layman’s view of financial crisis

Since the financial crisis is all the rage these days, and pundits pontificate about greed on wall street and lack government oversight, collaterized debt obligations, credit default swaps, etc., and consequently take the discourse out of the reach of the common man such as myself, I have tried to put a historical perspective together based on my personal journey to try to make some sense of the current situation in simple lay terms. There are famous economists in famous universities who have blogs (see run by MIT profs, and other blogs run the freakonomics guys, university of chicago profs, etc..), and I actively recommend reading those blogs as well.

The story begins in my sophomore year of college when I had to write a term paper for the economics course. I decided to write about the debt trap that many countries, especially developing countries, found themselves in. While researching the paper, I was astonished to find that the country that was the most ‘in debt’ back in the late 1980s was the United States. The reason the US never got caught in the debt trap, I was told, was the capitalist society in the US almost always guaranteed that the capital was invested in projects whose return was higher than the rate of interest on the debt. Indeed people were lining up to lend money to the government of the United States because the perception was there was essentially no risk of default. Other countries, especially developing countries, ‘mismanaged’ the capital and invested in projects that did not provide sufficient returns making them borrow money to repay existing debts and consequently getting into a debt trap.

Now why is it that the capitalist system in America is able to find things to invest in that return better results? Well, it is because it is a ‘huge market’, that is, the GDP is high and there are many possible uses of the capital and we have good institutions, etc… What constitutes GDP? It turns out that 2/3rd of GDP is consumer spending. So, as long as people are buying, it looks like we have a good thing going. Now how are people able to buy? Are their incomes high? It turns out that over the last few years, the income distribution has become more polarized, so for even though the median income in 2007 was 50K, the bottom 40% earned significantly less than that, i.e., less than 36K.

In most countries, people accumulate assets by saving and investing, and that usually assumes that their incomes are higher than their spending. Here is where the logic seemed to start falling apart for me. It turned out that not only did the US have a huge public debt, but also a lot of private debt. Meaning the average US citizen spent more than he earned. But I was told that there is social security, medicare, etc., so the average american does not need to save as much. But to actually regularly spend more than what they earned? How could that be sustained? Well, that was because 68.1% of americans in 2007 ( owned their homes, and as long as the value of their homes kept going up, they could borrow against their homes and spend.

Coming from a country where half the folks live on less than a dollar a day, this was an amazing phenomenon. Home ownership is a privilege for most people in the world, it seemed to be a right in America. In fact, politicians would routinely talk about the ‘American Dream’. They conveniently forgot to mention that the great american dream is financed by the great american debt! So the whole world is betting on the American citizenry consuming, and actively encouraging that behavior by lending them money.

The argument seemed to be backward, meaning that normally one would think that one accumulates assets and puts the down payment on the house and pays a mortgage, so, one has to reduce consumption to afford a home, but it seemed like the expectation of increase in home values drove an increase in consumption. Credit was freely available to folks who wanted to consume because the government kept the interest rates low, and the government itself was able to do this because it was able to borrow easily, mostly because there would be possibilities for investment that were dependent on the US citizen spending even more money. So in some sense the whole world was betting that the real-estate market in this country would keep going up and people would keep buying. In fact, it seems that they kept lending money to the US government on this essential premise. All this when industry after industry essentially disappeared to lower-wage countries which in my mind would undermine the consumer demand that seemed to be the primary driver of economic activity and growth.

I remember talk about US being the ‘ownership’ society where the house was the single largest asset that most people owned, so the argument seemed to predicate on getting more people to own homes. That would give people the asset base to continue to spend money and grow the economy. And then, from the late 90s and early 2000s, especially after the dot-com crash, I could see the distinct push to enable even more people to own their own homes, even people who were among the lower income brackets. I remember various powers-that-be rationalizing it as putting people in homes drives our economy. There were multiple research papers written by prestigious universities on why housing for low-income folks was critical for their economic well being (see for a fascinating view of the financial returns of home ownership for low income folks). Of course, the paper did talk about the risk of the property values going down, the risk of default, etc., but, the general theme clearly was that home ownership was good for low income folks, and it was good for the economy as a whole. In fact, home ownership rates went up from 66% in 1998 to 69% in 2004 and dropped to 68% in 2007.

The net effect of this was that interest rates on home loans were amazingly low.  In fact, we were able to buy a home because of what we thought were really low interest rates. So, I was part of the statistic that contributed to the increase in rate of home ownership. And of course, once I got into a home, the number of things I spent money on went through the roof. So, I could see the argument that home ownership drives a certain level of economic activity that in all likelihood renters dont drive.

