Credit Crisis

What's going on with financial markets? What is a $700 billion bailout? Is my bank safe?

These are questions that I'm hearing all the time now. Having worked in the banking industry for over 20 years I know a little about what is going on. So, let me try and cut through the politics and soundbites of fear and lay out some of the facts along with my opinion.

Mortgage Greed
This is probably the genesis of the current situation. Too many risky loans were made in order to make lots of money. Money was flowing into banks from 1) low Federal Reserve Rates, 2) Foreign depositors, 3) investors. Banks used this money to loan to home buyers and home investors. The huge demand for housing drove up home prices and home values.

Home owners took advantage of double digit home value increases to borrow against the equity and use that cash for consumer spending and investing. This stoked the entire U.S. economy as workers rushed to build houses, suppliers worked to provide home building supplies, land owners sold land for huge profits, and consumer good manufacturers built and sold all kinds of consumer goods.

But I'm getting ahead of myself. Back to the mortgage industry. I said too many risky loans were made. This resulted from a couple of market pressures. 1) The government and pseudo-government entities (Fannie Mae and Freddie Mac) pressured lenders into making home loans available to lower income borrowers by offering to buy up these mortgages thus removing the risk from banks. 2) Lenders coming up with creative financing options to qualify more borrowers. The economics are simple: more loans equals more money.

How a bank makes money
Banks don't make all their money from loan interest. Shocking, I know. Nowadays they make almost as much from fees with an enormous amount coming from selling mortgage loans. Banks will package (bundle together) mortgage loans and sell them to investors. These bundled loans are referred to as Mortgage Backed Securities or MBS. The investors pay the face value of the loans plus a premium for the interest that will be earned on the loans over the expected life of the loans. This "service release" premium is generally between 50 and 150 basis points (100 basis points is 1 percent.) This amounts to hundreds of dollars per loan. For example, a $200,000 mortgage sold for par plus 80 pb would net the seller $1,600 on top of the fees collected for doing the loan (appraisal fee, documentation fees, etc.) It's not hard for a lender to make $3,000 to $5,000 per mortgage loan. These loans are generally done with a buyer already committed to buy the loan so there is very little risk to the lender.

A bank will also make money by investing deposits which are not loaned out. Banks invest in MBS. But so do insurance companies, retirement funds, institutional investors and the average mutual fund investor. Historically,they have been good, conservative investments because the last thing a person wants to give up is their home.

What is a sub-prime mortgage?
It's really just what is sounds like: a mortgage loan that is underwritten to standards below those of a prime borrower. In other words, a more risky loan. But lenders tried to hedge on these loans by finding creative ways for the borrower to pay. Since consumers almost always shop payment (not rate) lenders developed programs to lower the payment. Interest only loans, variable rate loans with a starting rate well below market, 40 year mortgages, zero down. The list was virtually endless. But this wasn't all. Lenders began lending on stated income, meaning they didn't actually verify that the borrower earned what they said they earned. This was all par for our "get now, pay later" mentality.

So what happened?
With lenders cranking out loans by the thousands and investors buying them up, it's no wonder that normal oversite was soon trampled under foot. Politicians are trying to blame this on deregulation and lack of oversite, but that is a scapegoat. The industry is still very regulated. In my institution, for example, we undergo two independant financial audits per year. One by our regulatory agency and one by an independant auditing firm.

The buyer of the mortgage sets the underwriting standards. In other words, they provide the terms of the contract. If the lender doesn't meet those standards the investor won't buy the loan. Therefore, part of the blame goes to the large mortgage investors for loosening their standards. Fannie Mae and Freddie Mac happen to be two of the largest.

Of course, banks, especially large banks, still hold millions of dollars in mortgage loans on their books. And, to stay competitive they began lowering their own standards in order to write more loans. They may have done this with the idea of selling these loans at some future point in time or they may have planned on keeping them for the life of the loan.

The liquidity crisis
So this brings us to the crisis. As these loans started to default, the demand for them from investors dropped and eventually dried up. Banks and investment firms were left holding billions of dollars in subprime mortgage loans. Forclosures increased. Financial institutions had to put more money into loan loss reserves. Additionally, one of the requirements of the Sarbanes-Oxley Act is for companies to mark there investments to market value. As MBS investments lost value banks and other holders had to mark down these investments to market value diminishing their assets resulting in lower equity amounts.

So, the crisis is two fold. 1) Banks are unwilling to lend there diminished money (if they have any) to anyone but the very best borrowers. 2) Banks and investment companies are strapped with billions of dollars of potentially worthless loans/investments.

Now, I keep using the word potentially because not all of these loans have gone bad. Many have, but the majority have not.

What is the "bailout"?
What the government wants to do is borrow against future tax revenues to purchase these loans from banks. This will clear the bad loans off their books and allow them to begin lending money again. They also want to purchase these MBS from investment firms that will allow them to use the proceeds to purchase better investments thus protecting their investors.

The estimate is that the bad loans could equal $700 billion. The government would "protect" tax payers by taking stock warrants in the companies from which they purchase the loans. Of course, the government also hopes that as home values go back up they will be able to sell the homes and make a profit for taxpayers (I doubt that will ever happen, but that's a different rant.)

One of the sticking points has to do with executive compensation packages. Most executives have a terms written into their contracts that earn them hefty bonuses based on profits. But they also protect themselves by requiring a "buyout" of their contract if they are let go. By purchasing bad loans and investments the government can potentially create a windfall profit for Wall Street companies allowing executives to earn a big bonus from the bailout. Or, these executives could be paid to leave. Either way, the average consumer and their legislative representative thinks this is unfair.

What's will happen if a bailout is not passed?
It's hard to tell. We don't live in 1930 America. Economies are global. Despite what the politicians are saying there are a lot of regulations and controls in place. Trillions of U.S. dollars are held in foreign countries (but can only be used, ultimately, in the U.S.) But, the U.S. economy is also heavily dependant on credit. A lack of credit will certainly put the brakes on. To what extent, it's hard to say.

We are still well below the number of bank failures that happened during the Savings and Loan crisis of the 80's and that bailout wasn't even close to the one being talked about right now.

I would put my money in an insured account and wait to see what happens. If I am upside down in investments and have the time to wait it out, I'll leave them for the time knowing that they will eventually go back up. I'll decrease my spending and purchase only those things that are necessary to sustain me and my family. I'll pay off debts.

Bottom line: I'll do everything the prophets have been telling us to do for years.