Filed under: Market Trends, Wordy | Tags: Credit crisis explanation for dummies, credit crunch, easy terms, explanation, housing crisis, mortgage crisis, simple explanation
Most people hear about the so-called Credit Crisis but probably don’t really understand how it works. I never studied finance and usually avoid thinking about topics in overly complicated ways. Luckily, I learned about the topic first hand via my last two jobs. Here goes:
The Regular Joe: Consumers usually don’t have a lot of cash on hand to make big purchases. In fact, the United States savings rate has declined over the last two decades. Luckily, banks put their excess cash to good use by lending money to individuals. Mr. Joe gets to buy his $100k house and the bank gets monthly interest and principal payments. (Note: $100k house? For real? No house is that cheap but $100 is a round number and simplifies the math behind my explanations).
How Banks Should Work: A bank typically checks potential borrowers out before lending them any money. The borrower provides credit history, employment history and income statements to prove that he/she makes enough money each year to cover the debt payments for the new home. If the borrower meets these standards (underwriting standards) then he/she will get the $100k.
The bank is happy to get a steady interest payment but it’s out $100k in cash. Lets say that this bank made 1000 loans in one year—it’s out $100 million dollars. Luckily, the bank did a great job verifying that financial security of each borrower and is confident that they will all make timely payments every month until the loans are paid off. Imagine, 10% interest off of $100 million every month…that’s a lot of money. The payments are predictable, so it is possible to bundle all of these loans up, figure out what the monthly payments will be, and find an investor that is willing to buy this package of loans in return for steady payments.
MBS/Securities/Secondary Mortgage Market: In the past, Fannie Mae and Freddie Mac were the biggest investors buying these packages of loan, building up portfolios worth trillions of dollars. Sometimes they buy these bundles of loans for cash, other times they charge the bank a fee and then “guarantee” to make the monthly payments if the borrowers fail to do so. Fannie and Freddie can make this “guarantee” because the world financial market assumes that the government of the United States will back Fannie and Freddie up if anything bad happens. Financial markets make this assumption because the US Government created Fannie and Freddie at the beginning of the Great Depression to help stabilize the mortgage market—they used Fannie and Freddie to inject cash into the system.
So you know, this action of “bundling loans” is what the markets call securitization. The bundle is officially a “Mortgage Backed Security.”
Where do Fannie and Freddie get the cash to buy this $100 million bundle of loans? Again, since the financial markets assume that the government will back these companies up if anything bad happens, their corporate debt is practically as good as US Treasuries. For example, Fannie Mae will go on a road show in Asia and investors will give the company tons of money in return for an interest payment that is slightly higher than the interest on a US Treasury. Let us say that Fannie Mae will pay these investors 5% interest for the $100 million it will borrow to buy the bundle of loans we keep talking about. This interest payment will almost always be lower than the interest payment that the bundle of loans are pulling in, which is 10% in my example. 10% interest in – 5% interest paid out to investors in Asia = 5% interest on $100 million that Fannie Mae expects to get every single month until the debt is paid off. That is A LOT of money, especially when you figure that Fannie Mae really does trillions of dollars worth of business.
Wall Street: Banks in Wall Street saw that Fannie and Freddie were making a killing, and they wanted to get in on the fun too. Some banks take the cash in their clients’ deposit and savings account and use that to buy/securitize mortgages. Usually the interest rate they pay their customers on a particular savings account (the bank’s cost of funds) is lower than the aggregate interest rate their mortgages bring in (revenue). The difference is called the spread, and a positive spread = a lot of profit.
The Perfect Storm: Risky Products + Falling Housing Prices + Over Extended Banks = Writedowns
Factor A: In the good old days (1), borrowers would plunk 20% of the payment down and borrow only $80k. This was a good risk mitigant because it shows that the borrower is responsible (hell, he/she wanted to buy a house, set a goal, and saved $20k to meet that goal). In the good old days (2), borrowers would look for 30-Year Fixed Rate Loans. The payments on this loan are identical every single month for 30 years, so there is no confusion as to how much money the borrower should set aside to meet his/her debt obligations. In the good old days (3), borrowers would have to prove they made enough income to cover the loan payments for their house. All of these factors would help ensure that the money was being lent to a responsible borrower that would likely make timely payments on the loan until every cent was paid back.
