Now the credit crisis was caused in large part by a US policy of banks lending to individuals who couldn’t keep up with a mortgage, hence causing the bank to foreclose and a subsequent “toxic” debt.
My question is why are banks and financial institutions WORLDWIDE in trouble now because of the US policy? Did worldwide banks also lend to people who ended up not being able to pay up?
Shouldn’t the credit crisis just affect the US since this was in large part caused by a US policy. Please educate me.
Those bad loans were bundled up with some other bad loans, some fine loans, and some not so great loans and sold to financial institutions around the world. Mortgages are a commodity and are sold on the open market to whomever wants to invest in them. They’re rarely held by the people who wrote the initial mortgage.
First off, it wasn’t really due to individuals who couldn’t keep up, at least not totally, but more to do with the fact that home prices are falling rapidly and many people do not have equity in their homes and thus no reason to keep them. People were leveraging the equity they had in their houses by taking money out during re-financing and using home equity lines of credit to buy consumer goods and maintain a lifestyle they couldn’t afford. This was not a problem when home values were rising at 10% or more per year, but with the decline in home prices, these people now have debts that are much larger than the value of their homes and even if they can afford to pay, they have no reason to, and will just walk away letting the banks foreclose.
These bad mortgages were bundled with a bunch of good mortgages and shares were sold far and wide as a good, stable, investment for all comers; with average rates at about 6%, the return is decent and the mortgage default rate has been stable for the last 50 years or so with very little risk. The buyers included many foreign central banks, commercial banks, and corporations, really anybody that had several million (billion) in the bank and needed a safe place to keep it with any return being gravy. Typically the shares in these securities were bought and sold like stock: a company wouldn’t hold the security till maturity, but would sell it to someone else when they needed their capital freed up. These bundled securities are toxic, not because people are defaulting on their mortgages, but more because no one wants to buy these securities anymore… The investors that were just wanting a good temporary place for their money with a decent return and moderate risk are now stuck with them and cannot sell them. See Scylla’s good thread for details on this. These securities still have value; most of the mortgages in them will return ~6% yearly for the next 30 years even if 10% or more of them go into default. The defaulting mortgages will not lose their full value as the property can be auctioned off for at least 50 cents on the dollar (unless property values crash further). The problem is that the value of these securities are calculated by what people are willing to pay for it, which these days is zero, regardless of the maturity value of the security.
A worse problem for the market is that companies do not want to invest in each other as it doesn’t seem safe. So not only is lots of capital tied up in these “worthless” securities, but they don’t want to invest in anything else. Lehman Brothers, an institution that has been stable and profitable since before the US civil war, went under in part because of these securities and the associated credit derivatives it used for hedging. If a company like this can go down, anyone can go down, and so all the banks, companies, etc… that used to lend each other money with short term loans (say 1 day, 10 days, 6 months, this kind of thing), are now taking their money out of the commercial paper market (where these short term loans are made) and putting it where it is safer in treasuries. Because of this, the money that corporations need to run is unavailable to them and they have to either have capital before they undertake a project or not do it. Imagine, for example, McDonalds wants to buy their monthly ration of 12 million tons of beef for next month, and instead of buying it on credit as they normally do (they will get the money from the commercial paper market and pay up within a few days of the purchase), they actually have to have the cash on hand to do the deal (Note, I don’t know if this is how McDonalds does business, it is just a simple example). This is happening to every major corporation around the world now; their credit cards have effectively been cut off and they have to use cash for everything.
Combine this with the credit default swaps and other credit derivatives these investors were using to hedge their investments and speculate on the state of the economy, and we are in a world of shit as there are many corporations and banks that potentially owe billions of dollars, but don’t have this information visible anywhere in their books. So companies are even more terrified of lending money to each other because there is no way to know what kind of deals they have been in or who with, or whether the people they have been in business with have made bad decisions. Everything and everyone is tied together in a big ball of shit and the whole thing could come tumbling down even with the trillions now being invested to stop the collapse…
Shit, I don’t know, hopefully somebody with more understanding than me will come along and further educate us…
This makes absolutely no sense to me - the crisis began in the US and is presumably worse in the US (there have been no falling house prices over here). So what makes the US dollar a “safe haven”? Inertia? Habit?
Ah, was it you who posted the “pool of money” thing elsewhere, C3? That was pretty good.
After listening to it, I realized that investors from other countries thought they were buying very safe investments—Greenspan was only offering 1% on T bills so they thought these AAAs (?) were great…safe as money, good return. I always thought of the stock market as “Americans investing in America,” which it is, but it’s also the world investing in America.
Anyway, it makes sense to me that when investors from other countries get skittish about our (until this point) allegedly stable market, dominoes are going to fall back home. Money those investors had counted on reinvesting…gone.
Consider this, OP: I saw a story on the news a few years back, when they started redesigning our currency. It turned out that there were some Russians who were VERY worried. They’d been hoarding our money, figuring it was anybody’s guess what the ruble would be worth—say their govt went back to communism. Then we reassured everybody that no, the old money wasn’t worthless, this was just a new design but the old was still welcome.
Nowadays, they’d probably be more concerned about a redesign of the Euro
What is hard for me to understand is how a bunch of bad mortgages in USA can lose enough money to weigh down a large part of the banking industry world-wide. Do they have no safety margins at all? Since it seems to be spread to so many banks world-wide, shouldn’t the individual bank’s losses be smaller and thus manageable?
I suspect the answer is that the safety margins are pretty small. Banks are regulated in most countries, and regulation means that they are required to have particular ratios of assets to liabilities in order to trade. So they keep these ratios at the minimum required by law. But when a particular class of asset goes bad, either by losing value or (much worse) becoming unsellable, their ratios are on the wrong side of the line. They have to fix that by selling assets, but with a whole class of asset gone bad, they rapidly get into a position where they can no longer trade as a bank, and the government takes over the company in order to protect the depositors.
And part of the problem is that these assets were essentially investments in the housing bubble in the US, which very quickly burst. The housing market in the US is such a large part of all the banks’ assets that they all got into some kind of trouble at the same time.
Banks across the world have been making bad loans. Easy credit was not just an American thing, and there have been enough shocks to the financial systems in the last year or so that things are starting to tank everywhere. In a lot of countries, it certainly has no direct relationship to the U.S. mortgage crisis.
The problem is that companies like Lehman and AIG were heavily into the sale of credit default swaps. These functioned like a form of insurance - if your investment in mortgages went bad, you collected on the swap. Companies counted the value of these swaps as an asset on their books.
The problem is that the swaps were unregulated. Unlike normal insurance, the companies that sold them were not obligated to maintain a certain level of capital on hand to cover them. And unlike house or car insurance, where each individual policy was essentially independent, the swaps on mortgages were all essentially insuring the same thing. So when the price of real estate dropped, all the mortgage packages dropped in value and everyone wanted to collect on their swaps at the same time. And companies that had sold the swaps didn’t have the assets to pay them off.
