Financial Crisis in Layman's Terms

[BallentineChen]

A couple of months ago I heard a radio program that explained the mortgage crisis in a way that was very accessible. I was a finance major in college but I wasn't able to understand what was really happening until I listened to this piece. I figured that I'd share it here since the topic has been brought up so often: link (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.).

The other reason I'm posting this is that there's a lot of venting and finger-pointing on the forum, yet no one is really offering useful insights that interpret the nature of the problem, and that's frustrating to me.

[whiteslate]

thank you. Would collect my thoughts and give my two-cents then

[Apocynum]

Thanks. That's a great explaination. While I think there are other factors involved, this really describes the core of the issue.

[maxpot46]

The other reason I'm posting this is that there's a lot of venting and finger-pointing on the forum, yet no one is really offering useful insights that interpret the nature of the problem, and that's frustrating to me.
I've pointed out several times that the root cause of the crisis is money creation/credit expansion (and the accompanying malinvestment).

[BallentineChen]

I've got to agree, but what stood out to me the most in that piece was the pressure the banks were getting from investors after Greenspan basically told the int'l community to "fuck off." Yeah, money creation/credit expansion was what brought us the mess, but I see it more as a product of this underlying demand for higher returns, greed on the part of the entire international community. So when people are blaming Wall St. and the rest of the banks, I can't help but think that the egg is really on everyone's face. I traveled to Taiwan a month ago and my uncle was telling me how the financial crisis is all the US's fault, but how many foreign investors were asking for investments that they could have figured were unsustainable. Of course, you can say that the banks could have held their integrity and told those investors "We can't honestly deliver those results and still say that these are investments are AAA rated", but those investors will just go to a bank that says "Yes we can." I'm not excusing the banks, they obviously could have been more prudent, as some of them have demonstrated, Goldman Sachs for example. But to hold all of them up to a certain standard only when we're looking for a scapegoat? It makes little sense to me. That's why I'm not against the bailouts.

The shit hit the fan and we got over-exuberant, the best we can do right now is address the problem, wherever the blame may lie, and hopefully come out of the whole ordeal with the providence to avoid the same mistake.

[qwerty123]

The media exhausted the term sub-prime mortgage crisis, but this is a humorous take:

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There are also some fantastic explanations on youtube, but I couldn't find the one I was looking to post.

[Functianalyst]

I don't see one particular thing causing the crisis. I find it interesting that in the past decade incomes have taken a nose dive in keeping on target with inflation. There are reports that what a person made in the 80's increased in the 90's, but has increased little to nothing in the 21st century. What this means is that you are actually taking a cut in pay.

This is no excuse for the bad decisions made by many, but there are a lot of people affected that actually did have incomes and expected them to continue to grow since, there was no reason to believe that they would not. The NRP epiode is partially correct, because at the time of the housing bubble lenders and customers were expecting their salaries to continue an upward climb.

In 2005 the price of gas shot up and inflation has been on an upward momentum for groceries since. People should have intervened as soon as they started to witness consumers using their credit cards for grocery purchases and to pay their utilities. This did not just happen and trying to put it on a single blame only lets me know, we still don't get it. Just my thoughts, but it sounds like over simplifying in hindsight.

[jesse]

Took the time listening to said episode of This American Life linked in the first post, and it did to an extent clear up what was going on at the time. My limited understanding of the situation was mostly cornered on the shit hitting the fan big time when the massive influx of these sub prime loans began to run low on its steam.

At first this all seemed like a warped Enron and World Com accounting scam as investors saw a lucrative niche in pooling their money into mortgages. As more and more homes are sold, meaning the demand for homes is up, investors and the rest of the financial world are revelling in happiness. I would say around this time the movers and shakers decided it was time to really push the envelope and how much squealing this would widthstand before the good times stop rolling.

Certainly there are a few central points which might have planted the seeds of the downfall and the aftermath we're going through at the moment, I tend to simplify all of this down to an overheated system bundled together with greed. When you start getting slack and even outright dozing off at the wheel, alarm bells should have started going off when just about everything could be pooled together and have an impressive credit rating. Now you might say that lenders are so bummed out from the fast and easy days of credit that unless you're about as stable as a government bond, forget about credit. At the moment few banks trust one another or their clients in being able to repay their loans, all in all, a big stinking mess.

I can't say I'm surprised at the lengths some will go to make a quick buck or two. At the rate of things, this will take a couple years to shrug off.

[maxpot46]

It bothers me that "greed" is blamed for the crisis, because it doesn't really explain anything. It's human nature to be greedy and to maximize utility/profit, so if bankers are granted a monopoly on money creation, it is human nature that they will exercise that monopoly.

Thus, the problem is not greed but monetary policy (or more accurately, not the greed of the bankers but the greed of the government). You can regulate investments all you want, but if the Fed keeps creating money and allowing banks to create more money on top of that, the excess credit will find its way into the economy, causing malinvestment and bubbles (though not necessarily in the housing market).

[Krazy P]

The nature of the problem is human.

Individuals and communities (and now the global community) have a behavioral bias towards an optimistic assessment of future events and especially of outcomes of their decisions.

