Sunday, September 28, 2008

U.S. Credit Crisis

I've been closely watching the drama over the credit crisis this week and it has been absolutely infuriating.

It seems to me that the major cause of this problem is not getting the attention it so badly needs and deserves. This morning George Will said it well on This Week with George Stephanopoulos:

The sainted American people are the problem here. That is they have 105 billion credit cards. That's 9 per card holder. Self reporting they have about $12,000 credit card debt per household. Household debt is 139% of household income. I mean, they can't go on like this. The refusal to defer gratification is a fundamental attribute of childishness.
Over the past decade we have seen millions of people irresponsibly borrowing for homes they can't afford and corporations and government policies irresponsibly enabling them.

Excerpts from a 1999 NY Times article:
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.
This all led to increased home demand and sky rocketing housing prices which worsened and fed the problem. Now those of us who have been living within our means (and perhaps saving our pennies hoping to purchase one of those overpriced homes) have to "bailout" these lenders and borrowers? This is anti-American socialism and sickening.

My admittedly limited economic knowledge tells me we should let the free market be free. Failing businesses should fail, people should live in homes or apartments they can afford, and the housing price bubble should pop.

I heard one pundit say that we risk "a recession of up to 5 years" if we don't do the bailout. If a 5 year "correction" is needed so be it. I'd rather live through a multi-year economic downturn than take a major step away from free market capitalism.

Treasury Secretary Paulson has seemed to imply things would be worse than that and we risk some sort of economic dooms day without doing the bailout but he hasn't provided a real description of what that means or looks like.

The Presidential candidate who can stop this and the total economic collapse as envisioned by Paulson wins my vote.


msheeley said...

Mike, I agree with you on all of your points about how this all happened. To add to the problem was the lowering of banks reserve requirement in 2004. I.e. banks could loan more with less cash on hand.

I don't mind the government stepping in and at this point as long as the money is a high interest loan and the government gets equity in the company. The AIG deal will surely end up as a profitable deal for the US public within 2 years.

Governments can participate in a free market. It is still a free market as long as the Government acts in its own best interest.

As for housing prices, I still think prices have to come down another 30% in MA before people can truly afford a home.

Anonymous said...


Having worked in Financial Risk Management for the last 4 years at a large bank, I was in a unique position to analyse the technical causes behind the current so-called "credit crisis".

Financial Risk Management involves the use of 'pricing models' to estimate potential future values of financial instruments. These models calculate the risk of an instrument based on the number of variables, and with interest based products, the most important variable used is the 'mean time to default'.

The "mean time to default" is basically the credit rating. So as long as these CDOs had a credit rating of 'AAA', the model would assume that the mean time to default of about 8 years, whereas a subprime mortgage debtor has a mean time to default that is closer to 3/4 years, which would be a credit rating of B or CCC.
(I'm simplifying, more information here

Now not all of the mortgages in the CDO were subprime, as these types of instruments are generally made up of tranches of different mortgages on the bank's mortgage book. So the risk on the whole of the CDO was definitely not B, but it certainly wasn't AAA either.

The real crunch here though is that the credit rating determines the coupon (interest) rate. AAA assets have a very low yield, because their risk is virtually non existent. B assets have a high risk, and so investors expect a much higher yield to cover the risk (this is known as the risk premium).

So the banks were selling BBB instruments (CDOs) at AAA risk premiums, and making the spread between them. Given that there is often a large (up to 100 basis points) spread between those two I can see why the banks were keen on this practice. Lend at 600 and borrow at 500? Where can I get me some of THAT action !! ??

Given the massive profitability of this fraud for banks, one has to question the role of Moody's/S&P in all of this in their rating the CDO paper as 'AAA'. No doubt they will claim they were duped by financial whiz kid quants at the banks, but I think only the American taxpayer would be silly enough to believe that story.

On that final note, the Rest Of The World (tm) would like to extend a big 'Thank You' to the American taxpayer for volunteering to pay for our investment mistakes in your financial system. We could have done our due diligence on your mortgage backed derivatives ourselves and found them overpriced for the risk, but instead we decided to buy them anyway, and now you have agreed to pay the risk premium through your taxes.

THANK YOU, and remember not to vote!