whole mortgage mess from a former mortgage loan officer.

    [investnaked.googlepages.com]

    The worst part of this whole mess was the $30B gift the Fed gave JPMorgan earlier this week.

  17. humphrmi says:

    @Kevin Cotter: I don’t mean to make it sound like it’s all peaches and cream, but all the Fed gave JP Morgan was a backstop. That means they’ll guarantee any losses JP Morgan takes against the OTB they inherit from Bear Stearns. But make no mistake, if JP Morgan taps that loan guarantee, they must pay that back, with interest. And yes, the government is very effective at recovering loans they guarantee.

  18. humphrmi says:

    @Kevin Cotter: By the way, the guy writing that article you quoted… is an idiot. I can’t begin to separate his facts from things he apparently just made up without getting as drunk as he was when he wrote that. Don’t believe every idiot who writes up a web page. And by the way, loan officers were the idiots during the build up to this mess.

  19. doctor_cos wants you to remain calm says:

    @humphrmi: Don’t believe every idiot who writes up a web page.
    Or every idiot who comments on a web page (including myself).

    Here’s what’s odd to me, see if it strikes you as being strange.
    People are losing their homes! A shame, but no problem.
    People are losing their jobs! Again, a shame, but no problem.
    Gas prices are insane! A shame for the consumer, but profits are up!
    Bear Stearns is going under. HOLY FUCKING SHIT! HELP THEM OUT!

  20. Erwos says:

    Real estate will eventually rebound in the long-erm, unless the growing population of the US suddenly decides they like high-density housing better than single-family homes. I find that somewhat unlikely. Or the population could decline, which is more likely, but not probable.

    It’s all about the supply and demand.

  21. I found this article to be helpful. Right now, my money’s staying put.

  22. TWinter says:

    @Erwos: Sky high gas prices over a long period of time could cause more people to choose high-density housing over single family homes because it would let them live closer to work and use public transportation. Of course, that would be more an issue of dealing with economic realities than deciding that they like high-density housing.

  23. Erwos says:

    @TWinter: True. But, honestly, that’s not now and not the near future, unless you’re in the peak oil crowd.

  24. jimmycaynesbluntashes says:

    @humphrmi: I think there will be some more consolidation (IMO-is that what you do here?). All the big firms-including the golden child Goldman are still trying to cut corners (no free soda anymore). This downturn is obviously worse than the past few but the market has always been cyclical. People got used to the good times and the ’05 auto crunch didn’t affect Wall Street to any real extent. If I had to guess, there will be another 6-9 months of pain (although nothing like another BS, the fed will ensure that) and things will start turning around. Emphasis on start-most may not think they’re seeing anything until at least a year has passed. The banks that got deep into the free money machine mortgages are stinging and easy money made it easier for the IB side of the firms to be even more profitable (if that’s even possible). The smart guys will always have jobs; they will just need to work harder to make money.