At the back of my mind, what did puzzle me was how were these financed? Who would lend money to people whose incomes are low, so that they can buy a house, and spend even more money to stay in the house? It would be too risky. If I was one of the folks who needed to borrow, I would be thinking about the fact that a significant portion of my assets would be tied up in a fairly immovable asset, and if its value were to fall, it would devastate me.  I could not understand what the economics/budget of a supposedly ‘low-income’ person on a mortgage would be like. In addition, common sense seemed to indicate that for the lenders, the higher risk of lending to lower income folks would mean that they would have to charge higher interest rates to folks with lower incomes making it even less affordable for lower income folks to borrow large amounts of money required to buy houses. Micro-lending works in really poor countries, because the amounts involved are small, not because the interest rates are lower than market rates. After all, the median house price was four times the median household income in 2007. How can a person on a 50K income afford a 200K house, and also spend money on all the other stuff as well? That was the puzzle.

I just could not understand how we could put a roof over everyone’s head unless it was significantly subsidized by someone. Assuming a population of 300M, with 80M families, a 3% increase in home ownership rate (from 66-69%) translates to about 2.4 million homes. The kind of incremental lending that would need to happen conservatively assuming an average of 100K loan per home is a staggering $240 billion. That is some serious financing.

What was even more puzzling was how could traditional financial institutions make money in the process? It seemed too good to be true, you are doing a ‘social good’, by putting a roof over everyone’s heads, and you know what, you are able to do it in a capitalist system. Who would have thought this was possible? I was told it was the magic of securitization. That is, you bundle a bunch of these loans with other loans, and magically the bundle becomes less risky than the original loans. You then sell pieces of the bundled loans to folks and give them a return that is lower than the original interest on the loans that the original borrower will continue to pay, and you can make good money on the spread.

What is interesting is that financial companies borrowed money for short periods of time to buy up bundles of these loans until they are able to securitize and sell them off to others, and as long as there was a spread in the interest rates, and you were essentially printing money. As long as they are able to keep borrowing for short periods of time to keep doing this, there would be profits for the foreseeable future. Here is where the leverage of the banks comes in. All the banks were making these bets with borrowed money. The only risk was that enough people would stop paying their mortgage, or refinance, or someone would stop lending them money in the short term to do this securitization. What people did not expect was all of these things to happen at the same time. And whoever ended up ‘owning’ these securitized assets was left in the lurch because they were not worth as much as they once were. What is worse, no one can price these things because there is no clear understanding of the risk associated with the promised cashflow associated with the instrument. Hence they are toxic assets. Since the financial regulators also require banks to guess the value of assets on their balance sheets, and ‘balance’ the balance sheet (the so-called mark to market rule), it meant that as the random guess about the values of these instruments fell, banks now had to set aside real assets to balance their books. Here is where the banks that were over-leveraged, i.e., ones that had borrowed money to buy these assets took it on the chin. And there were some real wall street powerhouses such as Bear Sterns, Lehman Brothers, and Merrill Lynch.

Now, it is interesting that folks think that this mark to market is the cause of the problem because it forces to guess the value of the assets on their books and ‘balance’ it every quarter. They even point to the fact that this mark-to-market has caused many financial scandals in the past, including Enron, and more on that later. As it is, these financial instruments are opaque, and when you are a public company and take in investments from the general public, I think you should be required to explain the use of the public funds in a clear manner. Now this is more easily said than done, and may prevent certain kinds of economic activity, but, if we believe in having transparency for use of public funds in a public company, we have to have some rule like mark-to-market.

Everything seemed to be going fine with the system and everyone seemed to be enjoying the party until someone started thinking, now wait a minute, all this is based on free flow of credit and house values and therefore personal consumption going on for ever., and yelled fire, and there was a stampede. What is amazing is that this is the explanation I was given for what happened at Enron in 2001. Enron, also ‘securitized’ assets on its balance sheet and sold it to various partnerships, to get the assets off the balance sheet so that the performance of the company would look superlative. I remember as if it was yesterday when Enron declared a record profit in some quarter of 2001, and also said something like they had to reduce shareholder equity by some obnoxious account. This was because the securitized assets were backed by Enron stock and cash if they fell below some value. These assets were properties such as the infamous Dabhol power plant in India, the Azurex water utility in scotland, etc.So, they were very unique assets that were very risky and securitization did not help in reducing or managing the risk of the actual endeavor.What is more interesting about Enron is that the law that they actually broke was that the parties to which they ‘sold’ the securitized assets were run by their CFO whose participation in which was underwritten by Enron. So, Enron should not have been able to take the assets off their balance sheet.

