The Great Wall Street Meltdown Part 1

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Warning number 1: This is a long post, part of a multi-post series on the crisis in the financial markets.

Warning number 2: I never took an Economics or Finance course in my life. I will not quote economists or provide citations and statistics. Not because I want to be simple and lucid. It’s because my knowledge of finance is extremely limited. All that follows is based on my understanding of the present financial situation, an understanding formed by reading the popular press.

Warning number 3: Which means that everything I say below may be wrong. But what’s wrong in that? At least, I didn’t get half a million dollars bonus and an apartment in Manhattan as reward for being “wrong”. Right?

The backdrop

In a land far far away (the United States of America) a long long time ago, there was a great housing boom.

Okay wait. I am getting a bit ahead of myself.

So first a little perspective.

In the US, buying a house is considered to be one of the best investments one can make. This is particularly true because the government, as part of long standing policy, encourages people to own their own homes by allowing tax-deductions on mortgage interest payments. This means if you took a loan to buy a house and are making monthly payments towards the mortgage as well as toward property taxes, the government puts some of that money back into your pocket by allowing you to deduct a per centage of those expenses from your federal taxable income. In other words, a certain portion of your house-ownership cost is written off by the government from your tax bill.

Since the US government does not consider providing any such relief to people who rent (though such people are generally worse off than home owners), the financial incentive to own a home is that much greater.

So yes. Where were we? Yep. The housing boom. For the last few years, prices of houses were going up and up in the US driven by ever-increasing demand. So much so that people, many many of them in fact, started thinking like Mr. Bullah below:

“Hey this house is worth $500,000. In a year it will be $600,000. So if I can sell it then, I can get a 20% return on investment. ”

Of course there is a small problem. Bullah’s net worth, in terms of his savings, are $10,000 (2% of the house’s cost). And just to make things worse, he has a bad credit history having defaulted on his credit card bills a few times. In order to make the very basic minimum down-payment for the house (usually 20% of the cost), he needs $100,000 i.e. $90,000 more straight away.

He goes to the bank.

Now in normal situations, the loan officer would look at Bullah’s bank statement and his credit history and show him the door telling Bullah politely (after all his name is Bullah) that he just does not have the equity to make such an expensive purchase.

However these are not normal times.

What happens is that on seeing Bullah’s loan application, the loan manager smiles, shakes Bullah’s hand and provides him the loan on his down-payment. Yes the full $90,000. Plus the loan manager also provides as loan the rest of the house cost (i.e. loans him an additional $400,000) enabling Bullah to take possession of the house right away with zero-down.

So what does Bullah provide as collateral? Nothing.

The only catch is that in exchange for the high (and unreasonable) risk the bank is taking on giving this loan , it expects a very high rate of interest from Bullah. This transaction between Bullah and the banker (let his name be Lucky Chikna) is what is known, in common parlance, as “subprime lending”. Lucky Chikna is happy because he is going to get a lot of money as interest for his investment (albeit more than a bit risky), which, in turn, is going to translate to a higher commission for him.

And Bullah—he is only too glad to get any loan.

As he tells his worried brother Chutiya: “Don’t worry about the high rate of interest. In a year, we will recovered our money and quite a bit more. So no problem.”

And so this came to pass that thousands of such “sub-prime” loans are written by greedy creditors out to make a fast buck on the high interest rates and then accepted (often many loans at once), with glee, by equally greedy common citizens who think, based on advice given by “pundits”, that the housing market would be the golden goose that would keep on giving. Year after year.

The Federal National Mortgage Association, nicknamed Fannie Mae, and the Federal Home Mortgage Corporation, nicknamed Freddie Mac, are special private corporations that have strong government ties. Fannie Mae and Freddie Mac were started by the US government so that they may provide credit to the banks (i.e. the primary lenders who loan money to people to buy houses). This was to enable primary lenders to provide more mortgages to common people and thus promote home ownership.

In short a Baap ka baap.

Let me explain how I think this works (the actual process is a bit more involved). Say I buy a house for $500,000. The total amount I have to pay back to my bank at the end of thirty years (my mortgage period) is $600,000 distributed over monthly payments. The bank however has to pay the seller of the house $500,000 right away and then wait for 30 years before they have their full principal and interest back. In other words, the money would be “stuck” for that period of time.

This is where Fannie Mae/Freddie Mac come in. They go to the bank and if they believe that the bank has followed sound lending practices, they buy the mortgage from the bank for say $520,000. Which means that the bank gets its $500,000 back immediately along with $20,000 interest without having to wait for years. It has thus not only made a profit but it has recovered its principal leaving it free to re-invest this amount into another mortgage.

Now Fannie Mae/Freddie Mac will be the party responsible for collecting on the $600,000. Since the mortgage was bought for $520,000, at the end of the mortgage period it will have made a $80,000 profit.

Now where did Freddie Mac/Fannie Mae get this $520,000? Why doesn’t it worry about the fact that its money will be stuck for 30 years? That is because Freddie Mac/Fannie Mae sell what are known as mortgage-backed securities to investors.

Just like an index fund allows an investor to invest in a bouquet of companies with the spread of companies reducing his risk of betting his money all on one horse, a mortgage-backed security (MBS) allows an investor to own stakes in a large number of different kinds of mortgages.

