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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. 

Eureka!  Wall St. would enter the mortgage business, once the stodgy home of Savings and Loans, who, by the way, had their own crisis when our little quants were napping peacefully in the afternoons with their binkies and blankies.

So far, so good.  Now all we need is a good rating, so investors will buy our mortgage packages.

What Happened – Part II

The Raters

The quants’ bosses then danced off to the rating agencies (Standard and Poors, Moody’s, and the like) to show them their fabulous investment packages, consisting of mortgages with geographic diversity.  Just LOOK at the data.  Very safe.  Very safe indeed.  And such high returns.  Why, they deserve the highest rating, don’t they?  Big, big fees later, the rating agencies decided, why yes!  They were very safe.  Highest rating was granted, and big, big fees were made, without the pesky need to track the details.

Seeing as how lenders could package up all their loans and sell them off without the annoying requirement to see whether they were repaid or not, lending standards were relaxed.  After years and years and years of lending that required 20% down payments, and mortgage payments that could be no more than 30% of gross income, lenders were encouraged to r-e-l-a-x.  Those hard core lending requirements were now archaic.  Too stringent.  How about a 15% down payment?  As long as prices were always rising on a national level, why be so strict?  How about 10% down?  5% down?  No down?

Mortgage lenders were now selling the loans to Wall St., who sliced them up into tiny little pieces and sold them to widows and orphans packaged together with hundreds and hundreds of other mortgages.  And, with overall rising home prices, these packages were be super safe, weren’t they?  Sure, a few will go bad, but the whole country has never had home prices decline all at once.  

Thus sayeth the raters. 

What Happened – Part III

The Lenders

Now that their loans were being sold, lenders didn’t need to be so tough about employment standards for our borrowers.  As long as the borrower has a job, that’s fine.  Why, if they lose their jobs, they can still sell their house.   In MOST places, prices are going up, so they’d be fine.

Even lenders who didn’t want to play this game of hot potato found themselves making difficult decisions.  They either relaxed their underwriting standards, or they lost their loans to lenders who would refinance with relaxed lending standards.  Either the lenders had to play, or lose their assets.

What Happened – Part IV

Demand-Push Housing Price Inflation – Then Deflation

What the quants didn’t factor in, nor did their Wall St. bosses mention (flooded in profitability as they were), is that by increasing the demand for houses to include squillions of people who would have never qualified for mortgages under the old, archaic rules, prices would be pushed up to unsustainable levels.   It’s in Econ 101, and it’s called demand-push price inflation.

For those of you who live productive, fulfilling lives without having taken (or remembered) Econ 101, if you increase the demand for a thing, the prices will rise until demand equalizes.  Unfortunately, before demand equalized, the result of lax underwriting standard produced the inability for many of the people who took loans with newly relaxed standards to actually make payments.  And the unthinkable happened.

Those houses all went up for sale, and housing prices throughout the U.S. fell at the same time. 

No one knew exactly what percentage of all those loans that were packaged together were the bad ones.  They weren’t all bad, but definitely some were.  So how much were these packages worth?

No one knew, so no one was buying.  The widows and orphans who owned these things, along with banks, insurance companies, hedge funds and zillions of other investors that owned them, had no buyers.

We lost faith in these things.  We became non-believers.

What Happened – Part V

Depressing, But Not Depression

Housing is a big part of the economy.  It’s generally the largest asset owned by a family.  When our house is worth a lot, we’re worth a lot.  No matter that if you actually sell the house, you’ll have to buy another one that’s also worth a lot. 

We feel rich.

Housing prices are falling.  AND, Wall St., a party to this housing problem, also fell, in part because it had sold assets, those packaged mortgages, on which nobody could set a value.  Two big parts of the economy went ppppppfft.  Our 401(k)s and our houses are both worth a lot less now.  Unemployment is over 8% – and climbing.  In some parts of the country, it’s over 10%. 

We feel poor.

Back when we felt rich, we were fixing up our houses, going on vacations and going out to dinner.  Now, we are putting off spending because we’re scared.  Banks are scared to lend money, and we’re scared to spend it.

Back at the beginning of our discussion, we said

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.

Why did we stop believing?  We felt poor. 

What’s Happening Now – Part VI

Renewing Belief

How do we start believing?  We look at the facts.

Ninety per cent of us who want a job are still working.  An enormous amount of money has been allocated to banks by the Treasury, in order that they start lending money again.  These are hard times, to be sure.  But the world is not coming to an end. 

A huge financial stimulus package is on its way into the economy that is designed to create jobs. 

As soon as we start believing that this will work, and behaving in accordance with that belief, the economy will strengthen.  Generally, about six months prior to an economic recovery, the stock market will move up.  Chairman of the Federal Reserve Ben Bernanke says that he forecasts the beginning of economic recovery at the end of the year.  And, we’ve recently seen a 20% upswing in the stock market from its lows.

There are signs that buyers are coming into the housing market, with interest rates at historic lows and lower prices.

All is not lost.

Do you want to help the economy? 

Start believing in the recovery, and acting accordingly.