So, the net-net is that securitization, or market-based mechanisms while very interesting and fascinating, are not the answer to managing risk in every situation.

Now this system of securitization was predicated on the bundles of loans having lower risk attributes than a single loan. Think of it as there is always a small chance that a family loses income or has some other unfortunate circumstance and therefore cannot make it payments, but if you put in 1,000s of homes together, the argument was that the chance of similar default are lower. But, is that really true? Now I know that if you bundle financial instruments that are less than perfectly correlated, they will offer a better risk-return tradeoff than any single instrument. So if you buy shares in a company that makes sunscreen and one that makes raincoats and umbrellas, your portfolio value will be more stable and you will likely have a higher risk-adjusted return than if you bought shares in only one of those companies.

So, the kazillion dollar question was whether these bundles of mortgages were like any other financial instruments. The only way it would work is if these bundles comprised of mortgages of folks whose risk of default was not perfectly correlated. The question was how was the risk of the bundle calculated, and how did it match reality. Here is where the answers become very fuzzy, it looks like there were mechanisms to estimate risk, and even to provide ‘insurance’ (so called credit-default-swaps), but, it all had to be predicated on some assumptions of default from millions of families who had historically not owned homes, even in America. So, I cannot imagine that there were reliable models to predict the default risk of folks who got the so-called sub-prime mortgages. Our assumptions around the risk of default were all essentially broken by the increase in home ownership because our models for predicting risk of default were completely off.

It turns out that all of us are paying for trying to put an additional couple of americans per hundred into homes. In some sense, my hunch that putting everybody into a house needs to be subsidized by society is right. Either the government has to tax and subsidize, in which case, we would be socialists, but at least you get to vote every few years to decide who gets to call the shots, or we have to redistribute resources based on ‘market-based mechanisms’ where we have very little to no control over the companies unless we have enough ownership stake and are active shareholders.

In economics/finance, one needs to be a empiricist, meaning, one needs to gather the evidence for the application of mathematics to the phenomena that we observe. It seems to me that wall street had a platonist view thinking that the reality was generated by the numbers. There are of course the contrarians such as Nassim Nicholas Taleb who are probably laughing saying ‘I told you so’, but we need more of those skeptics who are able to question the emperor’s clothes when the herd is rampaging and taking all of us over the precipice.


4 Responses to “layman’s view of financial crisis”

  1. Prakash Siva Says:


    Nice blog – enjoyed it. Your blog seemed to setup the following argument:
    1.Banks lent money to an extra 3% (higher than some long term average) of folks towards home ownership.
    2.They shouldn’t have been lent the money in the first place (sub-prime loans)
    3.These loans were bundled with good loans and sold to investors. Bankers tried to insure against all these loans defaulting at the same time.
    4.The economy tanked and these folks defaulted on their obligations.
    5.This dragged down the value of all our investments (starting with houses), resulting in the economic mess we are in.

    I disagree – here is my 2c ( now its probably worth 1.2c this year) argument that these folks are not exclusively responsible for the mess we are in.

    There is a rich body of work in the social sciences that correlates increased home ownership with a variety of positive social outcomes at the individual, household and community level. These outcomes include stability, social involvement, local political participation and activism, environmental awareness, child outcomes, health, crime, and community characteristics. Check out, specifically the references towards the end.

    The broad majority of people and government at every level is typically interested in encouraging the occurrence of these positive outcomes. Increased house ownership was seen as a reasonable mechanism to achieve this goal. US GDP was ~14 trillion in ’08 (probably higher in earlier years). So, why not spend an additional 1.6% (240 billion) of GDP if it’s a cost effective way to improve social outcomes? Agreed that this this is a big ‘if’. But, could the potential savings from lower crime/incarceration rates along with GDP increases that arise from increased productivity (better health, education and environment for all) offset the 240 billion cost?

    The answer we are finding out is NO, but its not exclusively because the 3% messed up. If that was the case, the economy should have contracted only by ~1.6% (240 billion out of 14 trillion) assuming that all 3% go bankrupt at the same time. Since this is not the case – US economy contracted by 6.4% in Q4 ’08, I believe the following played a bigger role in this crisis:

    1.Our money suppliers (the East Asians, Middle-east folks and all others who buy US Treasury bonds) were willing to bet on US GDP and productivity constantly going up for – with no dips even in the short term. Extrapolating from increases in productivity during the 80’s and 90’s, they believed that the US GDP and productivity increases dwarfed anything that could be produced by their local economies. In short, they were willing to lend us money at extremely low rates.