So when Freddie Mac/Fannie Mae make the $80,000 profit on its $520,000 investment, it can keep a per centage of the $80,000 as its commission and passes on the rest as dividend to the MBS-holders i.e. all those who made an investment in that particular mortgage.

Now as is evident, higher the rates of interest are on the mortgages that form an MBS, more are the payouts to the investors in that MBS. With financial experts betting on the housing market to grow and with the consistently high returns on such securities, the prices of MBSs appreciated greatly with investment banks, institutional investors like pension funds and hedge funds all rushing in for a piece of the action. And added to the fact that securities issued by Freddie Mac/Fannie Mae had an implicit backing of the federal government (i.e it was “expected” that the government would cover the investment in case of financial downturns) and one can understand the craze for Freddie Mac/Fannie Mae MBSs.

Now were Freddie Mac/Fannie Mae head honchos well-aware of the shaky foundations of the MBSs they were peddling? You bet they were. But then why should Bullah and Lucky Chikna be the only greedy ones when Lambu Atta , the big boss of Freddie Mac/Fannie Mae is also in the game? Buoyed by the high returns on MBSs, the management of Freddie Mac/Fannie Mae helped themselves to obscene bonuses and vulgar pay-increases. Of course, in the midst of all the excesses, they conveniently forgot that their charter officially stipulated that they were to use their profits to buying more mortgages, increase capital flow in the housing market and thus push down mortgage interest rates.

Money as they say does strange things to memory.

In the lucrative business of buying mortgages, Freddie Mac/Fannie Mae were not the only players in the town, though they were the largest. Different kind of financial institutions like insurance companies and even normal banks were falling over themselves in order to buy sub-prime mortgages from the primary lenders and sell them as part of their investment products. Yes those very loans that had been given to credit-unworthy people like Bullah who had no assets to cover the huge amounts of money they had taken out.

Something was bound to give. With a financial disaster of a war, rising national debt, falling dollar, job losses and out of control oil prices, those people who had taken multiple mortgages out on their $10,000 bank account no longer had the money to make the high monthly payments.

The buyers they had predicted would buy their houses at a premium—well they were no where to be found.

So thousands and thousands of home-owners just threw up their hands and declared bankruptcy. Houses were foreclosed and seized. People were evicted.

But then the question remained: who would buy these seized homes?

No one. Cause people had no money—a state technically called “Loot gayee Laila”. Banks, once they realized that the housing bubble had popped, had tightened their lending policies (after the horses had all bolted) and so loans were no longer easily available. Houses stayed on the market forever. Their prices nose-dived.

And mortgage-owners were left holding non-performing, fast deprecating assets on which they had to pay property tax in order to keep holding onto them till a buyer could be found.

Remember that $600,000 payment Freddie Mac/Fannie Mae needed in order to pay the dividends to the MBS holders and also take their commission, the expectation of which had forced MBSs to stratospheric levels ?

Well the news was that there was no $600,000 coming.

MBSs , once bought at high premiums, had started losing their value rapidly.

Disaster was now at the gates. For banks who had invested in mortgages themselves. For Freddie Mac/Fannie Mae. For people who had bought MBSs. For anyone who had guaranteed a mortgage or bought one. In short, ruin for most of the economy as black suit bankers sat on a mountain of useless MBSs that was often not worth the piece of paper written on.

Was that all? As the line from Bombay Boys goes “Abhe khatam naheen hua chutiye”.

I made one gross oversimplification in my preceding narrative. (Well more than one. But bear with me.)

When greedy banker Lucky Chikna gave the loan to Bullah, he told him that Bullah will get the loan only if he takes out an insurance on his mortgage so that if in the (unlikely) case that Bullah cannot make good on his financial commitment, the insurance company will pay the remaining amount on the mortgage. Bullah now has to make monthly payments for his mortgage insurance (over and above his mortgage payments) but Bullah doesnt care. Cause he has the pot of gold at the end of the rainbow. The fact that the mortgage is insured is also good for Lucky Chikna as he has covered his bases, should someone ask him what kind of risk mitigation steps he has taken.

Now let’s consider the situation from the point of view of the insurance company. Ibu Hatela, the big chief, suddenly gets all these house-buyers who want mortgage insurance and are ready to pay a nice premium for them. Ibu thinks to himself :” This is good. With the way the housing market is, there is not much chance of the house buyer going bankrupt–he will always be able to sell his house and make a lot of money. So no chance of him defaulting. Let me keep on selling these insurance products.”

And so he keeps selling. Because his company is well-known, the insurance-buyers never ask him “Do you have assets to cover all your insurance liabilities?”After all, when we buy car insurance from Geico or Progressive, do we ever stop to ask them if they actually have the money to pay $25,000 for damages, if I total someone else’s car? No we do not.

And so insurance companies kept on making out these insurances far beyond their covering capacity. The premiums were like “free money”, insuring (as one expert opined) cars in a country where there were no car crashes. Why just housing? Companies started insuring any kind of big loan with the guarantee of coughing up the cash should the loaner default. Just like mortgage-backed securities, these “I shall pay up when you cannot” instruments (technically called credit default swaps) were being bought and sold on the market at high premiums and companies who were dealing in them were raking in the profits.