Well, the good old days are no more. The “traditional” market got tapped out and banks started offering more aggressive products in order to attract new, less traditional borrowers into the housing market. To do this, they stopped requiring down payments, they stopped asking for proof of income, and they created new products that make it difficult to predict what the borrower should pay back from month to month. Banks knew these moves were risky, and that is why they charge borrowers higher interest each time they chose to build a mortgage that deviated from the template seen in the good old days.
To use the terms out in the news: Borrowers in the good old days were charged interest rates equal to the prime rate. Borrowers with risky mortgages (no down payment, no proof of income, and/or risky mortgage product, etc) would have to pay a higher interest rate making them subprime borrowers because they are less credit worthy than the borrowers that pay the prime rate.
Now, banks thought that they would avoid any serious risks because a) they were charging higher interest rates and b) housing prices in the last five years have gone up. In a worst case scenario, banks and securitization agencies figured that a borrower that stopped making his/her payments would simply be foreclosed upon, the bank would take ownership of the house, and sell it for a profit since housing prices were going up, up, up. By selling the house for a profit the banks would be able to pay back investors that bought the securities (or bundles of loans). Yes, the investors would lose out on steady interest payments but at least they got their original investment amount back in full.
Factor B: Guess what, housing prices fell. I’ll leave the reasons behind this phenomena for another post. All you need to know right now is that banks no longer had an easy out in case borrowers started to default on their loans.
Factor C: Lets say a bank takes $100 million in deposits, buys mortgages, securitizes them and then sells them to investors for a profit. They get $100 million back in cash and repeat the process all over again maybe ten times so that the original $100 million is holding up $1 billion in investments. Then, something bad happens. Borrowers stop making payments. The investors that bought the securities demand payments. Who is going to pay? Who loses? How much is lost?
Update 9/18/08: Lets go back to this concept of $100 million dollars holding $1 billion worth of mortgages up. The original $100 million is the actual amont of capital (aka cash) that the bank has at hand. Using it to dole out mortgages, selling these mortgages to Fannie Mae for cash, then re-using that cash to dole out more mortgages is what we call “levering up.” This hypothetical bank has levered itself 1:10 because it owes $10 for every actual $1 that it has on hand. Remember this point because I’ll explain how leverage brought down Bear Stearns, Lehman, Fannie Mae, Freddie Mac, and Merrill Lynch.
Writedowns: The perfect storm happened and many borrowers started to default on their mortgages at the same time. Banks are usually prepared for a certain amount of losses, breaking risk down to two factors: 1) Probability of default and 2) Loss given of default. People placed in mortgages that were inappropriate for their income level raised risk #1 and the fact that housing prices fell raised risk #2. That’s why banks are facing unprecedented losses right now.
Unfortunately, the end of the money train still expects their payments. Remember that banks give mortgages out, bundle the mortgages together only to securitize them later on. The investors that bought bits and pieces of these securities demand their payment (interest and principal payments). This brings us to the global market.
The Global Credit Crisis: The mortgage securities market is global. Investors around the world buy securities that are backed by properties in the United States because, in the past, these securities produced a nice and predictable interest payment. These securities were once considered uber safe investments and were being snatched up left and right. Rating agencies concurred; they analyzed the mortgages behind the securities to make sure that everything was in line (i.e. safe borrower, good property investment, reasonable interest rate, etc). The best securities got AAA ratings.
