20 February 2009

Understanding the Financial Crisis

As an economist I make a pretty good historian. I simply listen to what people say about the financial crisis, don't understand it, and look at the past to see who was wrong, who was right, who was clueless, in the past, and make my assessments.

Doesn't always work.

But today I found this neat little video on Andrew Sullivan that explains the whole fiasco with cute little pictures and elementary school words.

At last I understand.

I think.

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At 20 February, 2009 16:59, Blogger jack perry said...

Actually I found some problems with the video.

(1) No mention is made of the role government played in this, esp. government agencies whose role is to increase the rate of home ownership. I am surprised that no mention was made at all of Fannie Mae or Freddie Mac, who invented mortgage-backed securities (MBSs), the particular collateralized debt obligations that failed.

(2) In fact the video is somewhat mistaken, if not deceptive, when it describes all CDOs as mortgage-backed securities, when in fact there are many types of CDOs.

(2) The video explains how investors arranged mortgages into boxes, but failed to explain that these boxes were themselves sliced up, or that mortgages themselves were sliced up and pieces of mortgages were distributed into different boxes To be fair, I think that's the "financial wizardry" part whose details they left out.

(3) The video strongly suggests that the vast majority of subprime mortgages have been failing. In fact it seemed to suggest that the majority of mortgages period were failing. To the contrary, the vast majority of mortgages continue to be paid, including subprime mortgages. However, investors have perceived that the risk on subprime mortgages outweighs the reward from interest. The securities bundled safe, okay, and risky all together, so it wasn't possible to unload the risky debts in each security without also unloading the safe and okay debts.

(4) No mention is made at all of ARMs, or of the fact that in 2005-2006 the Federal Reserve Bank ratcheted up the interest rate from 1% to 5% or 6% (I forget) in an effort to head off inflation (which oddly enough was coming about thanks to fuel prices that the Fed can't affect anyway). Most ARMs are set 2-3% above the Federal rate, so people who could afford their payments when the rate was 1%, or even 3%, were unable to afford their payments when the rate was 5% or 6%.

For example, you still owe $100,000 on your house: when the federal rate is 1%, you pay maybe 4% interest a year, or $4000, roughly $305/month, in addition to your principal (if you pay principal; some loans were interest-only, believe it or not). Now the Fed raises interest rates, so your ARM goes up, say to 8% now instead of 4% (and some ARMs were higher if I recall correctly). At 8% you're paying $8000 a year, roughly $610/month, in addition to your usual bills and higher fuel prices.

It amazes me that this aspect of the crisis hasn't gotten more attention.

(5) If it makes you feel better, my current impression is that anyone who thinks they understand what's going on hasn't been paying attention. :-) I don't, for example, understand why the rest of the world's economy has tumbled as well. Something else is up besides our mortgage mess.


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