What that meant was Ibu Hatela would sell the rights to collect premium from Bullah to another guy, say Ballu Bakra and Mr. Bakra would in turn sell that credit default swap to someone else. The market for credit default swaps were red hot —AIG, one of the biggest names in insurance had $78 billion worth of swaps !

Again, all this was fine till the day the housing market went boom. Thousands of people began to default on their loans. All the cars in that crash-free world had just run into each other. The insurance companies and the buyers of credit default swaps, needless to say, did not have the cash to cover the claims. With the housing market going down, different other kind of business deals started going sour. Even more debt insurance claims were made. And the more they were made, the deeper the owners of credit default swaps sank into the swamp.

Then of course there were the investment banks—the Bears and Sterns and the Lehmans of the world. They had their proverbial finger in each of these superhigh yield pies be it the mortgage-backed securities or the credit default swap markets. As a result of years of high-paying lobbying initiatives, the investment banks had made sure that they operated under the minimum of controls and oversight, freeing them to take unreasonable risks while investing.

Initially it all went according to plan. Even better than the plan as a matter of fact. The more they raised the stakes and the more outrageous the risks they took, more money they got.

Income forecasts were manipulated by taking into account the so-called “value” of the credit default swaps whereas in reality it was nothing but “funny money” that existed only in an optimistic future, a tomorrow that would ultimately never come. And with such rosy forecasts and on the back of its great current “performance”, Wall Street paid out record performance bonuses across the board.

Till of course disaster struck. The MBSs sunk to junk and people started calling in the credit default swaps. The banks did not have enough assets to cover even a fraction of its liability.

When angry young man Amitabh Bachchan says on screen: “”Main paanch lakh ka sauda karne aaya hoon, aur mere jeb mein paanch phooti kaudi bhi nahin hai!” (I have come to conduct a deal for 500,000 but I do not have even 5 paise in my pocket) it sounds macho and cool. Now when investment banks are shown to have followed that same principle, it’s quite horrifying. To put it mildly. No wonder then that investor confidence and their overall credit-worthiness suffered.

The only way for the Lehmans and the Bears and Sterns to be able to survive would have been to raise money from the market and use it to discharge their obligations. But the credit market had frozen up. No financial entity in Wall Street was trusting anyone else with their resources. Starved of its cash flows, an investment bank like Lehman Brothers that had survived the Great Depression and two World Wars went belly-up. So did Bear Sterns before it was acquired.

AIG and Freddie Mac/Fannie Mae were in danger of coming to their knees but since they were considered too critical to fail , they were given federal life-lines through infusion of tax money to keep them afloat.

Two of the biggest banks–Washington Mutual and Wachovia were not so lucky and was taken over by other corporations.

And most importantly, the High End Girlfriend Index, the true indicator of the value of Wall Street fatcats, collapsed spectacularly.

The face of the financial world had changed within a few weeks.

But the drama..that was just beginning.

[Part two has the political fall-out of the Wall Street Collapse]

[Note: All names used for exemplary purposes in above blog-post are characters from the surreal epic “Gunda” (1998), one of the greatest movies ever made. More details here.]

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109 thoughts on “The Great Wall Street Meltdown Part 1

  1. Nice article. The CEO of Wa-Mu gets paid $19 Million for 19 days.

    Corporate Greed is killing America and is being rewarded amply instead of being punished.

  2. Good way of summarising what happened in the US. The big WTF is that no supposedly big companies saw this coming and still kept selling loans like Ninja (No Income, No Job, No Assets) and still thought they would come out good at the end of all of this.

  3. Great post GB… extremely succint. Small suggestion… include a reference to that great epic, cos new readers might not be able to (gasp!) figure out the whole connection ๐Ÿ˜€
    Hai Bulla, Hai Bulla…

  4. Well explained. Being in the business of making money work its magic, I would like to point out that not everybody lost out – a few did make good money shorting the crisis.

    By following Buffet’s simple adage “Be fearful when everyone else is greedy…”

  5. I’ve tried to read a million articles to understand the situation, this one has been the most informative. Thanks a ton!!!

  6. This is such an awesome explanation for someone like me – The fact that you used characters from the epic ‘Gunda’ made it that much easier to understand ๐Ÿ™‚

  7. A fantastic post chronicling the financial decadence of our times!! I don’t know whether your predictions are accurate, but they certainly seemed lucid, intelligible and extremely descriptive to me!!

    Especially great was the use of innovative character names (no doubt from that philosophically poignant film ‘Gunda’ :P) that actually mirrored the greed and avarice of the individuals that brought free-market laissez faire capitalism to its knees!

    A tremedously simple yet colorful depiction of events that conspired together to bring about such a cataclysmic failure in the world’s foremost financial super-power! From what you wrote and I inferred, it certainly seemed pure greed on the part of various individuals and entities that precipitated this disaster.

    Actually, if you think about it, this questions the very foundation of laissez faire capitalism – the one that proposes a completely de-regulated system. Such an extent of de-regulation, it would now seem, would only lead to a state of chaos brought about by unbridled and unchecked greed.

    Do keep writing and expanding on this subject in your future posts!!

  8. I am a long-time admirer of your blog though I have never commented before. My other identity is that I am one of the employees of a major Wall Street investment bank, one of the rare ones that have still managed to stay afloat. Unlike you, I have taken courses in Finance and Economics and if I may say so, one of my professors has been your father at IIM.

