Recommended reading: a simplified explanation of the current financial crisis

Corporate finance, Current events, Personal finance

If you still don’t know how the current financial crisis happened, there’s an excellent explanation making email rounds in a few Latin countries. Unfortunately, it seems it’s available only in Spanish. It’s such a good piece, though, that I’m offering a basic English translation below. (Edit (11/19/2008): The translation is of the version I received. If someone knows of an English version that probably does a better technical translation than mine, please feel free to let me know.)

It doesn’t seem to have an obvious author, though the Word Doc I received lists an “ojimenezr” at the “Caja Costarricense de Seguros Social – C.C.S.S.” under “Properties”. If that’s indeed the author, I hope s/he’s ok with me using it on my blog. A commenter (thank you Alvaro!) provided me with the author and a link to the original piece. The author is Mr. Leopoldo Abadia, a 75-year old ex-professor at IESE. According to an , he wrote the piece one afternoon in January and the thing went viral (at least in Spanish-speaking countries). His blog called contains a link to the original piece, which he regularly updates. As such, please note that Mr. Abadia has since then (last edit looks like it was done on 11/6/2008), so my translation is of an older version. However, I believe it still does an excellent job of explaining the basics leading up to the financial crisis and in that sense is not out-of-date. Despite having heard of CDOs and followed articles in the Economist, I had no real idea how everything was connected together until I read this document.

Here it is:

Background

2001: Internet bubble explodes.
2005-2007: The Federal Reserve lowers the price of money from 6.5% to 1%.

With such a low mortgage interest rate, the housing boom takes off. In 10 years, the real price of housing doubles in the US.

The problem begins

What for a small American investor is a blessing — that is, the power to buy a second or third home at a really low interest rate — becomes a profit dilemma for bankers, because although they can now place many loans, their average income from interest charges drops.

Faced with this particular paradox, more than one banker in the United States comes up with the idea of:

A. Giving more risky loans (through which they can charge more interest), and
B. Offsetting the low margin by increasing the number of operations (e.g. 1000 x a little bit is more than 100 x a little bit)

With respect to (A), riskier loans, they decided to:

1. Offer mortgages to a new type of customer called a “Ninja” (= No Income, No Job, no Assets). E.g. people without fixed incomes, without fixed employment and without collateral.

2. Charge the Ninja additional interest, of course, since there’s more risk

3. Take advantage of the real estate boom.

4. In addition, full of enthusiasm, they decided to grant mortgage loans with a value greater than the value of the house that the Ninjas bought. According to market trends, those houses in a few months would be worth more than the amount given on their loans. Moreover, since the U.S. economy was going very well, the debtor who is insolvent today would eventually be able to find work and pay off their debt without problems.

5. Call this kind of mortgage “subprime mortgages”. Note: “Prime mortgages” have little risk of default. “Subprime mortgages” have a higher risk of default.

All this worked well for several years. During this time, the Ninjas were meeting deadlines and paying their mortgages and moreover, since they had more money than their new property was worth, they purchased new cars, had remodeling done on the house and went on vacation with the family. All this, naturally, paid in installments and with more money than they received from the bank.

With respect to (B) above, i.e. increasing the number of transactions:

Since banks were suddenly giving many more mortgage loans at a time, they noticed that they were running out of money. The solution was easy: turn to foreign banks so that they can lend them money. After all, globalization’s useful for something!

In this way, the money a simple British taxi driver deposits this morning in his Savings Bank in London (let’s call him Peter) can be that same afternoon in Illinois, because his bank has lent his money to the Illinois bank so that they can provide it to a Ninja!

Of course, the Ninja in Illinois does not know that the money will come from London, and Peter knows even less that his money, deposited into a serious entity like his bank, now starts to be at some risk. Nor does the president of the bank where Peter deposited his money know. Moreover, the president thinks that the Bank of Illinois is a serious institution that’s pleasant to work with. Probably not even the manager of the branch of the bank where Peter’s a client knows what’s going on. At most he’ll know that the bank that he represents has invested a part of its clients’ savings in an Important Bank in the US.

