Why the financial crisis and who's really to blame?

I’m not a writer or a blogger. I commit these thoughts and explanations to writing in response to my friends, family, co-workers and children who want to know what’s really going on with this financial crisis. We are inundated with 60 second financial news pontificators and politicians all expressing varying views of the state of the crisis, who’s to blame, why it happened, how serious it is etc. etc. Here’s my attempt to boil it down in simple terms for we humans.
Interest Rates
Central to any possible understanding of how we arrived at our current financial state requires some understanding of interest rates and their affect on the economy and consumer behavior. There are two sides to every story. Interest rates are no exception. We, the consumer, generally understand interest rates as either i) what our bank pays us on the money we leave in our various checking, savings, money market etc. accounts or ii) what we pay to borrow money to buy things such as cars, homes or anything we pay for on our credit cards. Let’s call all these purchases “the good stuff”. True enough this is the ying and yang of interest rates. The important take away is that when interest rates are low “the good stuff” costs us less and we can afford to buy more of it because our payments are lower. Obviously the opposite is true in that when interest rates are higher we can afford less of the good stuff and hence, we buy less of it. But what of the other aspect of interest rates, the ones that our banks pay us for leaving money with them or more specifically lending our money to them? Clearly we would like to be paid the highest interest rate possible on our money and thus banks raise their interest rates when they want or need more deposits to attract us to open accounts or lend our money to them.

So far pretty basic. Here’s part two. Banks are not the only folks out there borrowing money and paying interest to do so. We have many options as to whom we can lend money and each of these options pay different rates of interest depending on the riskiness of the loan. We can loan to the federal government by buying US Treasury bonds (very safe hence, they pay a low interest rate), we can loan our money to state and local governments by buying municipal bonds and we can even loan money to businesses of all different sizes and industries by buying their bonds. All of these bonds pay the buyer (i.e. the lender) varying interest rates. How likely it is that the loan will be paid back determines the riskiness of the loan and thus, how much interest the borrower must pay the lender to entice them to lend the money.

Who sets these interest rates?
There are many market forces at working driving interest rates. For US dollars one of the primary drivers is the interest rate set by the Federal Reserve (“the Fed”) for money they will lend on a daily basis to other banks and institutions. When the Fed is worried that the economy is slowing down what do they do to speed it up? They lower their interest rates in the hopes that folks will buy more of the good stuff, thereby stimulating commerce, creating new jobs and generally growing the economy. However, if rates are left too low for too long the economy can overheat. When that happens there is not enough of the good stuff to go around and we bid up the price of all the good stuff. We also create too many jobs without enough workers to go around to fill all the jobs, hence, businesses need to pay more to get people to come work for them. Eventually, they add this expense to all the good stuff. The important point to understand is that when interest rates are too low for too long it eventually leads to higher prices on all the good stuff (known as inflation) which is very bad. Therefore, the Fed is constantly looking at the economy for signs of a weakening or overheating economy and adjusting interest rates up or down to compensate for the prevailing economic wind.

Who are the lenders?
Well we kind of know who is doing all the borrowing – consumers, businesses, governments etc. – but who is doing all this lending? Well you may not know it but we all are. As I mentioned above, when we deposit money in a bank we are lending money. When we buy bonds we are lending money. But that’s just us the consumer. There are other really big players in the world sitting on lots of cash that want to lend it out and get paid interest on it. Who are these players? You know them all. When you pay insurance premiums to your insurance company what do you think they do with that cash? Those enormous pension funds that hold money aside for the retirement of workers need interest on their money. All those colleges and universities sitting on piles of endowment money lend their funds to earn interest. And what about those incredibly wealthy oil nations sitting on piles of money we paid them for oil? What about the newly emerging economies of China, India, Russia, Brazil etc.? You guessed it, they are lending it to us, the borrowers, the purchasers of all the good stuff, the governments that need money for their spending, to businesses that need cash to run and grow. And where’s a better place for these foreign entities to lend their money? You guessed it. The good old US of A. Think about it. We borrow their money to buy all the good stuff – oil, flat screen TVs, sneakers and clothes and cheap labor services etc. – and they lend it right back to us so we can buy more of the good stuff. What a great set up. They make money on the goods and services they sell us and they earn interest when they lend those very same profits back to us and we are like mice on a treadmill oblivious to these simple facts all the while trying to earn more money to buy more of the good stuff and hoping that interest rates remain low so we can pay for the good stuff we bought and the good stuff we want to keep buying. What about us? Well those money markets we buy actually lend out our money so they can pay us the interest. Like it or not we all are the lenders. Its 11 O'clock do you know what loans are in your money market?

Do lenders like low interest rates?
Not an easy question. The answer is yes and no. They like it because it stimulates us to buy all the good stuff but they don’t like it because they want to earn more money. Do you want to earn 1% or 6% in your money market? Folks just can’t live on 1%. So what do they do? They take on more risk to get higher interest rates. They reach ever higher and higher to get paid a higher rate of interest. The longer interest rates remain low the thirstier the lenders become to make loans that will pay them a higher rate of interest. If the thirst gets really bad they stop caring about the risk and just need to satisfy their thirst.