    With my background and my experience as an investment banker for almost two decades, I can say that this article is by far the most lucid, the most concise and definitely most entertaining piece of text that has been written about the present financial mess.

    I have read almost all your posts and I have often wondered how different you are from your father, whom I respect a lot, in terms of your sense of humor, your irreverant world view, your political viewpoints and of course your vast knowledge of popular culture. In this post, perhaps for the first time, I could see your father speaking through you. The same logical flow, the same analysis and the same style that characterizes your father’s teaching is so evidently present in this brilliant narrative.

    Of course I would never expect him to use quotations from Amitabh movies or character names of B-grade classics but then that is what is so uniquely Greatbong!

    While you may have never taken a course in Finance or Economics, I am positive that your analytical brain and your ability to understand so clearly a very complex economic problem, is in no small measure your intellectual inheritance.

  9. @GB,
    Excellent post, I have been ranting to my buddies without knowing in this detail, now I can rant with a little bit of understanding ;-). BTW, did your dad help you understand all this?

  10. Thank you for all the nice comments.

    @Tapan: Added a line at the end with a Gunda reference for the uninitiated.

    @Anonymous: I am extremely extremely flattered to be compared with Baba. Thank you.

    @Poochandi: No I have not spoken to my father about the current financial crisis.

  11. arnab,

    what all the nytimes, TIME magazine,CNN,Stephen Colbert,fox news(well, not fox news) could not explain to me, your post did. Why Mr Paulson Jr has not found you yet?

  12. Really good post. Perhaps it would have been better if you took vipinโ€™s analogy of John Lennon. Summarizing the post, it made a lot of sense for banks to give sub-prime loans because just in case the borrower defaults, the bank will end up owning the house (collateral), and since the prices always rise, it means the risk is negligible. Alas, the assumption was wrong.

    The insurance companies on the other hand made a blunder that goes against the very principle of insurance โ€” spreading the risk. Since in a population, only few people are unfortunate to have, say a car accident, insurance company spreads the risk of these few people among the whole population. However, since they have to make profit, it makes sense to not cover risks that can potentially hurt everyone. Thus you will rarely (my bet is never) find insurance company that will cover damages because of wars. Floods and forest fires, though systematically affecting large population, still affect only a fraction of population and can thus be ensured. By insuring the mortgages, they blundered by coving items that can get affected throughout their consumer base.

  13. Gunda had its Mithunda, who is going to be the Mithunda of this finicial gundaraj;
    Macain who stopped campaigning or Bush who came on TV or Henry Paulson or Chinese yuan or Middle east petrodollars ……

  14. Wow! You deserve a Nobel for using the Gunda-raj concept to explain the economic turmoil. Call it the gunda-raj economic theory. Although the cash for the prize will be paid in MBS.
    It is by far, the most brilliant piece on the current financial situation that I ever read. Hope part 2 is out soon.

  15. I’d read a few more articles before, which explained everything about the current situation … but no one ever gave out the real names of Freddie Mac and Fannie May !!! Most authors thought that people would know what Mac and Mae are … but you GB, without any preconcieved notions wrote the best post of all.

    Thanks a ton!

  16. One of the best posts on this topic so far and also one of the easiest to follow! Needless to say that the Gunda characters helped understand it better… ๐Ÿ˜€
    Keep up the good work! ๐Ÿ™‚

  17. Great Post GB! Extremely well explained writeup of the current situation. I am very much impressed by your work.

    Thanks

  18. A tour de force from you GB. I think I have said this before but I will say it again : why do we not see such crisp and informed writing in the mainstream media?

  19. Awesome post! I am a person whose eyes usually glaze over at the first mention of the word “finance” – but I read your post through to the end in one shot. In spite of reading (oh well, trying to read) tons of articles about this mess, I did not quite get the overall picture till I read this post. Thank you so much!

    Waiting for part 2!

    p.s. If you are not already in the teaching field, you should seriously consider getting in there.

  20. Pingback: Stupendous Man » Wall St. Meltdown

  21. Hi GB, I have not read all the comments, so it is possible that what I am writing might have been pointed out already, but a couple of things:

    1) the insurance, the credit default swaps, was purchased by the banks and financial institutions and not the home buyer. But your point about it being funny money is still on the money!!

    2) The fact that the mortgage backed swaps were assigned either AAA (extremely safe from default) or AA (very very safe from default) ratings by the ratings agencies is being overlooked. Buyers figured that if the Moody’s and S&P are rating these securities as AAA then there is no default risk at all. On top of that the returns are higher so it would be a no brainer to invest in these securities. That added to the false sense of security the buyers of these notes had. Of course, AFTER the tatti hit the pankha, Moody’s et al started to downgrade their ratings.

    Your post is very well written and i can’t wait for the second part.

