The Credit Crisis for Dummies

The Credit Crisis for DummiesDavid Leonhardt does a yeomanlike job of explaining the inexplicable, the credit crisis. Here’s the meat of his explanation:

It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she’s going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

I’ve got a few quibbles with that explanation of events. I think things go back a few years farther. An enormous amount of money was made in the mid 90’s in technology stocks and some investors got used to the idea that big profits could continue to be made indefinitely with little risk. That idea increasingly took hits around 1998 as the Dot Com boom began to peter out and the investors, who still had lots of cash, started looking around for other sure things. They thought they’d found one in the scenario that Mr. Leonhardt lays out.

The other quibble is the notion that it’s only recently that Wall Street or American business, generally, has been shocked “into a state of deep conservatism”. When you only bet on what you think are sure things, you’ve already in a state of deep conservatism. Entrepeneurialism intrinsically means the assumption of risk not using every legal and political avenue to mitigate it and the entrepeneurial spirit has been on the ropes for a long time.

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