Wednesday, September 24, 2008

What is a credit crisis, and why do we have one?

Okay, I am stepping away from posting on Qatar, and delving into economics. Hey, it is a hobby of mine, and news lately has definitely piqued my interest. A couple of people here have recently asked me about the "American credit crisis" and why they should worry about it half-way around the world. With the disclaimer that I am a Human Resources executive, and my formal economics training consists of 12 credit hours of college work about 15 years ago and a two-year subscription to The Economist, here is a summary of the issue and why we should all have a collective global frown:

Imagine you have $1,000 in your purse or wallet. On September 1 your cousin Bob asks to borrow $500 from you. He tells you that he wants to buy a 1999 Ford Behemoth that is worth $1,000 and will pay you back on October 1. In fact, he is so sure of the deal that he tells you on October 1 he will pay you $550 for loaning him the money, or you can keep the Ford. Sounds like a sucker bet. You've known Bob for awhile, and while he has had his ups and downs, the money is not exhorbitant. Besides, he is working and you get to keep the car if he welches on the deal. You gladly hand him the cash.

Two weeks later Aunt Polly asks to borrow $400 for two weeks in order to buy a limited edition Hello Kitty pop-can cozy. Aunt Polly has a fixed income, so you are sure to get your money from her. Not only that, she also promises to give you $440 when the payoff is due in two weeks, or let you keep the pop-can cozy. You see Hello Kitty everywhere, and know you cannot go wrong here.

October 1 arrives and you are waiting at home for the $990 that Bob and Aunt Polly will collectively pay you when the phone rings. Bob informs you that he is sorry, but due to his recent layoff, he cannot afford to pay you back. No worries, you will make arrangements to pick up the $1,000 vehicle. Aunt Polly also discovers that her food, heating oil and prescription drug costs all shot up 8% in September and she is having second thoughts on paying you back for the cozy. After all, chilly cans with a smiling kitty are cold comfort when the house is freezing inside.

On October 2 you receive Bob's car and Polly's cozy. However, when you try to resell the Behemoth and the cozy, you find that the maximum you can get for the vehicle is $200 and not the $1,000 that it was valued. Apparently, nobody wants to drive Behemoths anymore. Toyota Smilies are now the rage.

You also discover in horror that the market for cozies has dramatically shifted to silk screens of the band Wall of Voodoo, and Hello Kitty is so yesterday. Your $1,000 starting position has now turned to $300 almost overnight. When your neighbor Jon, who is a hard-working and dependable person, knocks on your door and humbly asks to borrow "just five bucks" because he left his wallet at work, you have to tell him no because your money is too tight and you cannot take anymore chances. This is the start of a credit crisis.

Your depleted cash position has you in such a pickle that when your car conks out on the way to work you are forced to ask your parents for a loan of $50 until you get paid next week. They sympathize and tell you they would to love help, but are a bit stretched themselves as they are waiting for other family members to pay them back on other loans. In fact, just last week nephew Joe stiffed them for $500 on a Chevy Monstrosity. Pam gave them an Underdog cozy that turned out to be worthless. And don't even get them started on that black-sheep, Jocelyn. Besides, don't you still owe them $20 from last week? Sorry, but they have deep pockets and short arms at the moment. You're on your own. The credit crisis has just spread and escalated.

Unable to drive to work, you lose your job and join Bob and Aunt Polly on Hard Luck Street. You are not surprised to find Joe and Jocelyn there already, but when your parents arrive two weeks later you are really worried. Who will save the family? There is now a full blown crisis.

In the real world, a lot of loans were made on housing with inflated prices. Some of these loans went to shady characters, though many went to good people who simply borrowed more than they could afford in the hope of turning a quick buck ("flip that house"). Others just had to have the McMansion, and bit off more payment than they could chew in the long run. With post 9/11 interest rates so low, borrowing was cheap and there was plenty of money to go around. With so many people willing to buy homes, construction of new homes took off at a pace not seen since the 1950s, and prices of existing homes soared.

