what went wrong

If you want to understand how our country and the world landed into this financial mess, you should listen to NPR’s This American Life episodes “Bad Bank” and “The Giant Pool of Money.” They are the clearest and easiest to follow explanations that I have heard. You can listen to a streaming podcast or download a transcript for free here. I thank my brother Phil for calling these episodes to my attention.

Here is a too brief summary: Many countries became rich selling us oil and electronics, and when they wanted someplace safe to park their new wealth, we created mortgage backed securities for them to invest in. Originally this was a great plan, as the securities we offered were backed by solid mortgages. We made an honest income and foreign investors received a reasonable return with little risk.

But the deal was so good that investors wanted to buy more, and soon their demand outstripped our supply of mortgages. This led directly to the subprime mortgage mess, as our banks and mortgage brokers kept lowering their lending standards in order to write more mortgages that they could pool into mortgage backed securities and sell to foreign investors. Soon we were giving mortgages to people without jobs or a down payment, and even a few who were already dead.

The scheme seemed to work as long as housing prices continued to rise, but once the dead and deadbeat homeowners began to miss their mortgage payments, the value of these previously considered safe investments began to plummet. Now banks and investment firms are stuck with mortgage backed securities that that no one knows what they’re worth: partly because of the unstable value of houses and partly because each security contains pieces of thousands of mortgages, in various stages of foreclosure or currency.

To make things even more complex, banks divided and spliced together these mortgage backed securities into collaterized debt obligations and sold them too. Any given mortgage was pooled with thousands of others into a mortgage backed security, which was then cut into pieces, each of which was combined with pieces of other mortgage backed securities into a collaterized debt obligation. So even if a homeowner wanted to renegotiate her mortgage, there is no way to know who to talk to.

Besides this excellent summary in the NPR broadcasts, a couple of things caught my eye.

1. “The Giant Pool of Money” contains disturbing stories of mortgage brokers who got caught up in the bubble. They knew that their mortgages were bad, but since they were making a fortune selling to willing investors and since everyone else was doing it, they went along. There are some juicy quotes here for sermon illustrations.

For example: “Glen didn’t worry about whether the loans were good. That’s someone else’s problem. And this way of thinking thrived at every step of this mortgage security chain.”

“No income no asset loans. That’s a liar’s loan. We are telling you to lie to us….Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened…we did it because everyone else was doing it.”

2. Since banks don’t know the value of what’s on their balance sheets (or the sheets of other banks), they are prudently refusing to lend, even to other banks. And so the subprime mortgage crisis has blossomed into a credit crisis, which is threatening to take the U.S. and the rest of the world into a deep recession or worse.

3. The “Bad Bank” episode said that banks cannot lend their way out of this credit crisis. Our problem is that they have leant too much too irresponsibly, and so, according to the NPR expert, “it is no solution to try to lend more.” So apparently what the president and the congress say is the answer is not going to help.

According to another expert on the episode, the only solution is for the government (i.e., taxpayers) to buy these bad MBS’s and CDO’s from these banks at the highest price that we can afford. This alone will free the banks to begin lending again. For obvious reasons, no one has the political will to do this. But if NPR is right, we are just delaying the inevitable. The banks and mortgage brokers selfishly made and sold bad loans, and now we are going to pay for their sins.