  22. Beautifully written article, greatbong!! Of the millions and gazillions of articles that I have read on this fuckup, this one is the most informative and understandeable. Your non finance background actually helps as you are not wasting time with jargons and statistics which confuses rathr than clears the doubts.
    One small correction – You have written that no collateral was taken. Well actually security in the form of the house being bought was taken. The funda behind giving loans to the “poor track record” (PTR) people was that in the event of default the house could be taken over and sold at a higher rate. That way the bank would earn even higher since the house prices were expected to go up at a rate higher than the interest rates. Once the bust happened, the loan takers started wilfully defaulting thinking that it is better to default now and let the house go to the bankers as paying installments dutifully at a rate higher than what the house deserves was bad economics.
    So in the end the banks got screwed by the people. And the 700 bn. bailout is in effect the U.S. Government’s way to say “Here is you gift for screwing up and wasting your money”. And I thought the Indian Government was a bigger ass.

  23. Just a tiny bit of nitpicking:

    In this line, ‘Again, all this was fine till the day the housing market went boom’, shouldnt it be ‘…the housing market went bust’?

    Good post.

  24. GB..you are really a great bong…you epitomise all the best traits of us bengalis..look at what you did man!!…so much funda for somethng you dont even understand….:-)… you might try refraining yourself sometimes you know…this post was HILARIOUS…..!!!

  25. Too good greatbong. With your style I think you can be great professor. Very clear and lucid. Cant wait for the second installment.

  26. @Fish out of water:

    1) the insurance, the credit default swaps, was purchased by the banks and financial institutions and not the home buyer. But your point about it being funny money is still on the money!!

    I dont think I said anywhere that home-owners bought CDSs. Homeowners bought insurance i.e. they paid the premiums on the insurance that guaranteed a payout to the back should the homeowner default. CDSs, in turn, were bought by investors who were putting up the money backing this “I will pay it if you cannot” guarantee and in return getting a share of the premiums.

    Thanks to everyone for the comments. I have done some teaching (on something very different than this) and hope to do more in the future.

  27. Arnabda. Nice post. But don’t you think you let the “Istandard and Gareeb” pundits off the hook. They should take a major part of the blame here.

  28. Really well written — & I am an economist myself! I wish I could show this to my students; only trouble is they won’t understand the Gunda references.

    There’s just a couple more details I’d like to add:
    1. By definition, a subprime loan was supposed to be a loan that Fannie/Freddie could not touch. But in 1999, the Clinton administration explicitly lowered the standards they were supposed to meet in order to allow more low-income people to buy homes. Freddie started dealing in some subprime mortgages some time after that.

    2. Fish out of water makes a great point about the credit rating agencies pretending these securities were rock solid. Basically all their risk models assumed that mortgage defaults were independent events (sorry about the statistics jargon!) They, & the whole fool’s gallery of financial institutions, did not imagine that any situation could arise that would make a whole bunch of homeowners default at the same time. Turned out, when so many of these loans were ARMs, all it took was rising interest rates & falling home prices. DUH!

    3. Despite all this, the crisis would never have gotten as bad as it has were it not for one fundamental problem with all these financial institutions — they were all grossly overleveraged & undercapitalized. In plain English, the i-banks had $30 to $40 in debt for every $1 in equity. Meaning if even a small portion of their investments went bad, their equity was wiped out & they faced bankruptcy. This is the main issue that underlies everything.

    Why were they so overleveraged? Well, it allowed enormous profits when the going was good. If I have an investment that I expect will pay me 10% & I put in $100 of my own money, I make $10. But if I put in $10 of my own cash & borrow $90 at 5% interest, I make $10, pay $4.50 in interest, & keep $5.50 — which is a 55% return as against 10%! And these guys were doing it on a scale of 30 or 40 to 1, instead of the 9 to 1 I illustrated! (9 to 1 was the old legal limit on i-banks which was lifted by the SEC in 2004). Awesome as long as my investments keep paying. But the minute they turn sour, I am up tatti creek without a paddle because I still have to pay back $90 with $4.50 interest.

    And so without addressing the basic underlying problem of undercapitalization, no solution or bailout is going to work in the long run.

    Whew! My longest comment ever.

  29. Hi Arnab Da,

    One more interesting reading. All capitalistic markets will go through this one day or the other, as greed would take over one day, as experience brings complancency.

    Essentially, overdoing anything would result in the same.

  30. In the followup, could you give us opinion as to how this affects us – non-Americans in America? That is something I’m very curious about (so far, the only effect here has been a slight bit of inflation)

  31. arey baab, pura duniya ne angrezi mein jawab diyela hai, lakin apun kya apla bambaiya mein jawab giving yaar.

    you are too much explaining too good yaar! like apun am reading and apun am hasing (laughing) so much tight becoming- no bedouah ka zaroorat!

    like even road side wallah can to be understand, man.

    ekdum must to be going down in annals of economic studies.

    Galbraith, Keynes, Friedman cannot to be explaining any plainer.
    Apla vote tere liye, bhai!

  32. I have a question for Greatbong, Wafa and other knowledgeable folks here:

    Why does the Federal Govt have to buy the toxic mortgages? Couldn’t they have instead given the bailout money as a loan (rather than a “gift”) to Wall Street, and then letting the banks figure out what to do with the toxic mortgages themselves?

  33. @Curious: Well as you said, they are buying the mortgages. And since they shall now own the mortgages, there is a chance that they might profit from them (if the mortgages are valuated properly—which is a big “if”) down the line. If they had provided the bailout money as a loan, at very low rates of interest, there would be no chance of profit. Plus. when a few years hence house prices increase, the banks would again make profits (they have to only repay a low-interest loan) and the government would have got next to nothing for the investment they made. Plus if the government gave a loan right now, what would be the collateral? The houses? How would they be valuated? Again the same problem.

