A Financial Crisis Explainer

 

At first glance, this is a story about debt. Mine, yours, the banks (oh, especially the banks), and not at all the government’s. Despite all the hoopla, our government doesn’t have a debt problem, didn’t then, and shouldn’t any time soon. An overly-concentrated and under-regulated financial sector exploded the debt problem into an everything-problem that brought us within inches of a Great(er) Depression. But this raises the question of how we became so indebted, of how the banks became so goddamn dangerously important. The 99% weren’t left behind overnight, nor will everything be set right when the economy recovers. And that’s why Occupy Wall Street isn’t just about this crisis. It’s also about the broken social bargain that set the stage. It’s about an intellectually bankrupt economic narrative that conflated blind faith in markets with the public interest, and brushed aside all evidence to the contrary. Well, the crisis is proof to the contrary, and Zuccotti Park is about not being brushed aside.

This story, and this movement, is about more than just, “those greedy jerks screwed us.” Though screw us they did, and this, roughly, is how it happened.

 

A Quick Primer on the Finance World

Banking, at its core, provides some useful, basic functions that are key to keeping the modern world functioning. It’s good that we have somewhere safe to deposit our savings and earn a little interest. It’s good that banks can use these savings to provide other people with credit, letting someone buy a home without having to accumulate hundreds of thousands of dollars first. Institutions that provide these services are called commercial banks. Banks always lend out more than they have on hand, but they are regulated and maintain a “cushion” so they can cover depositors’ withdrawals even if a few loans don’t get paid back. Even a perceived risk of a bank not being able to make good to its depositors could cause people to pull all their money out, destroying a bank even though it might have otherwise survived.

Markets for bonds let us provide this lending function more broadly, and markets for stocks let companies raise money in a way that allows others to share in the profits. Investment banks are hired by companies to create these stocks and bonds and sell them to the investors that make up the market. There are also futures and options, which can help insure against future price fluctuations (i.e., an airline can buy oil futures or options, so that a spike in oil prices doesn’t wipe them out), and derivatives, like the ones involved in the mortgage fiasco. All of these things are referred to as “securities.”

Then there are the players trying to make a profit off of their investments, like private equity firms (typically buying a company and breaking it up to sell the components) and hedge funds (betting on anything). In theory, these guys help provide more funding and make markets price things “more efficiently”. In practice, a lot of them get paid a ton of money for orchestrating a zero-sum game that shifts money from one pile to another, often churning up markets in the process. Hedge funds especially often rely on leverage to increase the profitability of the small price changes they are betting on, which means this: They buy a $100 stock with $10 of their own money and $90 they borrowed (they are levered 10:1). If the stock goes up 10% to $110, they can sell it, pay back the loan and be left with $20 (a 100% profit). If it goes down 10%, after paying back the loan, they are bankrupt. When we begin our scene about a decade ago, the repeal of the Glass-Steagall Act has let banks combine commercial, investment, and insurance operations into one. For the hell of it, a bunch started up internal hedge funds. Meanwhile, American households have become more indebted than ever before.

 

The Mortgage Crisis

At the beginning of the 2000s, home prices had basically been on a steady climb for 40 years, picking up even more speed in the 90s. Houses were expensive, but since everyone thought prices would keep climbing, people were willing to take out—and banks were willing to provide—riskier mortgages. This could mean adjustable-rate loans, where an initially low teaser rate would jump up after a few years, or subprime loans to “riskier” people, who had low incomes or bad credit and normally couldn’t afford the mortgage rates offered to them.

Banks would sell the safer mortgages to Fannie or Freddie, government-created corporations, who would package a bundle of mortgages together into a mortgage-backed security (MBS). Investors could buy these MBS, providing a bigger supply of credit for new mortgages, and in return would receive the payments from the underlying mortgages. Investment banks also got in on the game, especially with these riskier ones. The i-banks could buy riskier mortgages more cheaply, and then, through the magic of “collateralized debt obligations” (CDOs), sell them at the higher prices of safer investments. The theory was diversification to the nth degree. Complex mathematical models showed that, if you grouped together mortgages from all over the country, and then grouped safer ones with riskier ones, and then split this package into “tranches” (incoming mortgage payments first were used to pay those who invested in the highest tranche, which was the safest, and so on), the unreliable crap mortgages could be sold like they were the safest bet out there. Mortgage CDOs could be sliced and diced into something called a CDO2, or packaged up with CDOs built out of credit card debt or auto loans, blending them together into something so complicated that you couldn’t figure out what was in them if you wanted to.