How does the thirst get satisfied?
So what do you do when you have all these people and institutions wanting to borrow money because interest rates are low and on the other hand you have all these folks that want to lend money at higher and more attractive interest rates? That’s the job of Wall Street. That’s what they do. They bring borrowers and lenders together. (They also bring together investors with sellers of businesses but that’s for another day). Wall Street brings these “buyers and sellers” of money together just as Wal-Mart brings together the consumer and the manufacturer of everything on their shelves. Just like any good business, when a product is in demand Wall Street’s job is to innovate and find a way to give the people what they want. So how did Wall Street meet this need? In the simplest of terms, they bought up all the loans paying higher interest rates they could find, they packaged them up into nice little bundles of loans and then sold off pieces of these bundles to all the lenders / investors throughout the world that were dying of thirst to get paid a higher rate of interest. All those funny little acronyms you hear like MBS, CMBS, CDOs, and CDS were just complicated little pieces of many loans that lenders could use to make loans at higher interest rates. It turns out the thirst was enormous for these loans so banks and lenders of all shapes and sizes kept making these loans knowing they could sell them to Wall Street who would polish them up and sell them to the insatiable ultimate lenders. The originators (mortgage brokers and banks etc.) of these loans knew Wall Street would buy up all their loans. Most of the originators didn’t even understand the forces at work that created this demand. They just knew the demand was there, they could make lots of money for each new loan they could originate, and they were easy to sell because rates were so low and almost anybody could qualify. So the originators went to town making the loans and using Wall Street as a conduit for the lenders to buy them all up.

Back to the borrowers
So once again, who borrowed all this money? We did. Everyone that bought the American dream, many for the first time. Everyone that bought a bigger better American dream. Everyone who refinanced their American dream to lower their payments by never repaying the principle of their loan (often even adding to the original loan over time). Everyone who borrowed against their American dream to go buy the good stuff or pay off their large credit card debt they used to already buy the good stuff. Everyone that thought they could make a lot of money buying up houses and condos and reselling them for a profit. Ever watch the TV show Flip That House? Everyone who bet that interest rates would never go up and the price of their homes and real estate “investments” would never go down. Do you know anyone like that? A good guess is that you do and his name is you “The American Taxpayer”.

So what the heck happened to cause this train wreck?!
Interest rates went up and the air starting coming out of the balloon. In 2006 the Fed decided the economy was overheating and started to raise interest rates fairly dramatically. As interest rates went up so did payments on all this borrowed money lent to the American Taxpayer. Similarly, as interest rates went up, all the good stuff got a lot more expensive and people stopped buying much of it - especially houses. Pretty soon the borrowers stopped paying on their loans because they couldn't’t afford the higher interest payments. Go figure. At first the lenders thought this problem would be contained to the really bad “sub-prime” borrowers. Turns out that even the not so bad borrowers were actually pretty bad and they stopped paying their loans also. Once the lenders got wind of the growing number of defaulting borrowers they began to panic and sell their loans to other lenders. What really fouled things up, and why Wall Street is taking most of the blame, was that these loans were structured in such a way that no one could understand the loans they made. In other words all loans became painted with the same brush. However, when everyone runs for the door at the same time no one can get out. Overnight there were no more buyers of these loans and no one could sell the loans they had made. If you had to sell your house tomorrow and there were no buyers what would it be worth? So the cycle began to reverse itself, fewer lenders, higher interest rates which created less demand and lower home values which caused more defaults and more losses to the lenders. Eventually the lenders became stuck with their crappy loans with no other lenders to whom they can sell them. Since the lenders couldn't sell these loans and they were unsure how much money they would lose on these bad loans they had no money left to make new loans. Basically the system froze up. No lenders mean no loans to anyone! When no one can borrow money to buy the good stuff, businesses that sell or make the good stuff can’t survive. When businesses can’t borrow money to operate their business they can’t survive. When businesses go down so do jobs. Then no one is making any money to buy any of the good stuff and all the good stuff becomes worth less and less. Unless something or someone comes along to “unfreeze” the financial lending system this is the fate of the American Taxpayer and their economy.

Last week Hank Paulson and Ben Bernanke urgently went to Congress and asked permission to begin buying the loans and reselling them. This was to “unfreeze” the market and begin setting some market derived price, any price at which lenders could sell these loans. Not only might this "unfreeze" these loans but the government in all likelihood would stand to make quite a bit of money as these loans would be sold to the government at rock bottom prices. Unfortunately, our legislators in their ultimate lack of wisdom and understanding, decided this amounted to a bailout of Wall Street and that Wall Street alone should bear all the blame for this financial credit freeze up. The American Taxpayer / borrower should not be penalized. We not only don’t want to hold them to their obligations to repay their loans but we want to help them get out of these loans into more affordable ones now that interest rates are higher. The regulators that kept interest rates low bear no responsibility. Nope, Wall Street created this mess with all their new fangled financial engineering so rather than getting the credit markets moving again through government buying and selling of loans our Congressional representatives, with only one month from election, want to make sure that the American Taxpayer, who has no clue as to the problems facing our markets, our future economy and the role and responsibility they share in creating this crisis, knows that they have punished the bad guys without hurting the American Taxpayer.

What’s next?
Truth is no one knows. We shall see. As Warren Buffett said, “the hangover is usually proportionate to the party” and the American Taxpayer, Wall Street and Congress had one hell of a party. One thing is for sure, it is doubtful that the lenders of the past will rush in again to finance our lifestyle as we've know it, at least not for quite some time.

BREAKING NEWS - Who's going to lend the Fed the money to buy up to $700B of loans that the lenders can't sell? See for yourself - http://online.wsj.com/article/SB122262725903283485.html?mod=testMod