How to understand the financial mess we're in, or
It's a Wonderful Life, starring Secretary of the Treasury Henry
Paulson as Jimmy Stewart
I knew we were in trouble when Bear Stearns imploded, Lehman Brothers went
bankrupt, AIG collapsed, Merrill Lynch got swallowed up and, in a wink,
Washington Mutual and Wachovia got gulped down, too. Yes, we were in a
financial crises. And it was equally clear that most of us didn’t understand
what was happening. Most understood the headlines all right, but the story
further down the page was baffling.
I didn’t know how desperately ignorant we were until I heard talking heads
on TV tell viewers the best way to understand the crises was to watch the
old movie, “It’s a Wonderful Life.” If our best understanding of the mess
we’re in comes from that sappy film, then we’re running blindly toward the
abyss.
For those fortunate enough not to have seen it, “It’s a Wonderful Life” is a
sentimental view of the thwarted life of George Bailey (Jimmy Stewart) in
the claustrophobic town of Bedford Falls. Bailey’s family established the
Bailey Building & Loan Association, a bank that loans money to hard-working
poor people. At one point there’s a run on the bank and evil Mr. Potter
offers the panicked bank customers fifty cents on the dollar.
Jimmy Stewart is able to dissuade them by a heart-warming speech in which he
explains that the bank doesn’t keep their money idle, but loans it out to
other hard working poor folks in Bedford Falls, just like themselves, so
they can buy their homes and get ahead in life. The shamed and enlightened
depositors calm down and George pays them whatever they really need to meet
expenses, and at the end of the day the run is over and the bank is solvent,
having about two dollars left. The movie isn’t about global banks or credit
default swaps, so it ends quite happily.
In the real world, bankers and borrowers had a wonderful life, too, and for
a while it was as heart warming as anything in the movie. They believed
housing prices would always go up! With that in mind, it was easy for banks
to lend and for prospective homeowners to borrow. After all, in the unlikely
event that the borrower couldn’t make payments next year, the homeowner – or
the bank – could always sell the house to pay off the debt.
Unlike Jimmy Stewart’s bank, banks nowadays don’t keep the mortgages they’ve
written. They sell them to other financial institutions. This is a wonderful
idea, too, because if a banker knows he’s going to sell a mortgage, and get
rid of the risk that the borrower may not pay up, then it’s easy to write
big mortgages for all sorts of people.
Meanwhile, some financial institutions bought thousands and thousands of
mortgages and had a wonderful stream of incoming mortgage payments. With all
that money coming in, the dilemma was how to use it to get more money. There
are lots of ways to do that. Maybe the easiest is simply to issue bonds
backed by that mass of mortgages.
A bond is just a fancy IOU; you sell the bond, give the buyer a trickle of
cash and promise to give him his money back at some future date. In this
instance, the fancy IOUs are called collateralized debt obligations (CDOs)
or, more specifically, collateralized mortgage obligations (CMOs) and they
can be sold to financial institutions all over the globe.
Hedge funds bought a lot of these CMOs with borrowed money, sometimes
putting down only one dollar for every thirty they borrowed. And to guard
against the CMO not paying off, the institutions bought a complicated kind
of insurance called a credit default swap. Basically, for a very small fee,
the insurance company -- such as AIG -- promises to pay the value of the
bond in the unlikely event that the bond goes bust. By the way, these
insurance policies are private contracts, unregistered and unregulated. Dive
in; no one is keeping track.
An interesting feature of credit default swaps is that either the insuring
company or the bond holder who buys the insurance can sell the insurance
contract to a third party. And, indeed, some institutions sell a lot of
these credit default swaps. After all, if you wrote out too many of those
insurance policies, you might want to sell some, just in case some bonds
actually do go bust. On the other hand, if you thought Acme Explosive
company was about to go under, you could buy those cheap insurance policies
on Acme Explosive company’s bonds, and when the bonds collapsed, you could
collect big from the insurance company.
How many dollars worth of that kind of “insurance” paper is out there? By
the end of 2007 there were an estimated 45 to 62.2 trillion dollars worth of
credit default swap contracts. At the end of March, 2008, the Office of the
Comptroller of the Currency reported the amount in the US to be $16.4
trillion dollars. That’s a very hard-to-believe big number.
Now huge institutions all over the globe own very fancy IOU’s that are
linked in a long twisting chain that goes all the way back to ordinary US
homeowners paying their mortgages. But many folks can’t make their mortgage
payments and when an unlucky homeowner tries to sell his home he discovers
that other hard-up homeowners are doing the same thing, driving down the
price. Suddenly the bank and the homeowner find that more money is owed than
the house is worth. Wow!
So, little by little, then in a rush, people up and down the chain of
mortgage-backed paper began to sell – or try to sell – their mortgage-linked
assets. But the word was out. Nobody wanted to buy. That paper now has a
market value of -- nobody knows – maybe zero. And no bank wants to loan
money in a world where the other bank’s wealth may be in worthless paper.
At the close of the movie, Jimmy Stewart’s joyful bank depositors crowd into
his home with handfuls of dollars to rescue him while singing “Hark, the
Herald Angels Sing.” That’s not the way it turned out this time.
—Gene Mirabelli