Many securities backed by subprime loans received AAA ratings, and then they blew up. Investors started questioning the AAA grade much the same way you would question the value of an A+ in calculus if even the worst student in the class received an A on every test. Investors world wide started losing money on their supposedly safe subprime investments, so they wondered what other AAA investments were going to blow up? And what about BBB investments, because if the A’s were failing then wouldn’t the Bs be even worse off? Extend that line of reasoning and you will see why subprime loans in Arkansas affected global investment behavior. Finance is global, everything is interconnected, and a problem in one sector has the ability of spreading to others….like a contagious virus. Investors became wary of putting their money in anything—stocks (the Dow fell), corporate debt (it became more difficult for companies to raise cash for things like research, acquisitions, etc), and pretty much anything else that you can think of.
This is what happened next: Investors with cash were still willing to invest, but only if the price was right. An investor may have been happy with a 5% interest payment on a AAA security 2 years ago but now demands 15% in order to compensate for all of the risk (more defaults, losses, etc). Remember that banks and companies like Fannie Mae/Freddie Mac are in this business because they borrow money from one place (savings accounts or corporate debt investors) at one rate, purchase a bunch of mortgages that pay a higher rate of interest and keep the difference as profit. Can you see how they would lose money now?
Before: Borrow $100 million and pay 5% interest. Buy $100 million in mortgages that pay 10% interest. Keep 5% of $100 million = profit profit profit.
Now: Borrow $100 million and pay 15% interest. Buy $100 million in mortgages that pay 10% interest. Lose 5% of $100 million = A) losses losses losses B) The market dried up—-Why do the deal in the first place? Why invest in mortgages in the first place? Why invest in anything if you’ll lose money?
The cost of “borrowing” money became extremely expensive for financial institutions. Borrowing is another word for credit, companies couldn’t buy things (securities, other companies, money to build a new facility, etc) on credit; hence, the credit crunch. This had the unwanted but expected effect of slowing down the economy around the world.
Update 9/18/08: Back to the concept of leverage. Virtually every financial institution in the world levers itself. In our example, the hypothetical levered each $1 of cash on hand with $10 dollars worth of obligations. Leverage is great when times are good and absolutely horrible when times are bad. During the good times that $1 of capital on hand generates 10x the profit. When times are tough, that $1 generates 10x the losses.
The mortgage fiasco spread like a virus. Every package of loan that was securitized is tainted by the higher than expected losses. There are barely any investors on the planet earth that will touch these securities, which lowers their value even further. In other words, our hypothetical bank has $1 billion worth of stinky crap. Investors still demand their timely interest payment, but the original homeowners are no longer paying their mortgages. Somehow, our hypothetical bank has to use it’s $100 million cash on hand to pay $1 billion in interest obligations.
$1 billion – $100 million = $900 million that the bank still owes. The bank can try to raise more cash by selling its stock, but what if cnn.com or the Wall Street Journal already heard that the bank is in trouble and does not have enough cash to meet its obligations (liabilities)? Will rational investors buy this bank’s stock? Would you invest in a sinking ship? No. Of course not. The bank fails to raise enough capital, and has to declare bankruptcy because it cannot pay back the $900 it owes.
Lehman has declared bankrupcy for this reason. Fannie Mae, Freddie Mac, and AIG would have declared bankrupty but their failure would have produced a tidal wave of problems for the world, so the US Government “leant” them money so that they can meet their obligations. Washington Mutual and Wachovia are close to declaring bankrupty, but it is possible that a healthier (and larger) bank will purchase them and effectively “loan” them the money they need to meet their obligations.
Please check this site out for another very easy to understand explanation written by an Economist.
What is happening is bad. It is a once in a century ocurrence. It is unfathomable that some of the smartest people on earth got themselves in this mess. Why did it happen? Didn’t these bankers (like me) know that lowering underwriting standards would lead to more defaults? Didn’t these bankers (like me) think that over-levering was a bad idea? Was any of this accidental? Bad luck?
Yes and no. I explore these questions in other posts and will continue to explore them in the future.
And that is the Credit Crisis in a nutshell.
