The Credit Crisis: What It Means and What You Can Do About It
by The best explanation of the Credit Crisis this author has heard was by “South Park.” Why Kyle was right to extend credit, and how you can understand this without watching “South Park” – or listening to talking heads screaming at each other on the financial networks.
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The “Credit Crisis” is a ubiquitous phrase. It’s in the headlines of our remaining newspapers. It’s bandied about by pundits on news programs. It’s the root of our economic crisis. And the only explanation that I’ve heard that was both understandable and reasonably objective was by animated eight year olds on the very adult cartoon series “South Park.” So here’s an alternative explanation, for the benefit of those who don’t get their economic news from foul-mouthed little fourth grade boys in South Park, Colorado.
The word “credit” is derived from the Latin word “credere,” which means to trust or believe. A lender lends because she believes that the person to whom she extended credit will repay her at a fair return for the risk she takes in lending money. A creditor believes that the cost of borrowing money is less than the potential return on the investment he makes with that money. In other words, the lender believes in the creditor and the creditor believes in the economy.
The economic system is based on belief, with money, through cash or credit, as the symbol of that belief.
What Happened – Part I
The Quants
The current U.S. credit crisis happened as a result of “quants” selling an idea to investment bankers, and investment bankers believing that the quants really did figure out a way to package and sell away all the risk associated with mortgage lending. Quants, by the way, are usually recently graduated MBAs with great grades from Ivy League schools, who use the methodology of Quantitative Analysis to develop and analyze financial products with specific respect to risk and reward.
The quants found that, in reviewing U.S. history, at no time did home values decrease throughout the entire country at the same time. While there may have been falling home prices in one part of the country at any given time, there was strength, or at least stability, in another region or regions. Consequently, if one were to package together mortgages with geographic diversity, there would be relative stability in the overall portfolio, regardless of regional problems.
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Post CommentBrian Belefant
On April 7, 2009 at 1:40 pm
There you go again with the widows and orphans.
Kitty OKeefe
On April 7, 2009 at 3:20 pm
Just call me a bleeding heart liberal.
You may use that descriptive term liberally, as it applies to me.
Frances Merritt
On April 10, 2009 at 1:08 am
Kitty O’Keefe, you have done it again, made the complicated understandable – I think you should write a book, your knowledge and your wonderful sense of humor are a slam dunk. Now if you could help me rustle up a couple of those Quants and a few Standard and Poors so I can line them up and slap them a couple of times it would really help me in starting to believe.
On another issue, I am confused about mark to market. Some economists are against changing the practice for banks, while others think it will make banks assets more in tune with what is true. Wasn’t mark to market initiated so banks couldn’t cook the books about their assets? Okay, good idea – let’s keep the banks truthful. On the other hand, as you said, many of the mortgages are good, and people continue to pay them down etc, but since there are many that are bad the bank then has to lower the value on the mortgages even if the homeowner continues their regular payment. So say the loan is $300,000 – the homeowner keeps paying, is not moving, has a steady job but comparable houses have fallen to $250,000 so the bank is then required to lower it’s assets by $50,000 on that one mortgage, even if it is a good loan. The market always goes back up eventually so, let’s assume eventually the house regains it’s value. So I am puzzled as to what is the best answer. Can we trust the banks not to cook the books and remove restrictions of mark to market? Hmmm?
Kitty O'Keefe
On April 14, 2009 at 11:03 am
Great question, Frances. Theoretically, any policy that makes a financial transaction more transparent is a good idea. The problem with mark-to-market is this. What if there is no market? If one cannot attract a buyer, the price must be lowered to the point where buyers are willing to take the risk. But, what if risk aversion in a difficult economic environment is such that there are no buyers at a reasonable price?
In that event, marking to market may cripple a company to the point of driving it to bankruptcy.
A difficult situation, to be sure, and one that FASB addressed adequately with replacing market price with cash flow. With respect to these packaged securities, cash flow, or the amount of payments actually being make on the underlying loans, seems a much more reasonable way of valuing these securities.
Frances Merritt
On April 14, 2009 at 3:34 pm
Yes, it is a difficult question and we shall see how replacing market price with cash flow works, I guess it will all take time to work out. I wish they would value the loans in the securities the same way – resulting in the banks not having to lower their assets as much.