Photo by Mike Licht
The following is a guest post from The Weakonomist, the anonymous blogger behind Weakonomics.com.
The media has tried to explain the current economic crisis. But many of them don’t fully understand it themselves, so elements and details are lost in translation. The ultimate failure is trying to explain it in a matter of minutes – and this is impossible. You have to keep it simple, and then add layers of complexity as each level is understood.
So let me tell you a story.
Meet Ivan. Ivan is an investor. After a recession in the early 2000s, Ivan pulled his money out of the stock market. He wanted a safe investment, but interest rates were very low and because of this, government bonds offered a low return.
Ivan approached his friend Barry to see what other options he had. Barry is a banker. It’s his job to help investors find places to put their money – a broker of sorts. Barry suggested that Ivan invest in mortgages because they’re safe – real estate prices have never had a down year, so loan defaults are rare. Ivan thought this was a perfect solution.
Barry contacted his friend Mort. Mort is a loan officer at a mortgage company. Mort will help someone purchase a home by providing the financing, and then sell the mortgage to Barry. This frees up Mort to go help someone else with a new mortgage.
Mort has a few mortgages to sell to Barry, which Barry gladly purchases. Think of these mortgages as the eggs, flour, and icing needed to make a cake. Barry puts these mortgages together to create an investment product called a mortgage-backed security, or MBS. It’s the same thing as putting the ingredients together to make a cake. Barry sells the cake (the MBS) to Ivan.
Photo by Jeff Belmonte
At each stage in this process, everyone makes a tiny profit. Mort sells the mortgages for a bit more than he paid, and Barry might charge a fee for putting the mortgage-backed security together. Ivan will now receive income in the form of the monthly payments homeowners make on their mortgages.
Ivan was very happy with these results. So happy, that he came back to Barry with more money, and brought some friends with money too. Barry is happy to oblige their requests for more mortgages, and contacts Mort. Mort tells Barry he doesn’t have enough mortgages to meet everyone’s demand. Because interest rates are so low, everyone who can afford a mortgage already has one.
Then Mort gets an idea. What if he helped unqualified home buyers become qualified? By “exaggerating” reported income, or using mortgages that make payments cheaper up front and more expensive later, Mort was able to put people in homes that previously couldn’t afford one.
These mortgages were riskier than traditional mortgages, so eventually the homeowners would have to pay more each month. Barry was happy to buy them, and packaged them with other mortgages to be sold to Ivan. No one was worried about the occasional default because they could just sell that home. Everyone was happy – for a few years.
Eventually, those people in riskier mortgages started to default because they couldn’t afford the new, expensive payments. At first it was no problem – the house was foreclosed, sold, and everyone moved on. But as more and more homes defaulted, more and more homes were on the market. The abundance of supply, and no increase in demand started make the prices of home fall.
Photo by Jeff Turner
Soon enough, Ivan and Barry found they had too many homes for sale, and not enough money coming in from those folks that could make their payments. Ivan stopped buying mortgages from Barry because he didn’t have any more money.
As a result, Barry stopped buying mortgages from Mort. Without the money coming in from selling the mortgages, Mort couldn’t make new ones. Mort found himself sitting on a bunch of foreclosed homes and was no longer making money, so the mortgage company closed.
Barry was no better. He couldn’t sell his foreclosures because there were too many on the market, and Ivan wasn’t buying the good mortgages Barry had because Ivan was out of money, too. The system froze.
There is no happy ending to this story. No new investors were in sight to bring in new money, and not enough money was coming in from the good mortgages. With no new money, there were no new loans. This meant that even the most qualified buyers had trouble getting mortgages.
The lesson behind the story
So how did that get me laid off? Well it isn’t me per se, so much as it is the millions of Americans who have lost their jobs. The idea here is to show the connection between the frozen industry above, and whatever it is you or I do to make money. Let’s take a closer look at Ivan.
Ivan is an investor, which is just some generic term. Ivan represents all investors. When Ivan started losing money, he had to retool his operation in order to keep his organization afloat.
So what kind of business was Ivan in? It could be anything. It could be a hedge fund, it could be an insurance company investing premiums, or it could be simply another bank. So we can see how the financial sector was impacted. All these companies had to lay off people to save money and keep their companies alive.
Photo by Social is Better
Financial companies weren’t the only investors. You had universities investing endowments, churches investing surpluses, retirement pensions investing for conservative returns, even local governments investing tax revenue.
Why? Because everyone thought (and was told) it was a safe investment. They all lost money, and as a result, they had to cut back. Eventually, the banks themselves lost so much money they couldn’t stay in business anymore. The government stepped in to assist and… you know the rest. Since 2007, we’ve watched a domino effect toppling every industry.
Does this story help explain the crisis? What other questions do you have about our economic situation?
The Weakonomist is an anonymous blogger responsible for everything at Weakonomics.com. With a financial background and a passion for learning, he brings others into the light of economics and personal finance. As a banking insider he’s witnessed this economic crisis from the inside-out. You can usually find him at the corner of Wall Street and Main Street throwing rocks at traffic.