I discovered the Business Week MBA forum, where people post thousands upon thousands of comments ranking programs, picking programs apart, defending programs, etc. One major common denominator that weaves through nearly every thread in the forum is the following: MBAs gel with Banking/PE/VC or Management Consulting. Every once in awhile, the thread will include the ideas of someone who works in something completely outside of finance/consulting (i.e. nonprofit).
Why is there so much mystique around banking? Obviously, the money is a driving factor here. During good years, even junior bankers come out with $100k-$300k payouts (salary + bonus). I’m not sure how those figures look during bad years. MBAs usually get hired at the associate level, so I’m guessing that’s a $120k salary (if not more) and a bonus that is anywhere from 1x to 3x the base salary (depending on the year, of course). As an associate, the hours probably aren’t that bad…then again, my associates would have to work weekends, stay late at night, etc, and my group wasn’t that insane. Associates in other groups would stay past 2am on a good night. Still, it’s a lot of money…and I can see how that would be desirable.
Then again, I wonder if people understand the trade off. You get paid for the time you spend at the bank. I did it for 6 months before I burnt out/got laid off during the first round of fixed income cuts last year. I worked long enough to know that it sucks to stay late every night, it sucks to be utterly exhausted on Fridays from a long week at work and not enjoy Saturday because you have to put 10 hours in on Sunday.
Fine, I was an analyst….pay your dues and life will improve (less hours) even though the paycheck goes up by a lot. Then again, I know guys (VPs in PE, MA, etc) who get paid very well, have minions under them to crunch the numbers late at night, love what they do…but sometimes have to cancel a trip with the girlfriend, not attend their buddy’s bachelor party in Vegas, not go to their best friend’s wedding in the Caribbean….because they had to stay and work. Their hours are “better” (12 hour days instead of 15, only 5 hours on weekend) but there is something to be said about their lack of freedom.
It seems like people who go get an MBA want to go into banking or consulting. They are attracted to the deal environment, the type of work demanded of them, and the money. The Money, really. I guess $150k for school make sense if you stand to make at least $200k out of school.
I respect the rush to banking when we’re talking about someone who worked in banking before, has/knows what it takes to succeed in the field, and wants an MBA in order to advance into a management position. I get that.
But, and I say this after talking to a bunch of people, a lot of the MBA graduates going into banking have no banking experience….I recall talking to one ex-nonprofit worker who is looking forward to her summer stint at an IB this summer. I wonder, does she know what she’s getting into or is she intoxicated by the mystique that surrounds banking?
What if you don’t want anything to do with banking or consulting? That’s my case. I got into every school I applied to and got quite a bit of money from the programs as well. One top 5 school, one top 10, two top 15.
I guess I’d lean towards the Top 5 school if I wanted to pursue banking. It would be easier for me to get a job since more banks recruit from there and more alumni go into banking. Then again, all of these schools push out bankers which means a) banks recruit and b) alumni presence. Is the Top 5 school the best option?
Either way, I don’t want to do banking. Or consulting….so do these schools lose their perceived competitive advantage? Does the ranking of the school begin to matter less as the accomplishments and drive of the individual becomes a more important success factor? Does an accomplished and driven person benefit from the recruiting office of a top five school if he/she pursues a career outside of the office’s key strengths? Does an MBA matter outside of the first job out of school? Does the school make the person, or the person make the school?
I don’t think there are clear YES or NO answers to any of these questions. All I know is that Steve Jobs dropped out of no-name college before founding Apple. I know that Bill Gates dropped out of Harvard before founding Microsoft; I’m fairly confident he would have been just as successful had he gone to Princeton or Random University. I also know that most people don’t have what it takes to be the next Bill Gates or Steve Jobs. Most people are smart enough to do well, benefit from friends/contacts that open doors for them, and then rise the ranks by working/proving that they have what it takes to get promoted.
I’m rambling. My point is this—-Individual character traits (intelligence, personality, drive) drive success. Access to a strong network helps, but only marginally if your intentions are outside of the strengths of that network. If you don’t want to do banking/consulting, then I wonder how valuable that network will be….so how do you determine which MBA is best for you?