This speculation results in a significant correction or balancing of supply and demand that occurs every three generations.

Since the current event is really the first that is truly global in scope, it is difficult to predict future paths of recovery.

If the past experience with financial crises is any guide, it is clear we are in for a lengthy period of reduced demand.

[JohnDoe]

The nature of the problem is human.

Individuals and communities (and now the global community) have a behavioral bias towards an optimistic assessment of future events and especially of outcomes of their decisions.

This speculation results in a significant correction or balancing of supply and demand that occurs every three generations.

Since the current event is really the first that is truly global in scope, it is difficult to predict future paths of recovery.

If the past experience with financial crises is any guide, it is clear we are in for a lengthy period of reduced demand.

Or we are going to reinflate the bubble. We seem to be trying really hard to do that. (Note I'm not running into paranoia land claiming hyperinflation, but we are going to see some inflationary consequences of the amount of money were printing.)

[Apocynum]

There is another contributing factor that no one here has mentioned yet, that was also completely left out of the radio article: There has been a social movement to increase home ownership that got traction and really took off in the 90's. Banks were heavily pressured both directly and indirectly (via government typically) to find ways to make loans to people they might otherwise have turned down.

For some background on this side of things: To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.

So banks started making loans they didn't particularly want. There was a lot of money out there hunting for investments. And it may be a chicken/egg issue, but somewhere, sometime, someone got the bright idea to solve everyone's problems as well know now to put them all together and have the banks sell them off as investments.

[maxpot46]

If the past experience with financial crises is any guide, it is clear we are in for a lengthy period of reduced demand.Agreed, but to be clear the period will be lengthy only because of our chosen response (i.e. credit expansion, propping up of failing businesses and employees). History also shows that, given a different response that allows the market to correct, it would be only a year or two.

[jesse]

It bothers me that "greed" is blamed for the crisis, because it doesn't really explain anything. It's human nature to be greedy and to maximize utility/profit, so if bankers are granted a monopoly on money creation, it is human nature that they will exercise that monopoly.

Thus, the problem is not greed but monetary policy (or more accurately, not the greed of the bankers but the greed of the government). You can regulate investments all you want, but if the Fed keeps creating money and allowing banks to create more money on top of that, the excess credit will find its way into the economy, causing malinvestment and bubbles (though not necessarily in the housing market).

As far as I'm aware, banks were not government entities but I do agree that there is certainly something wrong when the Fed decides to go a bit crazy and adjust its rates in order to favor an organization or two over the rest. You would think a so-called central bank stays out of the politics of propping up a few while causing trouble for the rest of the gang with rate fluctuations and creating more and more money out of thin air causing its value to drop further and further down.

I do not directly blame the fed or the banking system, after all banks and other financial institutions were simply filling a niche where there was enourmous demand for and unfortunately it started to overload because it all was doing conspicuously well. From a business sense they will tell you're crazy if you tell your clients and investors NO when all they are yelling is "GIMME MOAR!!!111twelve!" or begin to develop a conscious in the process.

Greed itself is certainly not the main reason why it all blew up in our faces. Surely if a few more people had been awake and asked the tough questions as "is this sustainable" and "are we by any chance getting a bit too ahead of ourselves here". In the end it seems anything or anyone willing to take a loan or a mortgage was fair game, the rest were meaningless details which can be safely ignored. ;)
When the news about credit losses started rolling in, it also showed how entrenched and how deep the big boys of banking were in all of this. On second thought, it probably should not be that suprising given the amount of interdependency and globalization these days.

There is another contributing factor that no one here has mentioned yet, that was also completely left out of the radio article: There has been a social movement to increase home ownership that got traction and really took off in the 90's. Banks were heavily pressured both directly and indirectly (via government typically) to find ways to make loans to people they might otherwise have turned down.

For some background on this side of things: To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.

So banks started making loans they didn't particularly want. There was a lot of money out there hunting for investments. And it may be a chicken/egg issue, but somewhere, sometime, someone got the bright idea to solve everyone's problems as well know now to put them all together and have the banks sell them off as investments.

This might have created the initial climate for the bonanza unlimited days to kick-off, and it's not necessarily a bad idea to begin with. Home owenership is not everyone's idea nevertheless, declining those who are not prime customers should not mean they are by far and large excluded. Sure you can't get the same levels of profit but they are still customers and sometimes you can only adapt to the situation. Another option of course is if potential customers join up and form organizations which could potentially have a greater value for mortgage lenders than each family on their own. From my perspective, more often than not, business models and practices become too entrenched and block out other possibilities.

[chris]

I've always had this thought at the back of my mind that economics was unsound and all economists were loonies who didn't have a hope of predicting anything; that the capitalist system based on greed was flawed, so as a consequence crises were inevitable. I would appreciate it if somebody corrected me.

[RBM]

Naw, it was greed. The worst of human nature interfacing in a complex system. (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.)

[maxpot46]

I've always had this thought at the back of my mind that economics was unsound and all economists were loonies who didn't have a hope of predicting anything; that the capitalist system based on greed was flawed, so as a consequence crises were inevitable. I would appreciate it if somebody corrected me.Sure, replace "capitalist" with "corporatist" or "interventionist" and your sentence is completely accurate. True capitalism is based on private property and the freedom to enact voluntary exchanges, which does not describe our current system where government regulates pretty much everything (including the value of our property via the monetary system).

