EXPLAINING THE MORTGAGE MELTDOWN

My oldest son recently asked me to explain the current mortgage mess in terms a non-economist could understand. My reply to him follows:

1. Several years ago the government, through Fannie Mae and Freddie Mac started to make mortgages easier to obtain. They did this by pooling already issued mortgages and selling Bonds backed by them. This provided more money to issue mortgage loans.
2. Eventually the private market began to engage in the same sort of pooling
3. At some point in time a smart MBA or engineer turned financial analyst realized that real estate prices seemed to be on a constant rise. If this was the case, you could lend money to people who had poor credit. If they didn’t pay their loans you would make money on the resale of the house. If they did pay, you’d make money because their fees and interest rates were higher.
4. When this happened, many investment banks, and even commercial banks, saw that they could borrow short term at lower interest rates than they would earn on the long term mortgages. So they bought the mortgage bonds and borrowed short term, making money on the differential in interest rates.
5. Now we come to the real problem:
a. People started to default on the loans
b. The extra houses on the market pushed real-estate prices down below value of the outstanding mortgages
c. The value of the securities backing the mortgages began to drop.
d. Then people found out that the system assigning specific mortgages to specific bonds was so convoluted that you couldn’t tell if the mortgages backing your bonds were good or bad.
e. This drove the prices of the bonds even lower.
f. The short term debt that the banks used to borrow funds became due.
g. The lenders however would not refinance all of the short term debt because the bonds pledged to cover the debt in case of default, had less value than the refinancing need.
h. If what you owe the (short term borrowing) is higher in value than what you own (the mortgage backed securities) then you are legally insolvent (bankrupt).
i. Nobody wants to lend money to someone who is bankrupt. In times of uncertainty, nobody wants to assume any risk by lending to anyone.
j. Without credit, business stops and we have a depression.
6. Now we have to ask why the republican Mantra of Market Discipline didn’t work. I addressed this in a Blog I wrote several days ago and have reproduced here so you don’t have to go looking it up:

For “Market Discipline” to work the participants and decision makers in the system have to be subject to both the rewards and the potential losses from assuming high risk. When the decision makers are subject to the potential losses they tend to act in a prudent manner. The problem lies in the fact that the remuneration systems in place in today’s markets provide very high rewards to executives who engage in successful risk taking. On the other hand, if the risks are unsuccessful, there is no penalty to the decision makers. They may lose their jobs, but their separation packages have such high payouts that the losses are limited. Just look at the Fannie Mae and Freddie Mac CEO’s. The payouts are in excess of $10 million each. Bears Stearns had similar arrangements and I’m sure that Lehman executives will also come out well off. The biggest losers are the shareholders and the public. The people making the decisions are not the risk takers and have no incentive to be prudent decision makers.

Lets face it, if you are allowed to gamble with someone else’s money and are allowed to keep a high percentage of the winnings while getting paid for doing the gambling if there are losses, why wouldn’t you make the riskiest bets. In fact, looking out for your own self interest, you’d be dumb not to take inordinate risks. For you it is a win-win situation.

This is the simplest I could make it. To be honest, one of the biggest reasons for the whole problem is that the people making the decisions didn’t have a clue as to what they were doing. Let’s face it, look at all the education I have and look at how hard it is for me to explain it to you.

Good luck absorbing all of this. Let me know if I’ve helped.

Dad

Whoops

If you've read my "Nightmare..." blog, please substitute Palin for Huckabee and everything else will stay the same.

Also, please note that many commentators are speculating as to why McCain is doing so well when his policies are so in line with Bush's. I believe that my "Nightmare..." Blog has the answer: Unfortunately many Americans are just not yet ready to vote for a minority group member. I believe Obama's candidacy is ten years early.

There Is No Market Discipline!!

As an economist I have always believed that “Market Discipline” would provide the means of preventing excess risk and imprudent actions on the part of corporate executives. I believed that ENRON and World Com were aberrations. I did wonder, however, how these aberrations could occur.

The recent meltdown in the mortgage markets has convinced me that the excessive risk taking is not an aberration. Rather, it is built into the very fabric of the modern financial system. How this came about is very simple:

For “Market Discipline” to work the participants and decision makers in the system have to be subject to both the rewards and the potential losses from assuming high risk. When the decision makers are subject to the potential losses they tend to act in a prudent manner. The problem lies in the fact that the remuneration systems in place in today’s markets provide very high rewards to executives who engage in successful risk taking. On the other hand, if the risks are unsuccessful, there is no penalty to the decision makers. They may lose their jobs, but their separation packages have such high payouts that the losses are limited. Just look at the Fannie Mae and Freddie Mac CEO’s. The payouts are in excess of $10 million each. Bears Stearns had similar arrangements and I’m sure that Lehman executives will also come out well off. The biggest losers are the shareholders and the public. The people making the decisions are not the risk takers and have no incentive to be prudent decision makers.

Lets face it, if you are allowed to gamble with someone else’s money and are allowed to keep a high percentage of the winnings while getting paid for doing the gambling if there are losses, why wouldn’t you make the riskiest bets. In fact, looking out for your own self interest, you’d be dumb not to take inordinate risks. For you it is a win-win situation.