Filed under: Links that rock, Politics, Wordy | Tags: change, glass ceiling, moral incentives, Obama, Politics, speech, yes we can
I’ve been slowly writing a blog about The Glass Ceiling in developing countries. A Glass Ceiling of opportunity, where educated members of the middle class armed with college degrees are forced to work in low-skilled jobs because their countries lack economic opportunities. Their countries lack jobs. Their countries lack hope.
I explore two possible solutions that may help break this Glass Ceiling: Moral Incentives and Economic Incentives. I preface my argument in favor of Moral Incentives by saying that the United States has achieved change via this route thanks to inspiring leaders that maneuver the general population through change.
Barack Obama’s “Yes We Can” concession speech after the New Hampshire primaries is the epitome of the type of leadership that is necessary to create a magnitude of momentum capable of shattering the Glass Ceiling.
Below are the words Mr. Obama said to the crowds and here is a musical interpretation of the speech. The portions of the speech included in the music video are in bold.
Barack Obama’s Concession Speech
A few weeks ago, no one imagined that we’d have accomplished what we did here tonight. For most of this campaign, we were far behind, and we always knew our climb would be steep.
But in record numbers, you came out and spoke up for change. And with your voices and your votes, you made it clear that at this moment – in this election – there is something happening in America.
There is something happening when men and women in Des Moines and Davenport; in Lebanon and Concord come out in the snows of January to wait in lines that stretch block after block because they believe in what this country can be.
There is something happening when Americans who are young in age and in spirit – who have never before participated in politics – turn out in numbers we’ve never seen because they know in their hearts that this time must be different.
There is something happening when people vote not just for the party they belong to but the hopes they hold in common – that whether we are rich or poor; black or white; Latino or Asian; whether we hail from Iowa or New Hampshire, Nevada or South Carolina, we are ready to take this country in a fundamentally new direction. That is what’s happening in America right now. Change is what’s happening in America.
You can be the new majority who can lead this nation out of a long political darkness – Democrats, Independents and Republicans who are tired of the division and distraction that has clouded Washington; who know that we can disagree without being disagreeable; who understand that if we mobilize our voices to challenge the money and influence that’s stood in our way and challenge ourselves to reach for something better, there’s no problem we can’t solve – no destiny we cannot fulfill.
Our new American majority can end the outrage of unaffordable, unavailable health care in our time. We can bring doctors and patients; workers and businesses, Democrats and Republicans together; and we can tell the drug and insurance industry that while they’ll get a seat at the table, they don’t get to buy every chair. Not this time. Not now.
Our new majority can end the tax breaks for corporations that ship our jobs overseas and put a middle-class tax cut into the pockets of the working Americans who deserve it.
We can stop sending our children to schools with corridors of shame and start putting them on a pathway to success. We can stop talking about how great teachers are and start rewarding them for their greatness. We can do this with our new majority.
We can harness the ingenuity of farmers and scientists; citizens and entrepreneurs to free this nation from the tyranny of oil and save our planet from a point of no return.
And when I am President, we will end this war in Iraq and bring our troops home; we will finish the job against al Qaeda in Afghanistan; we will care for our veterans; we will restore our moral standing in the world; and we will never use 9/11 as a way to scare up votes, because it is not a tactic to win an election, it is a challenge that should unite America and the world against the common threats of the twenty-first century: terrorism and nuclear weapons; climate change and poverty; genocide and disease.
All of the candidates in this race share these goals. All have good ideas. And all are patriots who serve this country honorably.
But the reason our campaign has always been different is because it’s not just about what I will do as President, it’s also about what you, the people who love this country, can do to change it.
That’s why tonight belongs to you. It belongs to the organizers and the volunteers and the staff who believed in our improbable journey and rallied so many others to join.
We know the battle ahead will be long, but always remember that no matter what obstacles stand in our way, nothing can withstand the power of millions of voices calling for change.
