Truly understanding the Credit Crisis, and why this isn’t really ALL Alan Greenspan’s Fault.

I have had a lot of interactions over the past few weeks with people just baffled by what is going on in our credit market. I dare not claim to have all the answers (I don’t think anyone would) but this is a brief introduction to what the credit crisis is, how it happened, and why Alan Greenspan really is not the one to blame.

To really understand how the economy of the United States could come to its knees in a few short months there is one fundamental issue to understand, what is a mortgage backed security, and how did that shift incentives in the banking industry.

The key to this crisis is a misaligned incentive structure for banks. In a traditional bank loan, the lender’s balance sheet reflects the value of the asset it is lending money out for. This lays incentive groundwork for the bank to make good (safe) loans which they are confident will be paid in a timely manner because their bank is on the hook if the loan goes into default. In a Mortgage Backed Security a portfolio of loans will be assembled and then sold to a third party. These Securities are best described as a well diversified mutual fund that only contains real estate. Similar to a stock mutual fund a Mortgage Backed Security includes properties from all of the U.S. and with that comes inherent diversification. Property value in the northeast can go down but value goes up in the southeast, the overall value of the portfolio stays the same. It seems on its face to be great for the bond holder; however this structure removes the incentive structure on banks to make good loans. The bank now has the incentive to just make loans since they will eventually package these loans and sell them to a bond holder. The bank is now in the position to be completely risk adverse. To illustrate by example:

Oregon Home Owner gets a Loan from Local Bank A. Local Bank A then takes this loan, and sells it to an Investment Banks like JP Morgan in exchange for the principal amount plus some premium. The Local Bank has now cashed out of the risk. JP Morgan buys up mortgages like the one from Oregon Home Owner from all over the country and put them in one Mortgage Backed Security. This Security now has a risk value with a set return, all backed by assets throughout the country. The Security is then sold to a bond holder, ironically enough it is often another (or even the same) Investment Bank.

This process works, without fail, as long as the value of the underlining properties continues to rise, even with a few defaults in the portfolio the overall diversification yields a comfortable safety net. The lynch pin in this dream of an economy was inflated home prices. At some point (roughly summer 2007) Americans ran out of credit, and could no longer support the ever rising U.S. home prices. Now people are stuck in high risk adjustable rate mortgages, (how they got there is best understood in my previous article: You Would Have Been Stupid Not To Take A Teaser Rate, Adjustable Mortgage in 1999). Diversification does not work if the home value of every home in the U.S. starts to depreciate. Cue the snowball effect! When homes stop appreciating, homeowners cannot access the equity in their homes through a refinance. In tern they cannot make their now hugely inflated monthly payment on their adjustable mortgage, and even if they were making payments, their home is now worth significantly less with each passing day. As a result, EVERYONE stops paying their mortgage. The securities fall one by one, and investment banks are left with properties that no one can afford to buy.

The worst part of this story is that as banks start bleeding funds because people stop paying their mortgages, the credit market freezes for the functioning economy. Businesses with working credit lines suddenly see them disappear. Not because of late payments, just because the banks can’t afford the risk of laying out any more money. In tern the company does not have working capital for raw materials to convert into finished products, and the economy overall grinds to a halt.

Where does Alan Greenspan fit into all of this and why do we suddenly hate our beloved Fed Chairman? Mr. Greenspan is blamed for not putting a stop to this madness, and in some respect he is to blame. The Federal Reserve does claim responsibility for regulating banking institutions, which created this wonderful concept of a mortgage backed security. But before we string up Mr. Greenspan, the primary role of this banking regulation is and should be done by the U.S. Treasury. The Fed should return to their first true love, inflation control. Further Mr. Greenspan is taking the brunt for the real criminal the Securities and Exchange Commission. The SEC, who is charged with the integrity of the U.S. markets, were in love with deregulation but have never heard of a market incentive. So Alan, I think you should share your blame with Christopher Cox, William Donaldson and all his associates that preceded in the position since the early 90s, and for god sake take a nap!


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