First commentary:

So far, everything’s very clear, and it’s also clear to any person with common sense, even if he’s not a financial expert, that if something fails, it could impart an important blow to the system.

Second commentary:

Globalization has its advantages but also its drawbacks and its dangers. The people at the bank in London don’t know that they’re also at risk in the United States, and when they begin to read that they give out subprime mortgages there, they think: “What crazy things these gringos do!”

Furthermore, as it turns out, there are things called “Basel Accords” that require banks all around the world to have a minimum capital in relation to their assets. Simplifying a lot, the balance sheet of the Bank of Illinois looks like this:

ASSETS LIABILITIES
Cash at hand Cash that has been lent by other banks
Loans granted Capital and reserves
———– ———–
Total: X millions X millions

The Basel Accords require that the Bank’s capital not be less than a determined percentage of its assets.

So, if the Bank of Illinois is requesting money from other banks and giving many loans, the percentage of capital over the Bank’s assets declines and doesn’t comply with the cited Basel Accords.

The problem begins

Somewhere, some sharp guy remembered the advantages of securitization: the Bank of Illinois “packaged” the mortgages — prime and subprime — in packages that they called MBS (Mortgage Backed Securities, or obligations secured by mortgages). In other words, where before there were 1000 “loose” mortgages within “Loans granted” (above), now there are 10 packages of 100 mortgages each, in which everything exists, both good (prime) and bad (subprime) mortgages. The Bank of Illinois then seeks buyers for these 10 packages.

Where does the money they get for these packages go?

It goes to the Assets, to “Money at hand”, which grows, decreasing “Loans granted” by the same amount. With this, the ratio of capital to “loans granted” improves, and the balance sheet of the Bank complies with the Basel Accords. So far so good.

Who buys these packages through which the Bank of Illinois immediately “improves” its balance sheet?

Very good question! The Bank of Illinois creates affiliated entities, “Conduits” that aren’t companies but trusts or funds, and therefore have no obligation to consolidate their balance sheets with the Bank’s parent. That is, suddenly, two types of entities suddenly appear in the market:

The Bank of Illinois, with a clean slate
The Chicago Trust Corporation (or whatever name it wants to use), with the following balance sheet:

ASSETS LIABILITIES
The 10 packages of mortgages Capital: what it’s paid for these packages

Third commentary

If any person working in the Bank in London, from the president to the branch manager where Peter banks, knew any of this, they would certainly be upset. But since they don’t know, everyone speaks in weekly and monthly meetings about their international investments, which they do not have the slightest idea about.

How are the Conduits financed? In other words, where do they get the money to buy the Bank of Illinois’s mortgage packages?

The answer is, several places:

1. Through loans from other banks
2. Retaining the services of investment banks that can sell these MBS’s to Investment Funds, Venture Capital firms, Insurance companies, Holding companies, etc.

Fourth Commentary

The bubble continues to grow.

Fifth commentary

Note how the risk grows ever closer to everyday families, because just like Peter and encouraged by the commercial developers of the Bank of London, any of them can go and put their money in an American investment fund.

Continuing with the story

No one should doubt the good name of the bankers, wise professionals who know how to take care of our savings. Moreover, to be “financially correct”, the Conduits or MBS’s have to be correctly rated by rating agencies.

These agencies give ratings as a function of solvency, liquidity, and so on. These ratings say, “Money can be lent without risk to this company, to this state, to this organization, etc.” or simply, “Be careful with these other ones because you run the risk that they won’t pay.”

Note: We’ll include here what the word “Rating” means: the credit rating of a company or an institution, done by a specialized agency.

In general terms the levels are: AAA (the highest), AA, A, BBB, BB, C and D (very bad), and in those terms, a large bank usually has a rating of AA and a medium bank, a rating of A.

The rating agencies rated Conduits (Investment Funds, Trust Funds, etc.). and the issuings of MBSs (Mortgage Backed Securities) with these ratings, or they gave them other more sophisticated and sexy names, but in the end they say the same thing. They called them:

“Investment grade” for MBSs representing prime mortgages, or those of less risk (AAA, AA and A)

“Mezzanine” for intermediate mortgages (let’s assume this means BBB and BB) and

“Equity” for mortgages at high risk of default, meaning the bad ones, or in other words, subprime mortgages, which, throughout this story are the great protagonists

And the story continues…

Investment banks easily place the best MBSs (investment grade) to conservative investors, obviously at low interest rates.