    This is my understanding of government logic. Many experts advocate, instead of the MBS buying, a course of action where the government giving companies money (i.e. buying equity) in exchange for options and shares so that they can more directly benefit from an upturn as opposed to being saddled with mortgages whose value noone really knows.

    @Sigea: Thanks for your suggestion.

  34. Dear GB,

    This is my first comment on your site. I have read quite a few of your posts and must admit, I am a fan. I echo the sentiments of most commentators – for someone like me who could not understand much of the current happennings, but kept getting hit with news articles and people discussing – subprime, economic crisis, downturn etc, this has been such an eye opening experience.
    Like someone asked in one of the comments, I am worried about my position in this whole turn of events. I am a desi homeowner on H1-B( With the craziness of the GC process, there is no light at the end of the proverbial tunnel). With an upcoming presidential election, shaky job situation and a hefty monthly mortgage, what can I do to be cautious and prepared, what should I be wary of ? Thanks in advance.

  35. Congrats! You have done a great job at explaining in simple terms a very complex process. Unfortunately I can not refer your article to my American students as they would be at a loss trying to relate to the Gunda characters!
    Baba

  36. To Curious: Quite frankly the whole business of buying the mortgage backed securities can’t really work unless they overpay. The Fed/Treasury plan to use a reverse auction to determine the price & to sell them — basically a standard procurement auction, where they will buy from the lowest bidder. That means the institutions willing to dump them at the lowest possible price will be the first to sell them, unless they can all co-ordinate amongst themselves & hold out for a high price. Which would be illegal. So if these firms are willing to sell at a low enough price that govt can eventually make a profit on them, then there should be someone, somewhere in the world who would be willing to pay a couple of bucks more & snap them up!

    After all at the moment govt has no more information about the mortgage market than anyone else. Liquidity is tight, yes, but it’s available. In the last 3-4 days alone the Fed has made over $300 billion in emergency loans. So by definition the govt has to overpay even if they deny it till they’re blue in the face.

    Paulson was not admitting this but the truth is all he wanted to do was inject cash into the system. If the aim was to get rid of these securities from the firms balance sheets, why not just let the firms write them off? Why this farce?

    a. This way they get at least some money back in the future, which as Arnab said is better than zero.
    b. Taxpayers are not suffering nearly as much loss as people are making it out to be. This whole bailout is going to be paid for with borrowed money — it has to be! There’s already a $400 billion deficit — the money is simply not there. The govt is hoping that as the treasury bonds they issue for this need to be paid back, the cash flow from the MBSs (after all most people will still be making payments on their mortgages) will cover it, & taxpayers will not feel the pinch very much. The idea is for the money to just flow in a circle.
    c. As Arnab said, they need to inject capital into these firms that don’t have enough of it. Without a way for govt, or _someone_ to get equity in these firms, it was hopeless — like pouring more oil into a car’s leaking oil tank without fixing the leak. The current proposal does have some equity provisions in it & is vastly improved.
    d. That’s why the Republican’s idea of the govt providing insurance on these securities was such a dumb idea. It didn’t address the short term problem of liquidity or the long term problem of capital. Oh yeah, & it was providing insurance on MBSs that bankrupted AIG…

  37. Hi – It is a nice and excellent post. I couldn’t stop after first paragraph, went on reading until the last word.
    Waiting for 2nd part please……
    Also, explain the dangers of future DESI investments and housing market.
    Thanks in advance.

  38. I have been visiting your site for quite some time now. Ok truth be told its on my favorite lists.

    This post is till date THE most lucid, understandable narrative on the Great Financial Crisis of our times.

    Thanks a tone GB for making me understand what ‘sub prime’ is.

  39. Thanks for making this simple enough. Countless economics illiterates like youre truly will now be able to sound smart!Another interesting read on the subject: http://www.abcresourcehire.com/unleashed/stories/s2375624.htm

    The truth is, I-banking has always baffled me (I say this at the risk of sounding like a wannabe prophet who tries to cash in on an event after it has happened with an I-told-you-so smugness). This may of course be due to my total lack of understanding of the concept, but I had actually asked one of my I-banker friends a few months ago if he understood the fact that the most obscenely overcompensated people in the world basically make money by moving money, and intangible money at that! He told me he had a problem with the concept too – it seemed mathematically fragile, a zero-sum game. Again, only a couple of days before the Lehman fiasco, I had wondered on my blog about the most successful country of our times and its obsession with free market capitalism. Perhaps the uncanny coincidences are God’s way of trying to cure me of atheism. If it is, I must say it’s a really lousy way!

  40. People just love to hate Wall St. Probably because they are jealous of the fact that they earn such high bonus-es.

    People say that its a bailout package for wall street. Its not! Its a bailout for the entire U.S. economy and indirectly the world economy. The US govt. is not an ass to do this to Wall Street. Its trying to cover its own colossal fuck up over the Iraq war, where TRILLIONS of dollars of taxpayers money are being pumped (and people are so disturbed over 700 bn). The short term lending rates (T-bill rates) have been driven up just because of the drainage of money from the treasury for the Iraq war.