Ratings agencies like Moody’s and S&P, who are paid by banks to “independently” review the underlying quality of securities, also had a complicated model. But they forgot that housing prices could potentially go down. Besides, they were happy to certify top ratings so long as investment banks kept bringing them business. Investors, including pension funds, trusted the ratings agencies and thought they’d found a safe way to earn a slightly larger return, so they loaded up on CDOs. The banks that created the risky debt weren’t on the hook for any losses, and neither were the i-banks that (maybe) understood the risks and passed them on to investors (sometimes while betting against their own clients).

 

How Everything Went to Hell

To meet the high demand for CDOs, mortgage lenders eagerly created—and i-banks blindly scooped up—yet riskier mortgages for people who clearly couldn’t afford them.  This pushed home prices even higher. For a while. But a few years later, as rates reset and reality kicked in, payments to the lowest tranches started to dry up and the housing market started to cool off. Investment banks propped up the market for a little while, duplicitously telling their own clients these were great products, but eventually the drop in housing prices started knocking out even the “safer” CDO tranches. 

Investors, and banks stuck with the low tranches they couldn’t unload, lost a lot of money very quickly. But the dot-com bubble also destroyed a huge amount of wealth without causing a global systemic collapse. Here’s where the debt comes in. Some hedge funds (including the banks’ own) were levered as much as 30:1, and were wiped out when these bets soured. They couldn’t get new sources of credit, and they had to sell other assets to pay back their existing loans. When everyone does this at once, the prices of unrelated assets start dropping. And when people become afraid that the same fate could befall any security they own, they start selling preemptively and nobody lends to anyone. This same cycle of compounding losses within over-leveraged mega-banks became large enough that they themselves became a dangerous credit risk, potentially unable to pay their debts to each other, dragging down every corner of the financial system that deregulation had let them touch and causing the global economy to seize up. When Lehman Brothers went down, we were, as a society, on the eve of having most of our wealth wiped out (“royally screwed,” as opposed to just “screwed”). This is what “too big to fail” means. Hence the bailouts.

 

The Bailout and The Stimulus

            The quick and dirty version of the bailouts is that the Federal Reserve stepped in to lend banks as much money as they needed to stay afloat. With the Treasury, the most “toxic” assets were bought from the banks before they could do any more damage, and the useful parts of dying financial institutions were sold off to the still-standing banks. The government provided an all-but-explicit guarantee that these banks, now even more concentrated and even more systemically important, wouldn’t be allowed to fail. They focused on putting the fire out as fast as possible and didn’t worry much about punishing anyone. They could have forced banks to accept bigger losses on their screw-ups or prosecuted those responsible for mind-bending levels of fraud and negligence. But the goal was to stop the downward spiral of panicking markets and let the banks regain their health. They could’ve nationalized the banks, and then later broken them up into less dangerous fragments before selling them back to the private market (maybe even made a profit). The lack of consequences—especially in a capitalist marketplace that prides itself on rewarding competence and punishing its opposite—is infuriating. But at least the government didn’t sit back and wait for the market to “self-correct.” Because it wouldn’t have.

The massive hit to everyone’s wealth, the looming layoffs, and general terror meant huge drops in spending, which in turn makes incomes drop, and things started to get bad very quickly. (For more, see “Mend the Fed”). Unemployment insurance and the stimulus helped remedy the huge drop in spending, but not by enough. Federal stimulus was mostly offset by huge drops in state spending because state tax revenues also plummeted, and states aren’t allowed to borrow. The economy was deteriorating far faster than the government realized at the time, and doing anything at all was politically difficult. So, here we are, with incomes lower than they were a decade ago, still saddled with a ton of debt, and facing mass unemployment.

 

That Bigger Picture

            The stimulus helped, but it wasn’t large enough and obviously an incredible amount of pain remains. While some commentators are quick to blame the debtors, one has to remember that people weren’t really behaving excessively. We didn’t actually build too many homes (though they might have been too expensive, and in the wrong parts of the country), and spiraling tuition and medical costs also drove our mounting debts. It should be no surprise that, with three decades of income stagnation, households took on debt to maintain their standard of living. Regardless, the inherent differences in power, access to information, and the supposed expertise of the financial sector should lead us to question those who lent excessively in pursuit of outsize profits before we blame those who borrowed unwisely in pursuit of basic life needs.

We want to see Wall Street punished for what damage it has done and regulated so that this (or its next incarnation) can’t happen in the future. As far as the economy goes, we want a recovery that doesn’t just recapitalize banks, but also gets the rest of us back on our feet. We want to stop worrying and start living again, and this time, in an economy that serves the interests of everyone.  Occupy Wall Street has already helped shift the conversation from markets to people. Let’s keep it going.

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