So why are all these financial institutions in crisis? Here's what happened.
Joe wanted to buy a house, so he went to a mortgage broker and asked for a mortgage. His income was stagnant and his credit wasn't very good and he didn't have a down payment, but he got a mortgage anyway: a no-doc, no-money-down mortgage on an adjustable interest rate with two years of "negative amortization", meaning his monthly payments would be less than the minimum required to pay interest on the principal.
The broker found a bank who approved the mortgage and Joe signed it because house prices were increasing and it looked like they would go on increasing indefinitely (the start of the bubble). Pundits who ought to have known better were claiming that the old economic paradigm no longer applied and the market could grow forever.
Now multiply Joe by several million.
The banks had another reason for approving these risky mortgages and home equity lines of credit. The Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), both Government Sponsored Enterprises, were more than willing to guarantee over $5 trillion in risky mortgage debts, freeing the banks from obligation if the homeowners defaulted.
Other financial companies bought these mortgages off the banks, bundled them together in big blocks of securities, and sold them to still other financial companies on Wall Street.
The Wall Street investment houses didn't just buy these blocks of securities (assuming that the homeowners at the end of the line would continue being able to make payments); they bought them on margin. That is, for every dollar they had to buy securities, they borrowed another twenty or thirty dollars and invested those, too.
Quite simply, there was very little fiduciary or regulatory oversight into whether these risky and in some cases highly exotic investments were a prudent investment. The Fed was more interested in stimulating the economy with low interest rates; the underwriting was done automatically; the credit rating agencies were asleep ... and after the Savings and Loan bailout many executives just assumed that the government would step in again if any "too big to fail" companies ended up over their heads.
Everyone who could remotely afford a house (and many who clearly could not) already owned one, so there were no new buyers to keep the bubble inflating.
Incomes had remained stagnant for several years but house prices had kept going up, so people were spending larger and larger proportions of their income on mortgage payments.
Many homeowners had used the rising values of their houses to borrow money against their home equity (called home equity lines of credit), so the principal on their mortgages were actually going up, not down. Net personal savings in the US fell to zero.
The introductory teaser rates on adjustable rate mortgages began to expire for many homeowners, causing their mortgage payments to jump.
Oil prices were also rising steadily, eating into scarce income through higher vehicle fuel prices and higher consumer good prices. This put a further squeeze on homeowners who were already paying as much as they could afford on their mortgages.
Interest rates started rising in response to rising inflation from energy costs, a slowing economy and a dawning realization in financial markets that many investments were actually quite risky. That caused mortgage payments to go up for everyone who was on an adjustable rate.
As demand for new houses dropped off, the prices of existing houses flattened and began to fall. People suddenly found themselves carrying mortgages for more than their houses were worth.
All these financial pressures started to force some homeowners into foreclosure and bankruptcy. This increased the supply of houses on the market as banks repossessed properties and tried to unload them, which further depressed housing prices.
Because much of the economic growth of the past several years was in the homebuilding industry, the collapse of demand for new houses threw more people out of work and slowed the economy further, which left more people vulnerable to foreclosing, which in turn fed back into the vicious cycle of falling house prices.
Financial institutions that had invested heavily in subprime mortgage securities started to unravel. The subprime sector was the most vulnerable because the people making payments at the end of the line were the most likely to foreclose.
One of the biggest early failures was the Bear Stearns investment bank, which declared bankruptcy after their subprime hedge funds were revealed to have lost nearly all their value. Several Bear Stearns managers have been charged criminally for defrauding their investors about the risks of those funds.
At the time, Wall Street insisted that the financial crisis was confined to the Subprime sandbox and that it wouldn't effect other parts of the industry, but foreclosure rates were also increasing among prime mortgages as people on adjustable interest rates fell behind in their ability to keep making payments.
Freddie Mac and Fannie Mae became insolvent. Because they were stuck guaranteeing tens billions of dollars in defaulted mortgages and could no longer finance those debts with new mortgages (since house sales had dropped off), they could no longer raise new capital.
The Federal Housing Finance Agency placed both entities into conservatorship under the FHFA, dismissing their boards and taking over their management. The US Treasury effectively assumed over $4 trillion in mortgage backed securities and over $1 trillion in debt, adding this to the existing $9.5 trillion US public debt.
Mainstream financial institutions started to unravel. Organizations like Merrill Lynch and Lehman Brothers started to acknowledge that they, too, had gotten in on the act and invested billions of dollars in highly leveraged blocks of risky mortgage backed securities.
Suddenly these institutions discovered that their assets - the right to collect payments on those securities - were worth as little as pennies on the dollar compared to what they had borrowed and paid to buy them.
This crisis extended to banks and financial institutions in other sectors (like AIG, an insurance company) and other countries, particularly in Europe.
Lehman declared bankruptcy - the largest bankruptcy in American history with over $600 billion in corporate assets. Merrill Lynch accepted a buyout offer from Bank of America. AIG accepted an $85 billion Federal Reserve bailout after losing some 95% of its stock value when its exposure to bad mortgage securities became known.
Financial institutions hold untold billions of dollars in mortgage backed securities that are effectively worthless, not only because so many of them have defaulted but also because everyone's trying to unload them at the same time.
Treasury Secretary Henry Paulson insists that Congress has to approve $700 billion - chosen, according to a Treasury spokesperson, because it's "a really large number" - for the US government to act as buyer of last resort and snap up huge amounts of those crappy, devalued securities at a premium price so the financial institutions don't go bankrupt.
Paulson, a former CEO of Goldman Sachs, which stands to gain from the plan, warned that without a bailout, the financial sector itself could collapse entirely, throwing the economy into a deep, long-lasting recession and costing the government even more money in federally guaranteed bank deposits.
Under the Paulson plan, the government would end up owning up to $1 trillion in worthless securities and the financial institutions would return to solvency and profitability with those bad debts off the books.
The US Congress rejected the plan on the grounds that it essentially rewards the executives and boards of these corporations for their irresponsible and possibly even illegal management.
They are now adding conditions to the plan, including: limits on executive pay for the companies benefiting from the bailout; more assistance for homeowners facing foreclosure; government equity interest in the bailed out companies; and judicial and congressional oversight including the right to audit.
Paulson insists the bailout is necessary to solve the financial crisis, but the Congressional Budget Office argues that it could actually cause the crisis to deepen by exposing still more insolvent corporate assets.
It remains to be seen exactly how it will look when Congress approves it, but some form of bailout seems inevitable at this point.
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