Wednesday, September 17, 2008

An introduction to the economic crisis: part 1

A short summary of where we're at

The economy depends on people thinking their money is safe in banks, and bankers thinking their money is safe outside banks. No one thinks their money is safe in banks and bankers don't trust each other anymore. Therefore, we are f****d, because no one can get access to money when they need it - including banks.

The reason why no one thinks their money is safe in banks is because banks have lost money in the credit crunch and no one knows: how much money; whether they are telling the truth about it; and whether they will be able to pay.

The first way banks lost money was sub-prime mortgages. A sub-prime mortgage is a loan to someone with a history of borrowing money and not paying it back. This is called 'having bad credit'. But, in fact, the problem is much larger.

This is because:

  • Banks have been lending to all kinds of people who can't pay, not just sub-prime mortgage borrowers;
  • Investment banks and insurance companies have been doing naughty things with derivatives (I'll explain derivatives in part 2) and;
  • Organisations that are not banks have been acting in bank-like ways without a banking licence.
So, to summarise this far: We know we are f***d, we don't know how badly f****d and we don't know who is f****d. Furthermore, no one knows exactly what to do about it.

A little background on banks

Banks provide money to people who need to borrow money, such as home buyers and businesses looking to expand.

Commercial banks take people's savings and lend out the money. They make a profit by charging a higher rate of interest on loans than they pay on savings. The largest commercial banks in the UK are HBOS and Lloyds TSB.

Northern Rock and HBOS got into trouble by offering mortgages to people who couldn't repay them. They did this because house prices were going up so they assumed if the person couldn't pay, they could sell the house at a profit. If the person did pay, they could charge them a high interest rate on their mortgage if they were at risk of not being able to pay.

Investment banks act as an intermediary, allowing the public to lend money to large companies directly by buying bonds. A bond used to be a piece of paper proving that you'd lent money to the company. Now, bonds are electronic. The investment bank makes money by charging the large company a fee for its services. The major surviving investment banks are Goldman Sachs and Morgan Stanley. Investment banks that have gone bust in the credit crunch include Bear Stearns and Lehmans.

Barclays and HSBC have both investment and commercial banking businesses.

Going back to bonds

In America, investment banks had found a way to do the same thing that they did with bonds, with mortgages. This is called 'securitisation'.

Securitisation means that an investment bank acts as an intermediary between the public and 'mortgage banks'. An example of a mortgage bank is Countrywide. Countrywide lends money to US home buyers and then immediately sells the loans to investment banks for onward sale to the public. The resulting bonds are called ABS, which stands for asset-backed securities. Each ABS contains bits of around 1000 mortgages.

So far, so non-toxic...

I do not like them, Broker Joe. I do not like your CDO!

Investment bankers thought they could make more money by convincing the public that investing in ABS, even ABS based on sub-prime mortgages, was never going to lead to them losing their money. Hence, the invention of the collateralised debt obligation or CDO. A CDO is a brass plate with the CDO's name on that is controlled by an investment bank.

A CDO bought a large number of ABS and turned them into new bonds of various levels of riskiness. I do not understand this bit either, but ask not how sausages are made!

The key point is that if you bought one of the less risky or 'Senior' bonds issued by a CDO, you couldn't lose any money at all until more than a certain number of people with mortgages in the ABS had failed to pay them.

If you could convince a credit rating agency, such as Standard & Poor's, that it was very unlikely so many people would fail to pay their mortgage, then they would give these 'Senior' bonds a 'triple-A' rating. This meant they were rated as safe as the American, Swiss and UK governments, and safer than large banks.

Unfortunately, the rating agencies were wrong...

A number of pension funds, which had invested in the 'safe' 'Senior' bonds lost money. A pension fund, of course, takes money from working people, invests it and uses it to pay their pensions when they are old and grey.

Bear Stearns also got into trouble because it was either hanging onto a lot of 'Senior' bonds in the hope of making money from them, or it had stockpiled ABS ready to package it into CDOs. Either way, it lost more money than it could afford.

*****

Another problem with CDOs was that the legal paperwork was so complicated that it was often not clear who owned the underlying mortgages, which caused problems in court when the borrowers didn't pay.

Who owns the mortgage?
I don’t know
And you don’t either, Broker Joe
I would not know it here or there
I would not know it anywhere
I will not buy your CDO
I will not buy it, Broker Joe!

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