    The investment banks are the ones which has saved the asses of the commercial banks which made the stupid follies in the first place of lending to such high risk individuals, by securitizing the mortgages. If that would not have happened, we would have seen retail banking giants like BOfA, Citi, Wells Fargo sink along with the deposits of millions of american people.

    Its not a gift to Wall Street. Its a shrude move by the govt. by which it has taken a calculated risk to gain long term returns. It also on its own cannot solve the problem, the problem here being the fear in the mind of lending financial institutions and not lack of liquidity. If it can do its part of improving the sentiments of the lenders, it would have done its job.

    Surprisingly all of this morality over high bonus-es was not present when everything was good and people were having huge profits on the stock market. No risk no gain is what these banks believe in and which almost always is true. The boom in the economy is because of these investment banks, and when things start to go wrong due to external factors, then everyone wakes up from their sleep and starts pointing fingers.

  41. Hail GB for the greatly simplified version of such a complex issue. Can’t wait for part-2.

    Btw, did you get a chance to go thru Drona. I hear its a total made-for-a-GB-review type movie. Will love to read your take on that.

  42. If there is another article that explains the entire financial fiasco lucidly in such easy-to-understand layman terms, I’ve never come across it! Thanks much – waiting for the other parts.

  43. Absolutely brilliant post. Just brilliant.
    I, of course, cannot be sure of the authenticity of all the facts you’ve taken into account. But if indeed their true, then this post has to be undoubtedly the best around the sphere.

  44. Excellent post Arnab. I may have minor quibbles over a few things – mortgage insurance is not the same as insurance on mortgage based securities. One covers the underlying, the other the security created from the underlying and they operate in completely different domains.

    But on the whole, this is a very lucid and well-written post.

    @ats: Interesting idea, though my understanding is that this is more of a top-down problem rather than a bottoms up issue. Which means, that it was the great demand for mortgage backed securities by the global investment community that forced commercial banks and other mortgage lenders to relax their hitherto fairly stringent standards in lending.

    In any case, the principle of caveat emptor applies to everyone regardless. Why is it that some investment banks like Lazard have managed to weather the storm so well, while Lehman and Bear Stearns sank?

    Because no matter what kind of shitty mortgages are offered to them, it is the responsibility of the investment banks to perform due diligence when acquiring them. If there were no buyers for lier loans, they wouldn’t have been generated.

  45. Greatbong, i have a question regarding the issue and will be glad if you could answer it.

    The primary lenders played out by “Lucky Chikna” got back their money immediately from the Fannies and Freddies. So, in essence, when the housing boom went bust, they shouldn’t have suffered since they’d already got back their money. Also, the insurance companies like AIG etc had to payback Lucky Chikna some money when loans were defaulted on. 1) Hence, are there any primary lenders there who’re in turmoil. If so, how? 2) Since the Chikna’s got their money from two sources ie Fannies and Insurance companies, they theoretically today should be in good shape. Yet, why is everyone crowing about the US financial system “breaking down”. How did the lucky chinas come to suffer?

  46. “The primary lenders played out by โ€œLucky Chiknaโ€ got back their money immediately from the Fannies and Freddies. So, in essence, when the housing boom went bust, they shouldnโ€™t have suffered since theyโ€™d already got back their money.”

    Not all mortgages had been sold. Unless they needed the capital, a primary lender would be only too happy to pocket the 100,000 profit himself.And in many cases the primary lenders owned MBSs themselves as they were good investments.

  47. Gb,
    There’s something i am a lil curious about & would appreciate if you could clear it. Would it be fair to say that the $700 bn bailout will mostly be paid out of the pockets of the middle & upper clases, i.e people making more than $100,000 p.a & upwards (i know obama’s def of middle class is $250,000 but that sounds unreasonable). The way i see it, those makng about $40,000 or so (which is a huge chunk) have anyway walked away from their homes & the mortgage clause clearly states their other assets cannot be touched.. On the other hand, most indians & several others who fall into the above mentioned income bracket are stuck with homes who’s value has depreciated by at least 35% & will plummet further & since i made a sbstantial downpayment, i have no intention of walking away. Added to this, the burden of the bailout since i fall in the appropriate tax bracket? So, is it correct to say that all in all, the bullah’s of the world won’t really be paying for this mess ?
    Thanks.

  48. As a student of Economics, I feel that this post is wonderfully lucid and explains complex issues in a funny way. Shows Greatbong’s good understanding of the goings-on. Very informative , and lots of fun to read. Great post.

  49. Rohit: Here’s what I think-

    1. Lenders like Lucky Chikna – Highly over-leveraged businesses whose survival depends on the continual and steady sale of the mortgages generated to investment banks. Once the banks stopped buying these mortgages with terrible lending standards (a lot of the investment banks started doing that in mid-2007), their business model was toast.

    2. AIG – I repeat, AIG wasn’t insuring mortgages. It got into trouble because it had a London branch that was making a killing selling credit default swaps.

    When investment banks started going under, suddenly AIG was under a lot of strain for its CDS commitments. This affected a lot of other aspects of its business – its own credit rating, the cost of its debt, its capital requirements, etc.

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  51. Awesome. Good the situation is explained very nice.