Other more aggressive fund managers, venture capitalists, and so on, would prefer higher profits at all cost, meaning riskier profits. Among other reasons, this is because traders, managers and directors receive their annual bonuses as a function of obtained profit.

That leaves us with the very bad MBSs. How do you sell those without noting the high risk that they have within them?

Sixth Commentary

Things continue to get more difficult and, of course, those from the Savings Bank in London continue to make happy and contented statements, speaking of the smooth running of the economy and even the charitable work they do in the community.

Continuing…

Some investment banks managed to obtain a re-rating from the rating agencies.

The “re-rating” is an invention to raise the rating of bad MBSs, which consists of structuring them in sections, which they called ordered tranches, from highest to lowest based on the the probability of default, and with the commitment to prioritize payments to those less bad.

Meaning:

I buy a packet of MBS’s and am told that the three first MBS’s are relatively good, the next three are very regular, and the last three, frankly bad.

This means that I’ve structured the MBS packet into three tranches: the relatively good, the very regular, and the very bad.

I agree that if if no one from the bad tranche pays (or as these gentlemen put it, if the bad tranche incurs a default), but I collect something from the very regular tranche and enough from the relatively good one, all of it will go to pay the mortgages from the relatively good tranche, with which, automatically, this MBS can be rated as AAA.

Seventh Commentary

Some scholars are beginning to call these operations “financial magic”.

To stop complicating things for depositors like Peter, these tranche-ordered MBSs were rebaptized as CDOs (Collateralized Debt Obligations). Like they could have given any more exotic a name.

Not content with this, the financial wizards created another important product: the CDS (Credit Default Swaps). In this case, the acquirer, the person who bought the CDO, assumed a risk of default by the CDO that he bought, collecting more interest. In other words, he bought the CDO and said, “If it fails, I lose money. If it doesn’t fail, I get more interest.”

Continuing with inventions, they created another instrument, the Synthetic CDO, which many still have not deciphered, but that surprisingly gave an even higher profitability.

Moreover, those who bought the Synthetic CDOs could buy them through bank loans very cheaply. The difference between these very cheap interest rates and high yields of Synthetic CDOs made the operation extraordinarily profitable.

I forgot to mention one thing: the vast majority of these investment instruments, so risky but profitable at the same time, were insured by companies of recognized standing and prestige. This with the goal of “protecting the investor.” Welcome to the party AIG!

Up to this point and trusting that we aren’t yet completely screwed, it’s worth remembering one thing that we may have forgotten at this point: the fact that all the complexities of the operations described above was based on the Ninjas’ paying their mortgages and that the U.S. housing market would continue to rise.

But…

In early 2007, U.S. home prices began to decline.

Many of the Ninjas realized that they were paying more for their second or third home than what they were now worth and therefore decided to stop or could not continue paying their mortgages.

Automatically, nobody wanted to buy MBSs, CDOs, CDSs, Synthetic CDOs, and those who already had them could not sell them.

The whole thing was sinking and one day, the manager of the Savings Bank in London called to tell Peter that, well, his money had vanished, or at best, had lost 60% of its value.

Eighth commentary

Everyone tried to explain to Peter about the Ninjas, about the money in the Bank of Illinois and Chicago Trust Corporation, about the MBSs, CDOs, CDSs, and Synthetic CDOs.

Nevertheless, there is something that still no one knows: Where the hell is all that money?

There is a very important reason why this question has no answer: no one knows where is the money. And when I say nobody, I mean NOBODY.

But things go even further. Because no one — not even they — understand the muck of financial instruments that the banks (including investment banks) have in the mortgage packages that they bought, and since no one understands it, the banks begin not to trust each other.

Since they don’t trust each other, when they need money and go to the interbank market, which is where the banks lend money to each other, either they don’t lend it or they lend it very expensively. The interest rate that banks charge when lending each other money in the interbank market is called the Euribor (Europe Interbank Offered Rate).