For a lot of reasons, home prices eventually declined, and there turned out to be thousands and thousands of cousin Bobs who found they paid more for something than what it was worth. Banks were left holding millions of proverbial Hello Kitty cozies. The money they had to lend disappeared.

The canary in the global housing coal mine was Northern Rock in England (remember that name from last year?). One month after a run on the bank in September 2007 mortgage approvals dropped 31% compared with a year earlier. The tap on the money spigot had abruptly closed. With people unable to secure mortgages to buy homes, demand dried up. Remember the news about housing sales falling? The people trying to sell homes got desperate and lowered prices. Many homes are now priced at a 30% - 40% price discount compared to their 2005 values.

Big institutions like Washington Mutual, Fannie Mae, Lehman Brothers, and others had paid hundreds of billions of dollars for mortgages they thought were safe investments. As it became evident that the institutions were holding mortgage assets valued at 2005 prices and not prices grounded in 2008 reality, government regulators required them to restate their values based on actual prices. Overnight these institutions collectively saw trillions of book value turn into worthless pop-can cozies.

At best, these institutions could no longer lend money to anyone but the best prospects. Many of you know that Jocelyn and I recently bought a home. Even with excellent credit scores, steady income, and no debt we were denied a traditional 30-year FHA mortgage because we bought a condo in suburbia. It turns out that this represents the spookiest of all real-estate at the moment, and is considered quite toxic to lenders. After some networking, and diligent research, we secured a 15 year mortgage from a local bank after putting 20% down. Our banker told us they will hold our mortgage in their own portfolio directly, as there are no resellers willing to buy them right now.

That's the best case scenario. At worst, many financial institutions are simply going under as they find they have more cozies in their vaults than hard money to pay their creditors. Hard Luck Street now finds IndyMac, AIG, Fannie Mae and others joining our hypothetical family sitting on the curb. Meanwhile, nobody has money to lend.

Globally, trillions of dollars are evaporating. Not just in the United States, housing markets around the world are collapsing. And it's accelerating. Global markets rallied when the US government announced a $700 billion cash injection for the firms sitting on Hard Luck Street. Yesterday the markets were less exuberant. In fact, many economists are sobering up and questioning whether $700 billion dollars will even be enough to make a dent. $700 billion dollars. One of these economist is a former Federal Reserve official who implied the alternative is "financial Armageddon". Scary stuff.

Why? Because it is this cash that is used to provide businesses with the capital to buy new equipment, mortgages for us to buy homes, credit cards to purchase upcoming Christmas gifts, and auto loans for our new Toyota Smilies. It is the foundation of our economy, and the basis for the jobs that provide us with paychecks. Without a healthy economy, we will be the ones joining the family on Hard Luck Street.

Unfortunately, the entire banking and financial sector is strained. There is even talk the sacred FDIC guarantee on US bank accounts is starting to look and sound a bit like cousin Bob. The cash has literally disappeared in the United States, England, Canada, Japan, and numerous other countries around the world due to mortgages that turned out to be cozies. Our tax dollars, and those of citizens around the world, are being quickly redirected from roads, guns, and butter to saving the institutions from collapse. Government central banks around the world are pumping hundreds of billions into the market to stave off the financial Armageddon cited above. Only time will tell if it is enough.

If you wouldn't mind, I'll gladly pay you Tuesday for a hamburger today.

And there's your crisis.

-- Tony


Peter Lada said...

Dear American:

I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.

I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transaction is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed information about safeguards that will be used to protect the funds.

Yours Faithfully Minister of Treasury Paulson

(read this with a slight Nigerian accent)

Cory W. said...

I like the way you worded this Tony. Easy read, but still has the same result as a wordy economic book. Can only hope that it gets better, but I have a hard time believing that throwing more money at the issue is going to resolve anything. Credit was King for way to long in America.

Jocelyn and Tony said...

The American / Nigerian thing had me chuckling to myself for at least a half hour...Tony

Anonymous said...

Prior to the canary in the goldmine, there was also the cockatoo which I think was the HSBC sub prime loss reported much earlier in 2007.