Dipping once again into the blogging backlog.
It's old (from October 2008), and long, but this Financial Crisis for Beginners from InvestorsInsight is definitely worthwhile if you want a better understanding of what happened to the credit markets and why. Here are a few excerpts to give you a taste.
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. (The numbers are illustrative only.)...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 [banks], a mortgage is a product. This product gives them a monthly stream of payments...from their perspective, they are "buying" the stream of payments by paying you the loan amount....If Bank A resells your mortgage to Bank B, Bank B buys your payment stream from Bank A in exchange for a lump sum of money....[I]n 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....Now you have a pool of [mortgages, which] 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 [also referred to as tranches]....Each slice can be bought and sold separately, and each slice entitles the buyer to [a fraction] of the payments streaming into that pool. The price of these slices is based on current assumptions about the riskiness of those payments....The problem 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 [hence prices were high].
Let's say you are an investment bank and you paid $1 million for a slice of a securities offering (a pool). You put that on your books as 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.
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 $10 million of your own money. That's your "capital." You go out and borrow $90 million from other people, typically by selling bonds, which are promises to pay back the money at some interest rate. Then you take the $100 million and buy some stuff (like slices of mortgage pools), which pays you a higher interest rate than you are paying on your bonds. 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 $100 million in assets are now only worth $80 million. Since the value of your debt ($90 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.
[S]ince the Lehman bankruptcy on September 15, the crisis has moved into a new phase. In this phase, financial institutions are facing liquidity runs, or bank runs, whether or not they are solvent. How can this happen?...[B]anks tend to borrow short and lend long. [A typical mortgage is for 30 years, and the bank can't require the homeowner to pay it off early, while savings deposits tend to be short-term, perhaps a withdraw-on-demand savings account or a two-year certificate of deposit.] In the classic case, the bank takes money from depositors and loans it out as mortgages....If every depositor tries to withdraw his money at the same time, the bank can't call in its mortgages, and there won't be enough cash for everyone. Now why would this happen, since it is unlikely that everyone will need his cash at the same time? It happens if each depositor starts worrying that his...money might not be safe...then everyone tries to withdraw his money at the same time.
In ordinary times, bank runs don't happen. First, the FDIC insures all deposit accounts up to $100,000 [now $250,000] per account holder, precisely to prevent this kind of panic. However, in a real bank many of the liabilities are not deposit accounts and hence are not insured. Second, banks can ordinarily borrow money "against" their assets; that is, a bank with $100 in good mortgages can borrow almost $100 from another bank...by pledging those mortgages as collateral. [Securities] can also be used to raise short-term money.
These are no ordinary times, however. The fundamental problem is that all players in the financial system have realized that a bank that is solvent...can still be subject to a bank run. Once that happens, Bank A doesn't want to lend money to Bank B for two reasons: first, Bank A wants to hold onto its cash in case it becomes the target of a bank run; and second, Bank A is afraid that Bank B could be the target of a bank run, and hence is afraid that if it lends to Bank B it won't get its money back. Like all such panics, of course, this becomes self-fulfilling. [When perfectly solvent banks try to replace or renew their short-term loans—remember, they lend long and borrow short—they can't because no one is willing to lend them money.]....The key characteristic of such a crisis is that banks can be hit by bank runs—and go bankrupt—even if their assets are worth more than their liabilities.
There's a lot more, including an explanation of such TLAs as CDS and CDO, but if I put too much here it won't count as "excerpts." Besides, my head's still spinning.
