I don't know about you, but understanding exactly what happened to cause the great financial meltdown of 2008 is hard to understand. I think I finally have a handle on it after seeing tonight's episode of 60 Minutes and an interview by Steve Croft with Jim Grant from Grant's interest rate observer. I thought I'd outline it here:
The mortgage crisis is based on turning the riskiest mortgages into financial investments. At the core of the problem money was lent to people that could not pay it back.
Wall Street investment houses bought mortgages from banks and mortgage lenders and divided them into hard to understand securities for sale to their customers. The securities were based on mathematical models that combined the mortgages in ways that based on historical models would minimize risk. The securities were incredibly complex and certified by the ratings firms such as Moody's and Standard and Poors as investment grade.
The securities were sold back to banks around the world and pension funds.
In addition to these securities, the investment banks also sold credit default swaps which acted as insurance on the mortgage backed securities identified above. A credit default swap is a contract between two people that he will be paid if a financial instrument fails. It is insurance without being called insurance because insurance would be regulated. The problem was that since these were not called insurance, there was no government requirement that the seller maintain some capital reserves to pay if the insurance was called by the buyer. AIG, Citi and others sold these credit default swaps.
The credit default swaps made it easier to sell the mortgage back securities.
When homeowners started to default on the mortgage loans the investment houses had to pay off the insurance they had written. This is what caused Bear Sterns and Lehman to go out of business. The banks and investment banks primarily got into trouble because of the insurance they wrote. AIG was the largest insurer of credit default swaps.
The problem is that no one really knows how big the credit default swap market is although there is a rough estimate of 60 trillion dollars (4x the total US debt).
So who are the guilty parties:
- Individual home owners that took out mortgages and home equity loans knowing that even a slight interest increase would cause them to default.
- Congress and Fannie Mae for encouraging mortgage lenders to lend to low income individuals without some reassurance that the individuals could pay back those mortgages. This includes Barak Obama, John McCain and Joe Biden. Last I looked they were in congress when all this was happening.
- Wall Street for creating complex instruments that securitized mortgages that are so complex that only mathematicians could understand the true risk.
- Wall Street for creating insurance instruments that were in effect insurance policies. This is criminal and the government should go after the executives that allowed this to happen. Wall Street executives were also guilty of taking on more risk than was being revealed to stockholders.
- The investment ratings agencies for rating complex financial instruments as being investment grade. Investors should sue the ratings agencies.
- The SEC or whatever government agency agency is responsible for regulating Wall Street for not seeing the credit default swaps for what they are, insurance.
- The accounting firms for not properly accounting for the amount of risk being taking on by banks that were securitizing high risk mortgages and credit default swaps.
I can't say now that I understand it I feel any better.