Everyone now is aware of the economic malaise hitting the markets. There are tons of blogs and stories out there, the news is covering it like crazy. But some of you, like me, who don't have an economics background, nor work in the industry, are wondering just how the hell did all of this happen? I have finally found a story, in which a commenter actually walks through how all of this essentially started and how it's rippling through global economies like a virus - check out the story on the Economist.com's web site. The comment, from a reader I will paste below:
It would probably behoove everyone engaging in this debate to attempt to understand the roots of Lehman’s collapse, and of the liquidity mess itself. While many comments describe the troubled investment banks as “greedy” and “stupid;” such comments are both counterproductive and widely uniformed. The beginnings of this meltdown originated years ago in the conception of sub-prime adjustable-rate-mortgages (ARMS), originally handed out by quasi-governmental corporations to low-income prospective homeowners.
With the creation of these organizations, Freddie Mac and Fannie Mae, the United States opened a derivative market that has since evolved into a situation in which mortgages and like loans were back-sold to banks (Lehman Brothers, Goldman Sachs, Bear Stearns, etc…) who would then repackage them with various other debts into collateralized debt obligations (CDOs), subsequently sold to investors world-wide via stock markets, most prominently the New York Stock Exchange (NYSE).
Theoretically speaking, such practices yield a positive effect on the economy if one assumes the primary lenders like Countrywide are acting responsibly. Unfortunately, they were not. Once primary lenders discovered there was minimal risk on their end they began to lend irresponsibly, issuing loans to buyers with bad or no credit. Once these buyers defaulted, due to the recent crash of the U.S housing bubble, the larger banks who purchased via the derivative market got hurt, not the primary lenders.
It’s not hard to visualize how the initial collapse quickly ensued. While all this liquidity is being traded, re-traded, and multiplied everyone begins to lose sight of the fact that all this money does not yet physically exist. So, what happens when the borrower goes into foreclosure, and the money never will exist? Everyone gets hurt. Compound this to thousands of companies like Countrywide issuing hundreds of thousands of irresponsible loans to homeowners who then default on their mortgages when the interest rates rise and they can no longer pay. The end result is that the big banks lose billions, investors run away from hedge funds and the like, and the real estate market collapses into a downward spiral that, as of 2008, is still two or so years away from hitting rock-bottom. Sound familiar? Now let’s work on fixing the problem – in America and abroad.
Like most economic disasters, the sub-prime crisis needs to be dealt with at its roots. Brokerage firms across America must be regulated. To these ends, Congress must enact laws that would force these firms to issue loans only to buyers who are likely to fulfill their agreements, as well as mandate that the original lenders hold a certain percentage of their loan portfolios. Such measures would restore responsibility to lending, and while immediate profit for these firms, as well as the larger banks and their investors, would be cut in the short-run, this lower-risk environment would ensure that integral corporations like Bear Stearns and Lehman Brothers cease to collapse.
Though foreign economies are not significantly affected directly by the millions of American foreclosures, they are, in fact, ravaged by the products of the sub-prime meltdown Global corporations publicly traded in the international market place, such as CitiGroup, Bear Stearns, Lehman Brothers, UBS, Goldman Sachs, and others, were so heavily invested in the American sub-prime mortgage market that the crisis was able to use these banks as a means to traverse borders and spread, like a virus, to nations thousands of miles away; the London, Hong Kong, and Tokyo Stock Exchanges in particular were damaged. Regardless of these incredible losses, cleanup should be secondary to immediate prevention of further re-enactment of the situation in the United States.
As problematic as it is, the sub-prime mortgage crisis is a part (granted: a large part) of the greater dilemma that has become to be known as the “credit crunch,” an issue which has grown so complex it far exceeds the bounds of any comment. Consumers must also learn to spend responsibly, especially in an environment where a piece of plastic, easily swiped, can ruin credit in a blink of an eye.
With the global political and economic environments becoming increasingly non-polar to a point where more than just a few major players decide the financial fate of society, it is key that each power, whether governmental or private, learn from one another and vow to never repeat previous mistakes. As Goldman Sachs’s Gerald Corrigan states, “It is indisputable that the global glut of liquidity played a role in the 'reach for yield' phenomenon…” (“Paradise Lost”) power-brokers everywhere must come to this realization as well as the epiphany that a more responsible loan market will yield even greater profits and simultaneously provide for healthier economies everywhere. Until then, humanity itself remains in default.
-Richard Gerbino
R.T.G wrote: September 15, 2008 15:18