Understanding the Economic Crisis

I have been meaning to write about the economic crisis, but I haven't had the time, until now. Here is a simplified summary of what happened to the global financial markets and the U.S. Government.

The current collapse on Wall Street and other financial markets began with the subprime mortgage crisis. The subprime mortgage crisis was like a snowball rolling down a hill that eventually picks up enough snow around it to form an avalanche. It exposed many weaknesses and deficiencies in the free market system.

The subprime mortgage crisis began when the rates on adjustable rate mortgages started to adjust. As the monthly payments increased, homeowners found that they could not pay their mortgages any longer and were faced with foreclosure.

Some of these loans, amazingly, didn't require either a down payment or for the applicants to provide proof of employment or assets. There was little incentive for the loan originators not to sell these loans to applicants, as they received their payment on the number of loans sold. Applicants were able to get into houses beyond their means for a temporary low monthly cost and briefly live the good life. So how did this effect the rest of the market?

The foreclosures should have been isolated to the housing market and not affected the global market. However, these individual mortgages were bundled together and sold as securities or bonds on the global market. Often times, the values of these securities were not properly assessed, as no one truly knew the value of mortgages or assets behind them. As foreclosures rose and housing values fell, the values of the securities plummeted.

The securities were improperly rated by the rating agencies, giving investors a false sense of security (pun intended). Many purchasers of the mortgage backed securities leveraged their investment by purchasing them with loans and thus exposing themselves to large losses when the securities underperformed. Lastly, investment firms tried to protect against their debt risk by utilizing credit default swaps.1

Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums under the belief that that their losses will be covered if a default happens.2 The credit swaps market is not regulated, and these contracts were also sold or traded. When the economy was booming, banks and investors made a lot of money selling credit default swaps. However, in the end, these back-up protections were not adequately funded and were not financially viable during a big downturn in the overall market. The credit default swaps were unable to cover the losses of the securities.

This has led to an overall freeze in the world economy. No one is truly certain how much money people have lost and everyone is afraid to lend money, also referred to as a credit freeze. Thus, the economy slows even more, as companies are unable to gain the money needed to survive, and are forced to close, scale back operations, and/or layoff employees. Thus, we are now in the Great Recession.

Here are some articles that provide more information on the crisis, and use better terminology. A This American Life episode that does a good job of explaining it all. You can listen to it or download a transcript.
MIT article about quants and derivatives.
Time article about credit default swaps.2
A STATS article about understanding the crisis.1

So what about the U.S. government? We went from good (at the end of the Clinton administration) to pretty bad in just eight years. How did projected surpluses turn into huge deficits? The Center for Budget and Policy Priorities performed an analysis that shows that of the legislation enacted since 2001, 82% of the difference between the projected surplus and the actual deficit is due to tax cuts and defense and security increases. The Bush tax cuts greatly favored the wealthy and created the largest income inequality in the U.S. since right before the Great Depression. The wars in Iraq, Afghanistan, and other enhanced security measures have cost $864 billion according to the Congressional Research Service Report to Congress. Of that total, 76% is for Iraq, 20% for Afghanistan, 3% for enhanced security and 1% is unallocated.

Now, the solution for getting us out of the current recession and returning the U.S. to a sound financial position is an extremely complex and uncertain issue. For anyone who is interested, here are a couple of articles with different viewpoints (although both are from progressive media outlets) that I found very interesting.

Nobel Laureate Paul Krugman's letter to President Obama
Niall Ferguson article on HuffPost