    Caueies about the effect if bail out was not made.
    Who would have suffered ? As the root to the problem ie the buyer of the house and the lending bank do not really looks effected at the end.

    Are the top brass officers / CEO’s been hit for their action’s

  52. Articulate way of explaining the crisis…. I m sure, ppl who did not comprehend the crisis when it happened have got a very good insight into the very crisis….

    The illustrations used to explain the situations have added to the aura…. Good job done…..

  53. Good post GB, though i feel you could have focussed some more on the Leverage of the investment banks- falling asset prices hurt you a lot more when you are levered up 30-1 times!

  54. brilliant piece of writing, have forwarded it to all my friends. if you havent heard of frank zappa, you must try out his stuff once. he was a great, beautiful american musician who mixed high brow and low brow as effortlessly as you do in your writing.
    im very impressed.

  55. Must start with Kudos to the writer of this post specially given the lack of financial experience mentioned. I cannot imagine a simpler but fairly exhaustive explanation of the financial meltdown.

    I would have to agree with ats when it is said that the bailout as claimed to be for wallstreet is not just that. With the recent added turmoil in the money markets it is more of a bailout for the main street.

    To explain why i say this i would refer to the following example.

    For example if you have a huge company Z, which employs 100s of thousands of people, looking to raise some money as it needs to pay back some of its debt which is due to be paid soon. (It is infact very common for companies to have to pay back the debt which becomes due at regular intervals) In this market, banks are not willing to lend to each other, let alone other institutions and the same is the case with a lot of other financial institutions who would normally have provided this huge company Z with some money. With no access to cash to pay back this debt the company has no option but to either sell some assets to raise cash or declare bankruptcy. Its not a good market to sell any assets as if market knows about this problem for any company the assets would be bought for peanuts. So there goes our 100s of thousands of jobs, with our bankrupt company. Had there been a working capital and financial markets it would have been very easy to raise this money

    Even if this is not the case, companies need regular access to cash as mentioned in the article for day to day expenses. With gridlocked money markets companies are at the risk of again running short of cash eventually resulting in bankruptcy. There was recently a steel company which is on verge of bankruptcy due to this. Again implying a loss of those jobs

    If financial and capital markets freeze it will impact any common man as much as any of the bankers, and possibly more.

    Besides, why is it that the blame is put only on bankers who made money and not on that person who actually went asking for loan in the first place which clearly was not in his reach. Agreed, people who granted this loan were irresponsible but so was Bullah. It was greed from both parties involved, not just one group of people. To me its simply a case of people trying to live beyond their means and then running away when they cannot keep up with it. If one signs a legal document without reading or understanding it, he is as much to blame as the person making that deal with him. But, its human tendency to blame things on the person who is better off after this crisis. It doesnt go with politicians motives and human feelings to blame the guy who lost his home or a family that is living on roads as a result of this crisis. Its a mistake of all people involved, so stop playing blame games and work to find a solution thats best for all

    Totally agree with the point that rating agencies messed up big time. There have been reports where rating agencies have been reported to have bogged down the standards for ratings so they can get more business. truth of these is obivouly under debate.
    Where the rating agency comes in and why is it so important? The whole market needed to have an assessment of risk, involved with these MBS. With millions of mortgages it is not possible to analyse every mortgage seperately in any given MBS. Rating agencies were effectively out sourced this job to carry out the due dilligence on these assets, which obviously was not done to the best standards. Most institutions and investors would rely on the ratings given by the rating agencies to decide upon investing in them or not.

    I think it deserves a mention about the impact of the stock market crash on pension funds. Most pension funds invest in stocks, besides other assets like bonds, etc. The impact of this day on day crash of stock market might be felt quite hard by some people whose pension funds loose substantial amounts.

    Lastly it doesnt seem that the efforts by all central banks and governments are having much impact as this is not just a problem of mis-pricing and wrong valuations but also of trust. Trust forms the basis of our entire financial system. Trust for financial markets is like oxygen for living beings. Remove trust and we would be back to barter system and era before banks.

    Right now no-one trusts any other institution or bank to lend them any sum of money and without that no capital markets can work. The runs we have seen on some banks’ stocks like barclays recently have been as baseless as arguing that time-travel is possible or not (something which no one has any proof or logicaly sufficient backing), and its all because of lack of confidence. Something is needed to get this trust back…..i dont know what can do this…but it is essential

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  57. This was an exceptional blog entry. I don’t think I’ve seen this financial mess explained in such perfect layman terms.

    I’m still in awe with how you managed to convey all of that across to your readers. ๐Ÿ™‚

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  61. You have got the details wrong in the “insurance part”. Though AIG is an insurance company all it did was get its hands dirty by writing CDS on the toxic securities. The i-banks did it too, and in fact a limited number of i-banks were major players in the OTC CDS market. CDS acts as an insurance, but that does not explain why AIG is bust.

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  63. Thanks a lot and I appreciate the effort and capability to write a complex confusing stuff ,in a simple manner..I an not still very clear on this,will re read and ponder over it more..gonna read the next parts…Thanks for sharing..Good day

  64. Great job dude
    being a financial analyst and dealing solely in the RMBS sector I knew all this but what heck of an explanation…no one could make it clearer without using the economic jargons…
    so well done

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