Therefore, many problematic banks suddenly face liquidity problems.

Consequences:

1. They do not give loans
2. They do not give mortgages.
3. Many millions of investors who bought shares in these banks are starting to see the value of their shares minced.

To stop complicating everything, the European Central Bank begins to raise its interest rates. The Euribor 12 months, which is the benchmark for mortgages, starts to rise.

As the banks have no money:
1. They sell their holdings in companies
2. They sell their buildings
3. They create campaigns to make more investors like Peter invest more and under better conditions. European banks are already offering their customers term deposits of 4.75%. Incredible!

Now it turns out that the families in Europe are also beginning to feel pressed for their mortgage payments. The difference is that their mortgage is of their only home. By raising the interest rate, their payments rise (please always read the fine print in mortgage contracts). They have no choice but to tighten their belts and try to arrive safely and sanely at the end of each month. Already in Spain, many, many families are suffering because of this. Speaking of Spain, don’t you think it’s suspicious that Spanish banks continue to report exorbitant profits?

With the downturn in consumption, businessmen are buying less from the manufacturers (let’s say, socks). Certainly a sock manufacturer has no idea what a “Ninja” is. The sock manufacturer notes that since he is selling fewer socks, he begins to have extra personnel and fires some. And this is reflected in the unemployment rate, mainly in the city where the sock factory is located. There, people begin to buy less in the shops….

How long will this last?

Well, that’s a very good question, which is also very difficult to answer for several reasons:

1. Because we continue without knowing the extent of the problem: the figures vary from 500 billion to 1 trillion dollars.

2. Because no one knows who is affected. It’s unknown whether the hundreds of banks such as Peter’s, banks of all walks of life, serious and traditional, have a lot of crap in their assets. The worst is that even these banks themselves don’t know.

3. Only when in the U.S. mortgages unpaid by the Ninjas are carried out, or when banks can sell mortgaged homes (at the prices that they are) will we finally find out how much MBSs, CDOs, CDSs and even Synthetic CDOs are worth. Meanwhile, no one trusts anyone.

Ninth Commentary

Some people have described this as “the great scam.” Others have said that the Crash of 1929 compared with what’s going on now looks like a children’s playground game.

Enough. Perhaps too many traders have been enriched with annual bonuses that they’ve gone collecting all these years. Remember the young French banker who lost $5B at the Societe General Bank a few months ago? Where were these funds invested? How is it possible that his superiors were unaware of it?

Now, while it is true that bankers like that will be left without jobs (10,000 in Lehman Brothers alone), I guess since they’re farsighted that they’ve done a good job saving all their yearly bonuses that they’ve earned all this time for being so good at their work. They’ve collected this money religiously and have hidden it somewhere, perhaps in a closet or under a mattress. Certainly these ways of saving seem safer and more protected than putting them in all the financial innovations that could have occurred to any expert on Wall Street.

Financial authorities are greatly responsible for what’s happened. The Basel Accords, theoretically designed to control the system, have encouraged the abuse of healthy financial instruments such as the securitization of debt, even obfuscating and complicating enormously the markets they were intended to protect.

Did you know that investment banks in the United States are not under the regulation of the Federal Reserve?

The boards of directors of financial institutions involved in this problem have a great responsibility, because they haven’t realized the abysmal risk in which they operate.

Among these must be included the manager and president of the Savings Bank of London in which Peter confided his modest savings as a taxi driver. Some rating agencies have been incompetent or not independent from their customers, which is very serious.

End of story (for now)

The major central banks (the European Central Bank, the U.S. Federal Reserve) have been injecting liquidity so that traditional banks can have money.

The Federal Reserve and the Treasury Department have asked Congress for $700B dollars to buy mortgages, securities and the rest of the garbage instruments. The idea is to clean up the bad portfolio balance sheets of problematic banks, mortgage and insurance companies. In Latin American language, what the Americans have done is to nationalize the losses and privatize profits. Update: Last week, the US backed away from plans to buy bad assets using the $700B.

