Easy Money...And the Collapse of the American Economy

With everyone crowing about the financial collapse that we’re experiencing right now, I recently realized that I didn’t know what the real root of the problem was. Pretty much everywhere you look there were passing references to the mortgage and housing markets. Its been widely implied that this is where the crap started to hit the fan. That’s great, but what exactly happened?

So I asked some very smart people (the financial sage that is my father was a primary human source) and did some reading on the causes behind the situation we’re in now. This essay is basically what I’ve been able to synthesize from all the info that I got on the subject. There’s no serious number crunching, no economic jargon or obscure concepts, just the basic concepts explained in layman’s language. This might all be a massive oversimplification, but this is how I understand it. From all indications, it’s a correct outline of what is going on, but then again, who do you really know you can trust in times like these? Anyway, here goes...

It all started with easy money. People, Americans in particular, like to have nice places to live. Those people also, again Americans in particular, sometimes don’t live within their means (or have the slightest grasp as to what those means actually are). So these Americans, who didn’t know what their actual means were and made delusional by easy money, were looking for a place to call home.

Mortgage companies were more than happy to oblige these people looking for places to live. These companies offered extremely lax standards to get a mortgage. Requirement to submit proof of income, a crucial factor in lending because it indicates the likelihood that the loan will actually be paid back, was often one of the glaring omissions in the mortgage application. So it became commonplace that people were given mortgages on homes that were realistically way out of their price range.

The classic example of this, which is outlined in this fantastic article by Michael Lewis, is of the Mexican strawberry picker in California. This man, who spoke little or no English and had an annual income of about $14,000 was happily given a mortgage on a home worth three quarters of a million dollars. Any half-sane person realizes that there is something terribly wrong with that picture. There is an insanely high risk of default on that mortgage and in fact, default was almost a certainty. This, of course, is an extreme example and obviously not all mortgages given out were this high risk. The number that were, however, was unusually high. These types of high-risk mortgages, such as those mentioned thus far, are commonly referred to as “subprime mortgages.”

The banks, who are the ones giving out these mortgages, shuffled them all off to places like Fannie Mae and Freddie Mac. The loans were put into big bundles to be sold. These bundles were known as “collateralized debt obligations” (or CDOs). An important thing to remember here is that the collateral on the mortgages is the property itself, which can be taken in the event of a default. For later buyers, the incentive to buy the CDOs was that there was consistent income, in the form of mortgage payments, and in the event of default the property served as collateral.

The bundles of these loans that Fannie and Freddie had assembled were then rated by a ratings agency, two of the most well known agencies are Moody’s and Standard and Poors. These agencies would assign these bundles with ratings based on the risk associated with that loan. Loans that were most likely to be paid off were rated highly and those that were a greater risk for default were rated low. Loans with a high rating might be safer because they were less likely to default, but they paid a lower interest rate. Low rated loans were riskier investments, so they paid a higher interest rate.

For our purposes here, we’ll say that highly rated investments (low risk) would be rated AAA. Mid-rated investments (medium risk) would be BBB and low rated investments (high risk) would be rated CCC. So the ratings agencies slapped these ratings on the bundles that Freddie and Fannie threw their way. In a ploy to increase the number of highly rated investments they were selling, Fannie and Freddie hit upon the idea of further dividing up the original big bundles of loans. They were sliced up based upon rating. Then each piece was rated again. So the top loans in the piece that had been rated CCC in the original bundle were now given an AAA rating. This is despite the fact that in the grand scheme of things they were originally rated as pieces of junk. This skewing of the whole rating system is prime example of one of the major places where it all went wrong.

After being rated, these bundles were sold. They were bought by institutions such as pension funds and big investment banks like Goldman Sachs, etc. Often times, those who bought the bundles took the ratings that were attached to them completely on faith, doing little investigation and analysis of their own. They assumed they were getting a safe investment. The Wall Street and other financial institutions that bought these bundles often bought them with the intention of selling them along to someone else. In addition to selling them along, many of these institutions keep them and hold them in their mutual funds and other areas.

Meanwhile, back on Main Street, trouble was brewing. The result of easy money and lax standards to acquire a mortgage is that pretty much anyone who wanted to could buy a house. Thus, home values started to drop. Then people started to default on their mortgages. This is when the fantasy started to disappear and reality set in. These mortgages that people were never going to be able to actually pay finally caught up with them.

The houses that were purchased with the loans were still acting as collateral on the loan. The only problem was that with home values dropping, no one wanted to buy the houses. So now with people defaulting left and right, and house values dropping, the institutions that purchased the bundles of mortgages (often Wall Street financial institutions) were left holding the bag. That bag was full of rotten subprime mortgages. A great metaphor for this is when the music stopped in the game of musical chairs, Wall Street (or those holding the bundles of mortgages) were left without a chair. The people who took out the loans couldn’t pay them back, and the value of the collateral on the loan (the house) was dropping like a rock.

This is essentially the situation that we find ourselves in now. Like I said previously, this was a very simplified outline of what is going on, but for me at least it’s extremely helpful to get a better idea of what is going on. And to anyone who really does know what’s going on, I apologize for the errors that are most assuredly present here, hopefully they’re not too glaring. I also hope that this shed at least a little light on what everybody is talking about these days and how we got to where we are today. I know it helped me understand it better.