State of the economy

 

"Strange Times" by the Black Keys seems to sum up our current economic situation nicely. Indeed, these are some strange times to be living through. Whether this is a blessing or a curse is yet to be determined but what I can say for certain is that it sure is an exciting time to be studying finance.

 

Looking at what has transpired recently the only appropriate first post would HAVE to be about the current state of the economy. So without putting this off any more lets get right to it!

 

How this mess started

The first player in this game is a little thing called a subprime mortgage. This little guy was initially a vehicle designed to open up the possibility of home ownership to a whole new customer base. They worked fine until around 2005 when some major problems began to appear. It came out that some brokers were misleading borrowers by pushing them into loans they couldn’t afford with low teaser rates. The brokers could easily point to the past decade of home prices and say "Look they have been rising like crazy! You can surely refinance later and be able to afford the house then!" It also came out around the same time that borrowers had been misleading the lenders just as often by taking advantage of "liar loans." "I make $500k a year, just trust me." It was around this time that the default rate on mortgages began to soar.

 

The next piece was asset securitization. This allowed the banks that made the loans to sell them off to investors (mainly investment banks) who would then pool them together creating asset backed securities. Pieces of these asset backed securities were then combined to form new securities called CDOs. After a CDO was created it was sometimes bundled with other CDOs and split off again into more pieces which were called CDO^2. As you can probably tell these became extremely complicated securities and thus it was nearly impossible to assess how risky they were. These assets moved from investor to investor until they finally found a home with their end owner. Because these end owners did not want to be stuck if the borrower defaulted they used credit default swaps to eliminate their default risk. AIG was the go-to guy for CDS and they were profitable until they got hit with the large number of defaults that started in 05.

 

Probably the most important bit was the amount of leverage employed by the investors in these assets. A typical firm will have a debt to equity ratio of ~1:1 or 2:1, the players in this game had DE ratios hovering around 25:1. This need for debt gave financial institutions a strong incentive to move risky assets off of the balance sheet with SIVs (structured investment vehicles) and other exotic securities. The companies needed to remain lendable because they were mostly financed with very short term debt that was reissued constantly and if that funding dried up they would not be able to meet their cash flow needs.

 

Fannie Mae & Freddie Mac

These two institutions would act as middle men in the securitization process for prime mortgages. They would buy the mortgages, create the pools of mortgages, guarantee payment on them, and sell the final securities to investment banks. Because they were quasi-governmental agencies they had the ability to borrow money cheaper than anyone else in the world (other than the US government). People believed that the gov. wouldn’t let them fail, turns out the people were right. As someone so eloquently put it they earned "Privatized profit with socialized risk." FM&FM began to use their funding to buy and hold a significant amount of the mortgage securities in their own portfolios and they moved into some riskier types of mortgages (Alt-As, etc.). They effectively went from being large companies to being HUMONGOUS companies in a matter of years.

 

Putting all of the pieces together we get a very tall and very integrated, shaky house of cards that depended solely on house prices increasing. When the increasing home prices card was pulled out it began to bring the whole house down.

 

Market failure!

As losses on subprime backed mortgage securities mounted the market for them ceased to function. This made it impossible to value the securities as they were "priced to market" and if there isn't a market there sure isn't a price. This caused a stir among the large international banks. They began to question whether or not the other banks they were lending to would be solvent the next day. The rates for short term loans began to skyrocket and markets that were barely related to the subprime mess began to freeze up.

 

Bear Stearns

This was a highly leveraged firm that was funded mainly by short term debt. Early in 08 rumors began to circulate that Bear Stearns was having liquidity problems. This caused a run on the bank which basically made the rumors come true. The Federal Reserve stepped in and arranged a merger with JP Morgan Chase in which the Fed took on almost $30bn in questionable securities.

 

Fannie Mae & Freddie Mac V2.0

Losses began to rise in their portfolio of mortgages and on the guarantees they issued. When these losses were reported it spooked some large international lenders (thought to be China) and they stopped lending to them. Like with the run on BS their cash flow dried up and the US government ended up taking them over. Had they not stepped in the estimated losses were around $200bn.

 

Lehman Brothers

They were in a similar situation as BS, highly leveraged with short term debt, and just like BS that funding dried up. When they asked for a bail out the government rejected the idea and Lehman Brothers went bankrupt. The fallout on this is still spreading but it has already had some pretty scary effects. The reserve primary fund, a money market mutual fund, owned a large portion of LB's debt that is now worth $0. They had to announce that their NAV had dropped below $1 "breaking the buck." As of right now the final amount of damage done by the LB failure is unclear but it has to potential to be devastating.

 

AIG

AIG was the largest insurer in the world with operations all over the globe. Most of the insurance they wrote was just your general, run of the mill, vanilla insurance but they had a credit default swap unit. In return for a premium this CDS unit would guarantee against losses in mortgage backed securities. When everything came crashing down in mid 08 and the investment banks turned to AIG to make them whole, AIG couldn’t do it. The US government had to take them over because if AIG failed hundreds of banks around the US wouldn’t have the cash to continue operations. The losses from this are near incalculable.

 

This pretty much brings you up to date on the current state of the economy. I hope that this information will allow you to understand what has happened and why it is so important that the government gets it right. If we can take anything from this I think it is to make sure you do your own due diligence whenever entering into a transaction.