Monday, December 22, 2008

Explaining The Sub-Prime Loan Crisis

[This article is some months late. But in the interest of catching up and cleaning the closet, here it is.]

In the first article Economics For Children I explained how loans work. I ended with the stark fact that household debt in the USA totals $14 trillion, an amount that equals $185,000 for each household of four people. Yet family after family going bankrupt attracted little interest until big business began to be affected. Now apparently we are in the middle of a crisis.

This can be explained by starting with an important observation. Poor people make money by working, but rich people make money by gambling.

A popular form of gambling is the stock market, where people try to guess which companies will do well and which will do poorly. They invest money in those companies, and if they do well, they make money.

It is not just companies that can be gambled on, but currencies as well. If I bet the dollar will get weaker compared with the euro and in the future it does, I will make money. Even US citizens do this, despite the fact they are betting against their own economy!

I can also gamble on commodities like silver or platinum or wheat. In fact I can gamble on just about anything. And one of these things is credit risk.

Let's approach this from another direction. You'll remember from the last article that people take out loans for things they don't have the money to buy today. These loans are made by a variety of lending institutions who check out the credit risk and only make loans in cases where they are likely to see a return.

Or at least that's the way it used to be done. Two important factors have changed in recent years.

First, lenders started to make loans to borrowers who were too high a risk to qualify for market interest rates, so-called "subprime lending". This was done because rising housing prices encouraged investment. The basic idea is that if someone's house is going up in value (equity) they have an increasing investment and so can pay over the odds today for their loan. This practice was widespread. By 2007 over one trillion dollars was in sub-prime loans.

Second, consider that for every loan they make, a bank has potential income from the interest on the loan, but they also take a risk. If the home-owner defaults on (cannot pay) their loan, the bank will lose out on the expected income. These lending institutions took to selling off this investment/risk to third party companies. In this way the risk was distributed. The mortgage sector was connected to other areas of the economy.

These investments are called mortgage-backed securities (MBS) and can be gambled on the stock market.

All of this was based on an optimistic view of continuing house price increases. The central bank kept interest rates low to encourage buyers, which is to say to encourage personal debt. Furthermore, lenders offered variable rate mortgages, and encouraged higher risk people to take them on. These loans had interest rates tied to a central rate, and so were appealing... so long as rates were low.

But too many houses were being built and too many were bought for pure investment. When this housing bubble burst, the price of houses naturally fell. Interest rates went up and those with a variable rate mortgage found they could not afford the new rates. The higher risk buyers (those that should never have been offered a loan in the first place) now started losing their homes in record numbers.

This was bad but the practice of MBS made it worse. Sectors of the economy that had nothing directly to do with the housing sector suffered due to their investments in MBS. Rather than being contained, the financial crisis spread, and out to the global market as well.

I will not belabour the lessons that should be learned from this. Even a child knows the results of greed and gambling on nothing.



Crash The Driver said...

Hey Robin,

Great article on the current banking crisis and on how close we have come to seeing Marx's prophecy, that capitalism contains the seeds of its own destruction, fulfilled.

Coming this late in the news cycle, it takes its place as one of many attempts to explain the market melt down in such a way as to make it more comprehensible--this has become a popular genre in its own right. Each effort, however well intended, seems to always end up, to my mind, proving just the opposite. While there may well be simple principles underlying the dilemma, the actual mechanics of the melt down are so arcane as to defy any clear explication. Note, for example, the difference between your two posts on the topic, how the second one gets increasingly bogged down in elaborating terms and twisting itself into the knotted shapes of the market it tries but fails to fully describe. Mortgaged-backed securties are not traded on the stock market. The risk associated with each is sliced up into dozens of small pieces, bundled with other such slices, some from household mortgages, some from commercial, a pinch of car loans, a touch of credit card debt, and these are then sold as bonds to be traded on the bond market, which has distinctive features of its own regarding trading and pricing quite separate from the stock market.

And this is the point: global capitalism has become so arcane, so divorced from the world of human needs, that not even its own managers, let alone the people hired to regluate them, seem to have understood what they had set in motion. And this is not because they are simple-minded, or simply blinded by avarice. We will need to explain this to our children, but just how we will do so remains unclear.


robin said...

Thanks Chris for continuing the dialogue. I must say that I agree with your general philosophy but disagree on the specifics.

First: my post "gets increasingly bogged down in elaborating terms" but yet you wish further elaboration in terms of how the stock markets and bond markets differ. Surely one desire must give way to the other?

It appears you wish to dissipating blame for those who made bad investments and took bad risks -- laying this instead at the door of the abstraction "global capitalism". That is not a step I would make. Not when so many independent economic observers cried foul at the activities of specific individuals and corporations -- cried foul for years and were ignored. It seems obvious (not just in retrospect) that greed was indeed involved, and at a core level.

And yet...

Does capitalism "contains the seeds of its own destruction"? I would go even further on that point: capitalism is destruction, plain and simple. It destroys the individual, the value of labour, of one's own endeavor to make the world a better place. It destroys the environment with its false economies of "growth". It destroys community with single-minded competitiveness. It returns us all to the state of pre-civilization, of the savage.

Obfuscation will not do for our children. We can make sense of complexity, so long as we remember the limits of our understanding. My attempt is, admittedly, a poor one. Perhaps if we all, together, gave it a try?

Anonymous said...

Capitalism? Or was it socialists trying to sabotage? Isn't the problem rooted in Government meddling in the housing market and Clinton forcing lending institutions to push sub-prime lending... a socialist effort to gain the votes of poorer people by "giving" them homes when they can't afford them... the socialists appear to be "helping" the little guy, and when it collapsed, capitalism gets the blame when in reality it was socialist/elite greed for votes and power. It worked. Democrats appear to be the savior for the little guy against the attack of "capitalist" greed.
These lending institutions would never have made those loans if it wasn't for certain Democrats behind the scene pushing them into the guillotine.
Sabotage. Pure and simple... and ugly.

robin said...

I doubt you could find a single "socialist" in all the elected positions in the USA. Your argument is simply for unfettered capitalism as opposed to capitalism with some government control. I am not interested in these arguments one way or another, as they are invariably based on pure speculation.

"Sabotage" would imply some sort of conspiracy theory. No such paranoid hypothesis is required to explain simple human greed. I am with Occam and his shaving appliance on this one.

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