Moreover, although they didn’t set out to do this, we must remember that AIG is the world’s largest public insurer. Will Cristiano Ronaldo, who carries their logo on his shirt, know that it represents the biggest scandal in the history of international finance?

Winding up, a friend of mine asked: Where do the central banks get their money?

In order not to complicate this explanation of the crisis, let’s leave it as follows: We are all paying for the imprudence and bad faith of many bankers, supervisors and all the politicians who did not want or could not put a stop to the greed of some.

Paradox: Henry “Hank” Paulson and Ben Bernanke asked Congress for additional powers to manage the crisis. Do you trust them?

Finally, I repeat my question, “Where is Peter’s money?”

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9 Feedbacks on "Recommended reading: a simplified explanation of the current financial crisis"

Bernard Lim

Excellent stuff! Easy to read and understand. By the way, I’m from Singapore, half way round the world in the East! It was said that Eastern banks have better fundamentals having gone through the Asian Financial Crisis in 1997 and have been reporting profits in the last few years. Now, I’m having my reservations.



ricemutt

Thanks Bernard. I thought people might not read it because it’s so long :)

When I was in bschool, I thought financial engineering might be an interesting field to study. In theory, anyway. Seems that in practice, it might not have been very responsible to have created/used all those exotic financial instruments.



Alvaro Aguilar

Hi Ricemutt,

I have to confess as it was quite a long post I started reading at the middle, and as I was reading I was thinking, this sounds really familiar … and so more familiar as I continued reading. So I turned to the begining to look for the source and I have to say thank you for giving credit and stating right at the begining that it was someone else’s work.

Just for the shake of completitud I would like to give you the original source, the author of that whole story is a Spanish engineer who is like 70 years, studied at Harvard and has been teaching at IESE a Spanish Lebusiness School for 31 years. His name is Leopoldo Abadia and he even have a blog about the crisis where he keeps completing that story and is puting togheter a dictionary of the ninja crisis.

I hope you find it usefull and would like to thank you again for giving credit to the author even you didn’t know who he was.

Best,



ricemutt

@Alvaro: Thank you so much for letting me know the original source. I will now update the post to reflect that, as well as a link to Mr. Abadia’s blog. Always great when we can correctly acknowledge someone’s work!



BizBlogged1

The subprime mortgage crisis is an ongoing financial crisis triggered by a significant decline in housing prices and related mortgage payment delinquencies and foreclosures in the United States.

Finance blog, finance,economics,Corporate finance,Personal finance,Investing,Marketing/



Paul in HK

Peter’s cash deposit should be backed by the FDIC or something similar in Britain. Is this not the case?

If his Savings Bank is Icesave, then yes maybe he is not seeing his money right now, but event that bank is soon to start repayment. Are there others I which I’m not aware, that are paying 60 cents on the dollar for cash deposits?

Who out there has gotten 60 cents on the dollar as result of failed bank? (i.e not a failed investment bank)



ricemutt

Hi Paul – Yeah, I think the explanation is saying that losing Peter’s money is a real possibility though so far (knock on wood), it hasn’t happened yet. Doesn’t mean it won’t though. The problem is that if Peter’s or anyone else’s money has been used to buy assets of unknown valuation (SIVs, CDOs, etc.) then it’s not clear how everyone could get their money back at 100%. Sooner or later someone (perhaps the government if they end up paying out insured FDIC deposits, in the US now up to $250K through 12/31/2009) has to take the hit on these assets assuming their underlying value is less than what banks and institutions paid for them (which seems inevitable but is still yet to be determined).



Corban

I’m a business major; however, I have learned as much from this single translated Spanish article than my Corporate Finance class. It would appear that these many handy tools that I’ve learned, from NPC, WACC and liquidity management, can be used to create a machine ala Rube Goldberg.

What is the purpose of finance? To get money from where it’s at to where it should be. Clearly something went wrong here. However, strategic errors like these can’t be fixed by analyzing the tools, but by motivations.

Man, it really is like magic; it’s like that 64 = 65 geometry trick. Where’d that extra part come from?!



Steven Pang

Superb. Easy to understand. Thumbs up!



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