IS IT REALLY A CRISIS?
Make no mistake: We are staring into an economic black hole unlike any in nearly a century. Most people will wake up, make their sandwich, and go into work or school to come home at the end of the day as usual. However, many thousands of people have already lost their jobs. The United States unemployment rate climbed to 7.2% in December, the highest level in 16 years. People have lost their homes, cars, cell phones, and other assets on which they had been making payments. The question is not whether the abyss is there, but how deep and how wide that chasm extends.
HOW WE GOT (DOWN) HERE
The short short version: Borrowers were unable to pay their debts, and their defaults set off a chain reaction that has crushed financial markets worldwide.
The short version: The Clinton and Bush Jr. administrations set a stage for inappropriate lending to sub-prime borrowers with aggressive policies to increase home ownership in the United State. This was not a Democratic or Republican initiative, and no one party is to blame; but over time it did create an atmosphere that encouraged lenders to seek out every level of borrower.
Shortly after 9/11 the Federal Reserve reduced the overnight lending rate to 1.0%, offering easy money to almost anyone that wanted funding. The amount of borrowed money increased dramatically, and firms began leveraging - or using a larger percentage of debt to fund continuing operations and new projects - than ever.
Fannie Mae and Freddie Mac, the two largest mortgage lenders in the country, were/are perceived to have government backing, and were able to make loans at rates below that of the open market. This forced private and public firms without the perceived government backing to lend more aggressively, charge higher rates, and target high-risk borrowers. Lenders introduced more creative mortgage products such as ARMs, which offer a low rate initially before ballooning to a market rate after five- to seven-years.
In order to lend to low-income and high-risk borrowers banks packaged debt into securities, including mortgages. A bank could take a hundred high-risk mortgages and sell a security tied to those mortgages under the premise that, even if a percentage defaulted, the remainder would make up the difference due to their higher interest rates. At the same time other unique securities were being invented, such as credit default swaps. These allowed a firm to buy insurance against the failure of a third-party. In this instance you might buy insurance against the failure of certain debt obligations. If those obligations failed, you received the insurance payment. In essence it is a reverse incentive akin to burning your home to collect the insurance payment, but more complex (and therefore somehow more legal).
Securities regulators failed to regulate these markets because their fundamental assumptions about what was and was not a sound security were faulty. Mortgage-backed debt obligations tied to questionable debt became a huge underpinning of the investment strategies of financial firms, investments such as hedge and mutual funds, employers, and educational institutions.
In 2006 consumers - who had been leveraging themselves to the hilt with cell phone plan contracts, car loans, flat-screen television payment plans, vacation homes, and other extravagances - began to default on their payments. As the default rate crept upwards, firms with assets connected to mortgage debt, largely through derivative securities such as futures and other options contracts, began to encounter financial stress. In early 2007 Bear Stearns collapsed, and like dominoes other financial firms began to either fail, as was the case with Lehman Brothers, or pursue bailout from the government, as happened with Bear Stearns.
The issue was not exclusive to the mortgage crisis, as aggressive lending was extended to firms, small business, large business, and nearly anyone that needed capital, almost regardless of their plan to pay back those assets. Large firms dependent on revolving credit lines, not only Morgan Stanley but manufacturers such as Ford, found themselves recently unable to borrow cash for short-term obligations as banks and other lenders tightened credit lines. When banks stop lending, the economy grinds to a halt, and the Government has to decide whether it is in the best interest of the company to come to the rescue.
Today the marketplace is dealing as best it can with the fallout of years of inappropriate lending and investing in credit-based derivatives. This has meant cost cutting, liquidations, buyouts, mergers, and bailouts. Firms will cut spending, which in turn will slow the economy further, and reduce the number of available jobs as firms call in, "the Bobs" to eliminate non-critical employees. The downward spiral will eventually end as the unemployed find new jobs or start businesses of their own due to reduced interest rates and the ability to (somewhat ironically) borrow at a lower rate, but there is no indication as to how long this period of cost-cutting will last, or if it may be over already.