    2.All that investment money that was released by low interest rates (lower mortgage payments) seemed to be blown away by the majority on larger cars/SUVs, larger flat screen TVs, bigger houses and fancier vacations – actions that didn’t really improve US productivity. I’m guessing that none of these actions created lasting productivity increases, even though the GDP may have seen a positive blip. In short, most people didn’t save this windfall or invest it wisely for use over the long term.

    3.Even if folks wanted to invest this money wisely, there was Bush and the Republican majority in Congress:
    a. Encouraging major industries to maintain the status quo (no increase in automobile CAFE standards for cars/trucks since 1985).
    b. Fighting wars that are essentially not winnable or winnable at a cost high enough for these wins to be meaningless.
    c. Encouraging a lack of regulation which allowed the financial industry to resemble a casino with bets being made with almost completely borrowed money. Actually, this is an insult to casinos where the house is typically guaranteed to win. In this case, I’m not sure who represents the house in the financial casino…

    4.The bankers and the US quasi-government entities (FMAC, FMAE) screwed up by lowering the standards for everybody, including the majority – the other 66%. As you mention, mortgages have been sliced up and sold so many times, they are extremely hard to value. We have a really hard time understanding the true value of the underlying assets because all these mortgages tranches are in a sense infected with poor quality ones. And the infection is only getting worse with more foreclosures coming up.

    5.The bankers thought they could get away by insuring against default by a significant number of mortgage holders. However, these wizards never checked if the insurers (like AIG) really had enough assets to cover these worst case defaults. I’m guessing that we’d be fine even if a high fraction of the extra 3% of mortgages were involved a default.

    I’m not convinced that this economic crisis was exclusively caused by the 3% who enjoyed increased home ownership. It was caused by a toxic combination of the greed, hubris and the naive hope of the majority (through their elected representatives) that increased home ownership is a silver bullet to cure social ills.

    Prakash Siva

  2. kannan70 Says:

    Thanks for posting the comment.

    In fact, I am saying what you conclude with. That increased home ownership is a not a cure-all, and you know what all we were able to do is increase a couple of percentage points over the last 10 years.

    I am not saying that the 3% folks were exclusively responsible.
    What I am saying is that trying to model how they would default would have thrown off all the models. These are super non-linear things, and you have to focus on reality, not just what the models say.


  3. Siamak Says:

    sorry posted in the wrong section:)

    forget about all the crap we learned at MIT.

    Here’s how it all happened…


    Heidi is the proprietor of a bar in Detroit . In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Heidi’s drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi’s bar and soon she has the largest sale volume for any bar in Detroit .

    By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.

    At the bank’s corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide. Naive investors don’t really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics.
    Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation’s leading brokerage houses.

    One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his common sense, the resulting negativity and accurate assessment of the situation), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. Heidi demands payment from her alcoholic patrons, but being unemployed, they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy.

    DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better,
    stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans. The suppliers of Heidi’s bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds.

    Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers. The bank and brokerage houses are saved by the Government following dramatic round-the-clock negotiations by leaders from both political parties. The funds required for this bailout are obtained by a tax
    levied on employed middle-class non-drinkers.

    Finally an explanation I understand…

  4. Guru Says:

    Kannan – excellent analysis. This, coupled with the great comments that Prakash and Siamak have made have really added to my understanding of the meltdown. I can offer no other insights through my comment, so I will pose a question on a somewhat tangential topic:

    Much of the debate on “progress” seems to tie into this idea of growth – i.e. if a country is supposed to be making progress, its economy is growing at a non-trivial rate. This growth, if I understand it correctly, means a lot of “stuff” is getting produced, bought and consumed (even if not in the country where it is being produced), while making incremental gains in the efficiency with which said goods are produced and transported. All our current, man-made structures seem to incentivize this notion of growth. But this has drastic consequences for the environment. How long can such growth be sustained when people are living longer, multiplying faster and consuming more. There is only that much the earth can pony up and there aren’t enough asteroids hitting us right now – seen from the point of view of getting minerals in – or as a means to bring population down!

    While man-made structures might incentivize and celebrate such growth, nature might have the last laugh after all. Our growth strategies seem to be accelerating our collective destiny’s head on crash with nature.

    Is there a contrarian view to this? Am I missing something and being too naive in assuming our tussle with nature is a zero-sum game?

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