The Subprime Crisis, Explained

Cactus Cantina - 1 star
3300 Wisconsin Ave NW, Washington, DC

I was in Washington to visit my sister's family (after seeing my wife's whole family). We ordered takeout from Spices, a passable pan-Asian restaurant in Cleveland Park, and the next day we all went to Cactus Cantina, supposedly George W. Bush's favorite restaurant in Washington. I guess that fits: it's Tex-Mex, boisterous, friendly, and relatively uninteresting - not too surprising for a "Texan" who grew up in Connecticut and Maine. But they do rush the kid's dishes to the table, and they have one of those big tortilla makers that pumps out hot, fresh flour tortillas (not that you'll see many flour tortillas in Mexico, but this is Tex-Mex, remember?). The vegetable fajitas are just about the only vegetarian option, and the vegetable selection is healthier than fajitas have any right to be. The mojitos were also too sweet, but overall it was a fun place to be.

During the visit we drove past the headquarters of Fannie Mae, also on Wisconsin Ave, several times. Fannie Mae and Freddie Mac, as you probably now, are currently the epicenter of the financial crisis that could very well push the country into the worst economic slowdown since the Great Depression (matching the Depression is pretty unlikely). Despite the importance of the crisis to all of us, I think that ordinary, intelligent, well-educated people find it difficult to understand what is going on - at least judging by some of my friends and relatives. One problem is that even general news accounts presuppose an understanding of terms like "securitization," "CDO," and writedown." So I thought I would provide my own translation.

Historically local banks took deposits from savings account customers and lent money to homebuyers. They paid 1% for the savings accounts and collected 6% on the mortgages, and the spread (5 percentage points in this case) was more than enough to compensate for any homebuyers who couldn't pay their mortgages.

Then, as any explanation of the subprime crisis says, banks started reselling and securitizing mortgages. But what does it mean to resell (let alone securitize) a mortgage?

To understand this, you have to look at it from the bank's point of view. To them, a mortgage is a product. This product gives them a monthly stream of payments - about $1,000 per month for a 30-year, fixed-rate mortgage on a loan amount of $150,000 (numbers are very approximate), but that stream is not guaranteed; the homebuyer might not be able to pay (in which case they might have to renegotiate or foreclose, both of which are costly), or might pay the whole thing early. The price they pay for this product (this stream of payments) is just the loan amount; from their perspective, they are giving you the loan amount to "buy" the stream of payments. The lower the interest rate you get, the higher the price they are paying for your payments.

If Bank A resells a mortgage to Bank B, Bank B buys your payment stream from Bank A in exchange for a lump sum of money. Under stable market conditions, the lump sum that B gives A will be about the same as the lump sum you received from A (in which case A only makes money from various fees). You can also think of this as Bank B loaning you the money for your house, with Bank A acting as an intermediary.

Now, in practice, Bank B (or C, or D, ...) is often an investment bank. And Bank B often securitizes your mortgage. This means they take your mortgage and combine it with many (thousands of) similar mortgages. If the mortgages are similar according to certain objective criteria - creditworthiness of borrowers, loan-to-value ratios, etc. - they can be treated as homogeneous. (Something similar happened with corn in the 19th century; certain standards were established for different grades of corn, and from that point bushels of corn from different farms didn't have to be separately shipped and inspected by buyers, but could be poured together into huge vats.) Now you have a pool of, say, 10,000 mortgages, with about $10 million in payments coming in from borrowers every month. That pool as a whole has a price - the amount someone would pay to get all of those payment streams of that riskiness. In a securitization, the investment bank divides the pool up into many small slices - say 1,000 in this case. Each slice can be bought and sold separately, and each slice entitles the buyer to 1/1,000th of the payments streaming into that pool.

The price of these slices is based on current assumptions about the riskiness of those payments - the riskier those payments are perceived to be, the lower the price anyone will pay for a slice of them. The problem, as every overview says, is that at the time those mortgages were securitized, the buyers assumed that housing prices could only go up, and therefore the payments were not very risky; when housing prices began to fall, many more borrowers became delinquent than had been expected. As a result, if you own a slice of that pool, you still own 1/1,000th of the payments coming in, but your expectations of how many payments will come in are much lower than they were when you bought the slice. (There were some very sophisticated ways of dividing up those pools, but that is an advanced topic.)

This brings us to writedowns and, eventually, to the subject of banking capital. Let's say you are a hedge fund and you paid $1 million for a slice of a securities offering (a pool). You put that on your books as an asset (in the world of finance, a stream of payments coming to you is an asset) valued at $1 million. However, a year later, that slice is only worth $200,000 (you know this because other people selling similar slices of similar pools are only getting 20 cents on the dollar). You generally have to mark your holding to market (account for its current market value), which means now that asset is valued at $200,000 on your balance sheet. This is an $800,000 writedown, and it counts as a loss on your income (profit and loss) statement. And that is what has been going on over the last year, to the tune of over $100 billion at publicly traded banks alone.

The next problem is that, over the last two decades, most of our banks have become giant proprietary trading rooms, meaning that they buy and sell securities for profit. Let's say you start a bank with $1 million of your own money. That's your "capital." You go out and borrow $9 million from other people, typically by selling bonds, which are promises to pay back the money at some interest rate. Then you take the $10 million and buy some stuff (like slices of mortgage pools), which pays a higher interest rate (the expected stream of payments, divided by the amount you paid for it). Suddenly you are making money hand over fist. But then let's say that housing prices start falling, securitized subprime mortgages start plummeting in value, and your $10 million in assets are now only worth $8 million. Since the value of your debt ($9 million) hasn't changed, you are technically insolvent at this point, because your losses exceed your capital; put another way, the money coming in from your slices of mortgage pools isn't enough to pay your bondholders. And this is where Fannie and Freddie were until they were bailed out by the U.S. government (meaning you and me, and our children); by certain accounting rules, they had negative capital. Basically they borrowed huge amounts of money at low cost (because everyone assumed their debts were backed by the U.S. government) and used the money to buy mortgages (and slices of mortgages of mortgage pools), making them vastly profitable and earning their CEOs tens of millions of dollars in just a few years. Now their assets are plummeting in value and they need to be bailed out. That's American capitalism for you.

Well, there it is. Hopefully that will help you make sense out of your newspaper's business section - which, despite my retirement from the business world, remains my favorite section of the (virtual) paper. What lessons can we draw from all of this? There was a lot of greed, corruption, and incompetence all around, but most fundamentally I think that homeownership is overrated, both individually and as a societal goal. It warrants a separate post, but in summary buying a house is an incredibly risky thing to do with your money, makes absolutely no sense as an investment (it only works out for most people because home prices do usually go up a little bit, and the massive leverage created by a mortgage turns that into a good return), and is hardly the thing our government should be encouraging people to do (via the mortgage interest tax deduction most notably, which perversely subsidizes people in proportion to the size of their houses and the size of their incomes).