Part I Sub-prime mortages
It starts with the undisciplined lending of the banks in the recent years. The banks, pressured with bringing in bigger profits, start to lend to sub-prime buyers. These sub-prime buyers are people who are unreliable payers. It starts out well while property prices continue to rise.
With the 2007 almost-recession economy of the US at hand, the economy falters, companies start cutting costs and people lose their jobs. Property prices start to fall at this point.
With no job and no money coming in, the sub-prime buyers start defaulting on their monthly payments and the banks automatically seize their properties, demanding their collateral and protection.
However, here's the clincher. Prices of the houses and lots have fallen so low that it is now cheaper to let the bank own the property. How is this so?
1. The price of the property is now worth less than the loan. Example, a buyer makes a loan of 100k to buy a 100k property but now the same property only sells for 70k. It is much cheaper to let the bank seize the property at its current price of 70k. The buyer can only sell it for 70k and he will not be able to recoup his 100k anyway.
2. Owning properties will require the buyer to pay for annual taxes. This is an added cost on top of the worsening value of the property.
This situation is still a normal part of the banking business. They have provisions for these instances and they are ready to handle these problems financially but the problem doesn't end here.
Part II Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are for-profit private reinsurance companies established by the US government to buy the mortgages of the banks/ mortgage companies for a small fee. This frees up the money of the banks/ mortgage companies to again get more mortgages. This setup enbles the industry to grow faster than it will have been without these two reinsurers.
The problem continues here because as reinsurers, they end up as owners of the non-performing mortgages. The banks sell to them and now Fannie Mae and Freddie Mac have billions of property owners not paying them.
With the volume of defaults rising, the two companies raise their white flags and surrender.
The problem could have stopped here but it's more complicated.
Part III Collateralized securities
The banks and reinsurance companies, always looking for ways to earn more money and lessen their risks devises a way to spread the risk of these sub-prime mortgages. They know these loans are riskier than normal and they want to sell them to private investors. This spreads the risk of a 100k loan to 100 people instead of just one bank holding unto it.
The banks and reinsurance companies compile a number of sub-prime mortgages and package them as a security. Security works like a corportation's stock. You can buy and sell it over a stock market. Now, to make it even safer, they insure that security with insurance companies like AIG. It now looks safe and even sounds safe with the big bank names and the big insurance names giving these securities their stamp of approval.
AIG seeing the continuous rise in property prices and considering their size and financial heft, see insuring these sub-prime mortgages as no problem. They earn money for each insurance policy and if the buyers default, they can claim the property and sell it for more in the hot property market.
Banks and institutions around the world now gobble up these collaterized securities like money in a time deposit account.
Part IV The Domino Effect
Remember, the property markets at this point are already souring. Prices are falling and plenty of people are selling their houses and are defaulting on their mortgages.
When the mortage defaults reach the securities owners, the write-offs pile up. The bad loans add up and banks start announcing 100 million losses in one go. These write-offs, big and small spread to big and small banks, first nationwide and then internationally. It even reaches Europe. Old big banking leaders like Lehman Brothers fold up.
Now, insurance companies who earlier agreed to guarantee these securities are now tied to their commitments. They spend hundreds of millions of dollars to pay for these non-performing loans. The volume of claims reach a point that the insurance companies' cash reserves start to reach critical levels.
An insurance company has to maintain cash reserves to pay for insurance claims of their customers and they cannot ever have no cash. If these big insurance companies like AIG default, millions of customers will be affected. There are health insurance customers, car insurance customers, fire insurance customers and many more. For short, once these big firms fall, the ordinary customers will suffer.
Part V Banks don't trust banks
One after the other, banks big or small, are closing down. This trend breeds fear into the banking industry. Since it took months for the major banks to announce their losses, now banks are very scared to lend money. If they do lend money, they are at higher interest rates.
This then leads to a problem of credit or the so called credit-crunch. Money can't be borrowed or isn't easy to borrow nowadays.
Shrinking economy, banks closing, insurance companies closing and no credit, the economy will go further downhill.
Part VI The remedy
The US government will not allow the ordinary citizens to suffer from falling insurance comanies. It also won't allow a further shrinking of the economy.
It decides to intervene in this extraordinary time. The Federal Reserve opens up special loans to financially weakened banks and institutions like Freddi Mae. The US Treasury coordinates buy-outs of troubled banks and insurance firms. However, the biggest and latest rescue initiative of the US government is the $700 billion dollar bail-out law.
This law signed recently, allows the government to buy ALL the non-performing loans. This in effect frees up the problem companies like Fannie Mae, AIG, banks, etc. from counting these loans as expenses. In one stroke, the loss in many balance sheets disappears.
Conclusion
Economists have frowned on this socialistic and anti-capitalist move of the US government. This event should have enabled the smaller disciplined banks to rise up to the top and beat out the ineffective banks. The market forces should have been left to work out the mess. Too bad, with the US election in 30 days, and the potential to deflate the economy of the world, the US government decides to proceed with the initiative.
**********************************************
Success is 1% inspiration and 99% perspiration. Never tire.
Labels: Business
