Credit Crisis for Dummies (By a Dummy)

In the midst of the current financial crisis, people are looking to experts they can trust. Why then have I, Greenspanke, the so-called “finance minister” of the world’s 1,942,080th most popular blog, remained so conspicuously silent on the matter?

In short, I am a fraud.

Contrary to the many epithets (e.g., “First Dude of Finance” and "The Montell Jordan of Money") so often heaped upon me, in truth my economic “expertise” only extends to personal money management—not national (let alone global) finance as a whole.

As such, asking me to weigh in on something as wholly beyond my grasp as the world financial crisis is much like, oh I don’t know, asking someone with no apparent insight into the intricacies of domestic and international politics to run for US vice president.

All of that said, I have done some research (aided greatly by my mentor, TG), and will take a stab at briefly summarizing the current crisis.

Sowing the seeds of catastrophe
Roots of the crisis largely stem from the Federal Reserve’s 2001 decision, under then-chairman Alan Greenspan, to lower the “federal funds rate” (FFR) and then keep it low for several years (e.g., under 2% until Sep 2004). The FFR had a strong ripple effect on other interest rates like those for mortgages and car loans (see below graph). Thus, having the FFR so low for so long basically flooded the world with cheap money.

House of cards
In conjunction with this influx of easy cash, the real estate market underwent a meteoric rise in home values and, in addition, the banking system implemented an astounding reduction in eligibility requirements for would-be borrowers. Thus, not only did buying a home become a more tempting investment, but obtaining a loan to do so became absurdly easy. As my mentor put it: "no money down, no income documentation—your mom's cats could have gotten loans". As a result, the system enabled everyday people like Joe and Mario the Plumber to do things like buy homes beyond their means; or take out "second mortgages" on the seemingly ever-rising equity in their homes to buy things they didn't need like flat screen TVs and second houses.

A related issue is that mortgage salespeople (now affectionately known as "predatory lenders") had every incentive to sell high-risk loans (e.g., "subprime" and "adjustable rate" mortgages) to high-risk borrowers. Namely, the lenders got a commission for their sale and, what's more, the institution they worked for often turned around and sold the new mortgage (and its risk) to other entities like Fannie Mae and Freddie Mac. By the banks financing these loans to begin with, and by Freddie and Fannie buying such "mortgage-backed securities" from the banks, all parties put themselves at the incredibly risky mercy of (a) home prices continuing to rise and (b) borrowers continuing to make their mortgage payments.

Death of a party
Alas, circa 2006 the US housing bubble burst and home prices started to fall. Making matters worse for borrowers, by this point the Fed had started raising interest rates. Adjustable interest rates spiked, mortgage payments went way up, borrowers began to default on payments, and home foreclosures sprang up in droves. Soon enough, mortgage-back securities became "toxic assets" and the financial institutions who'd bet the farm on them—such as Bear Stearns, Freddie and Fannie, and Lehman Brothers—saw their risk come home to roost.

Bailout blues
In the wake of all this, stock prices have plummeted and the banks have taken huge losses, which has greatly impaired the banks' capacity and willingness to make new loans to businesses, individuals and each other. With lending (i.e., the glue that holds the economy together) in such dire straits, the US government has decided to step in with its projected $700b Troubled Assets Relief Program (TARP, aka bailout).

So, what is the bailout aimed to do? I think I'll quote my mentor (again) on that one:

The bailout package will help some because the government will buy from the banks $700 billion worth of the worst crap they have on their balance sheets. [The banks] will not get face value for this stuff - maybe somewhere north of the current very low market values which exist because there is essentially no market. In addition, the accounting changes that are part of the bill will allow the banks to sell the stuff, perhaps realize the losses over a period of time instead of immediately, and therefore have some capacity to lend, which may help lower rates for real people. As the economy is run by credit this is necessary but not sufficient for getting the economy going again. This will also help restore some confidence to arcane things like the interbank and commercial paper markets which are frozen or near frozen and in which rates are very high and impeding activity (emphasis mine).

In short, then, it seems the bailout aims to save the banks arses and, by doing so, help restore the banks' ability to lend and also restore overall confidence in the marketplace.

No time to blink
In conclusion, I trust that the elementary, bullet point regurgitation of other people's ideas presented above will put to rest rumors that I am anything but a novice when it comes to big time economics. That said, if the next president asks me to be treasury secretary, I will answer him yes because I have the confidence in my readiness, and know that you can't blink. You have to be wired in a way of being so committed to the mission, the mission that we're on, reform of this country, and victory in the war. You can't blink. So, I wouldn't blink then, if asked to be treasury secretary.