By MovedtoSyracuse on 09:44:38 10/03/08
[In reply to "Can you repost it?-missed it. *" by Buckcyrus, posted at 09:34:41 10/03/08]
We'll start with a history lesson:
In 1995, the Clinton Administration modified the Community Reinvestment Act (CRA) to allow the creation of subprime lending. This is lending to borrowers who may not normally qualify for loans. As a result, exotic mortgage products were created to accomplish this. Additionally, Fannie Mae and Freddie Mac created a secondary market for selling these types of products. Until then, they only participated in traditional mortgages. The secondary market allows banks to sell their mortgages, Fannie and Freddie then packages them up and sell them as Mortgage Backed Securities and Collateralized Debt Obligations. The buyers of these were looking for fixed income instruments yield better than treasury notes or municipal and corporate bonds. Subprime loans have higher interest rates, so their securities were higher yielding. Bear Stearns was an early supporter of subprime mortgage backed securities. (remember them?) As subprime lending skyrocketed, so did home prices.
This brings us to 2007, when all the subprime borrowers couldn't afford the overpriced homes they bought so they either sold or were foreclosed (forced sale). This put more supply on the market of homes than there was demand for and home prices plunged, creating a death spiral.
Wall Street firms and some banks held a lot of subprime mortgage backed securities. Bearn Stearns was levered up at a ratio of 40:1. Mean they had borrowed 40 times what they really owned. Lehman Brothers was at a ratio of 22:1.
Merrill Lynch sold its portfolio of subprime mortgage backed securities for 22 cents on the dollar. For all firms holding these, this kicked in "mark to market" accounting, meaning firms holding similar securities had to mark down their portfolios, causing many of which to have to raise capital which became difficult. The market with which these securities trade dried up. Period.
As many of the firms that held these securities were forced to raise capital, their stock prices plummeted. The cost of insuring their debt also skyrocketed creating another death spiral. The next domino became a crisis of confidence, mean that these banks depositors withdrew money. When that happened, their only choices were to sell securities (they can't), or raise capital (they can't). The biggest bank to fail as a result was California based IndyMac Bank (30 billion in assets). This was the largest bank failure ever. The next was Washington Mutual (300 billion in assets). Who's next? Probably Wachovia who at the height of the mortgage bubble bought Golden West Bank who was the largest originator of subprime mortgages in the country. How big is Wachovia? 800+ billion in assets. News just hit the wire as I was typing this that Wachovia is being bought by Citigroup.
Let's summarize:
Bearn Stearns failed.
Lehman Brothers failed.
Goldman Sachs has reformed as a bank holding company.
Morgan Stanley has reformed as a bank holding company.
Merrill Lynch sold to Bank of America.
AIG (worlds largest insurer) given a bridge loan by the government.
IndyMac bank failed.
Washington Mutual failed and was sold by the FDIC to JP Morgan.
Wachovia has now been sold to Citigroup in a fire sale.
Where are we now:
The credit markets are frozen. Subprime mortgages are not being sold, nor are good mortgages. Banks aren't lending to each other due to fear of failure. Fear permeates the markets. A good example of the fear is that the 3 month treasury note recently traded with a NEGATIVE yield. There was such heavy buying in this treasury note that people or institutions were willing to pay more than the maturity value knowing they'd lose some value.
What's next:
If congress doesn't unfreeze the credit markets, more banks will fail and the crisis of confidence will grow. You will see runs on financial institutions similar to in the movie "It's a Wonderful Life". The banks that don't fail will stop lending. Businesses needing to finance inventory won't be able to. Consumer won't be able to purchase homes or cars. Think about the ripple effects in the auto industry if cars aren't selling worse than now! Unemployment will skyrocket. Not to be an alarmist, but this could be the next Great Depression.