[mentor]

the system is ready to collapse..

[Delarge]

A bubble too far.

Rapid expansion of the money supply, severe misallocation, excessive exposure to high-risk assets, and credit default swaps.

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Delarge added to this post, 6 minutes and 34 seconds later...

I've always had this thought at the back of my mind that economics was unsound and all economists were loonies who didn't have a hope of predicting anything; that the capitalist system based on greed was flawed, so as a consequence crises were inevitable. I would appreciate it if somebody corrected me.

Most economists are indeed insane.

Capitalism, while flawed in a number of ways, is the soundest vehicle to achieving an economy in which human labour is minimal if not absent. It's also important to note that bubble economies are enabled primarily by improper management of the monetary system.

[Henry]

A couple of months ago I heard a radio program that explained the mortgage crisis in a way that was very accessible. I was a finance major in college but I wasn't able to understand what was really happening until I listened to this piece. I figured that I'd share it here since the topic has been brought up so often: link (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.).

The other reason I'm posting this is that there's a lot of venting and finger-pointing on the forum, yet no one is really offering useful insights that interpret the nature of the problem, and that's frustrating to me.

Chinese monetary policy to irregularly low interest rates in Europe and especially US. US consumers and investors were run by greed and went to ridiculous excess. Excess immigration 2000-2006 also contributes to severity of bubble due to demand issues. This created unsustainable asset bubbles in a number of important areas. Failure on the part of Greenspan to intervene as the bubbles appeared (read: stopping 100% or IO mortgages) contributed to the seriousness.

Bubble pulled a ton of new supply onto the market, as drywall, framing and flooring installers (both of which can be trained in about a week) were clearing 50 per hour in many regions of the country. Prices reached unaffordable levels around about the time that real supply exceeded real demand, have both real and nominal factors contributing to a collapse. This causes innumerable banking problems.

[Futuremouse]

i don't know. it all seemed to be pretty simple (if you oversimplify it, as i will do), and i harkens me back to a conversation i had with my father 3 or 4 years ago.

we were discussing whether or not i was planning to buy a house in the town i lived in. i said no, noting that since the fed had been dropping the prime rate to prop up the stock market and encourage business lending, that lower interest mortgages had become somewhat commonplace, and in response, prices had been rising. houses that had been in the area of $250K-325K (i lived in a somewhat desirable part of town) were now posting for $400K-500K. the only rational reasoning to explain that was simply because people could now afford payments on that principle, not that the tangible or intrinsic value of the property had increased by that amount. not like there had been a huge influx in population, making available real estate scarce or anything.

since, as 5th grade civics will teach you, prices will always be what the market will bear. it was a case of the chicken and the egg getting drunk and fucking in the road, and accidentally being run over by a truck.

lower interest rate + less stringent lending rules = more people qualifying for higher principle mortgages = housing prices reflective of increased flow and amount of capital available + developers hoping to cash in by building more homes and condos, etc = more supply then demand = prices start to fall = homes being worth less than mortgages = companies that had purchased packaged mortgage futures now own loans with collateral significantly less value than debt.

now, it wasn't like millions of people suddenly defaulted on their payments in one go. sure, some people were overtaxed when their ARM...readjusted, and maybe went into arrears or foreclosure, but the simple fact that people owed on property that was now worth less, and someone had the bright idea to buy and sell debt secured by collateral of fluctuating value, an imaginary gain turned into a colossal imaginary loss.

a bunch of people lost money that didn't really ever exist, anywhere, by being a bunch of stupids.

am i close?

point is, i didn't buy the house. my reasoning was that i could continue to pay a fixed amount of money per month as a predictable and reliable outlay for housing. i chuck out my rent, my landlord fixes my furnace, patches my roof, and, in most cases, pays for my water and heat, which was a gas fired burner in the basement. i know exactly how much i'll pay, and what i'll get.

now, when you buy a house, you invite 25 more mothefuckers to line up to take your money. sewage. water. refuse collection. property tax. h.o.a., if you have one, repairs, various insurances...

i pay one guy a flat fee. sure, i don't get a tax writeoff or anything, but i also don't get nickeled and dimed to death. instead of building $12-15K in equity (and paying through the ass for all the ancillary necessities) and being a slave to the market when and if i decided to sell, i quietly paid my rent every month and put $30K in cash into savings.

advantage, me.

[RBM]

the system is ready to collapse..

What do you base that on ?

Maybe the work of William R. Catton's 'Overshoot' (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.), or Richard Heinberg's Catabolic Collapse work (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.), Limits to Growth (To view links or images in this forum your post count must be 2 or greater. You currently have 0 posts.), or maybe just a gut feeling you've got :-)

"We can't honestly deliver those results and still say that these are investments are AAA rated", but those investors will just go to a bank that says "Yes we can."

There is an online explanation of how fundamentally flawed the system of the ratings regimen was - I just don't have it at my finger tips.