We have been told we cannot do this by a chorus of cynics who will only grow louder and more dissonant in the weeks to come. We’ve been asked to pause for a reality check. We’ve been warned against offering the people of this nation false hope.
But in the unlikely story that is America, there has never been anything false about hope. For when we have faced down impossible odds; when we’ve been told that we’re not ready, or that we shouldn’t try, or that we can’t, generations of Americans have responded with a simple creed that sums up the spirit of a people.
Yes we can.
It was a creed written into the founding documents that declared the destiny of a nation.
Yes we can.
It was whispered by slaves and abolitionists as they blazed a trail toward freedom through the darkest of nights.
Yes we can.
It was sung by immigrants as they struck out from distant shores and pioneers who pushed westward against an unforgiving wilderness.
Yes we can.
It was the call of workers who organized; women who reached for the ballot; a President who chose the moon as our new frontier; and a King who took us to the mountaintop and pointed the way to the Promised Land.
Yes we can to justice and equality. Yes we can to opportunity and prosperity. Yes we can heal this nation. Yes we can repair this world. Yes we can.
And so tomorrow, as we take this campaign South and West; as we learn that the struggles of the textile worker in Spartanburg are not so different than the plight of the dishwasher in Las Vegas; that the hopes of the little girl who goes to a crumbling school in Dillon are the same as the dreams of the boy who learns on the streets of LA; we will remember that there is something happening in America; that we are not as divided as our politics suggests; that we are one people; we are one nation; and together, we will begin the next great chapter in America’s story with three words that will ring from coast to coast; from sea to shining sea – Yes. We. Can.
I opened this blog in March 2006. Here is a quick summary of what has happened since then:
2006: Worked. Tried to prevent a housing crisis one small, insignificant project at a time. Tragically single.
2007: Worked harder. Joined a small team that was like the Navy Seals of corporate America. Got a lot done. Got restructured. Got pissed. Left. Moved to New York. Bulge Bracket. Worked my ass off. Got sick all the time, mainly because of stress. Market exploded. Got laid off. Now I’m here in my boyfriend’s apartment writing in my blog until I get sleepy again.
2008: Applied to business school. Am waiting to see if I get in anywhere. Am (kind of) looking for a job in the meanwhile. Just finished watching the third episode of Cashmere Mafia.
Keep in mind that Cashmere Mafia is fresh on my mind. Long story short, the show is about four “high powered” female executives that have fought there way to the top of their respective industries. These women dress great. They have hot husbands, boyfriends and girlfriends. They also have an insane amount of free time that allows them to meet up for coffee on a regular basis.
I assume that the creators of the show are targeting young professionals like me. They want to sell the life of the high powered female executive. Make it seem glamorous. Convince young girls everywhere that, if they work hard, they too can live the dream. Except I find myself feeling a little repulsed by said dream.
I don’t want to live for work. I don’t want my significant other to feel threatened by me, and I especially don’t want him to think that he can go off and cheat on me just because I bring in more money than him. I don’t want to be a cut throat bitch that gets ahead by double crossing anyone that gets in her way, including her colleague/fiance. I don’t want to admit how embarrassing and sad my husband’s infidelity can be, then pretend that a “hey, now we’re even” affair will make me feel better (so learns the character).
I’ve always worked hard. Always. If I’m being really honest here, I have to admit that I don’t think I’m that intelligent. I think I’m just a sliver above average, but compensate with persistence and hard work. It doesn’t hurt that I’m above average when it comes to connecting with people—a very nifty gift to have in the real world. Of course I would like to have a lot of money. Of course I would like to at least have the option to shop at places other than H&M or Forever 21. But if I continue on this path of honesty, then I have to admit to myself that I’m not willing to make the sacrifices required of the “super successful” executives in this world…or maybe these requirements are specific to New York.
It felt good to work hard at the Bank. It felt good to close deals. It felt good to know I was learning something. It felt good to make money, and not have to check the bill or give stingy tips. But I hated working late. I hated being stuck to my cube until 11:30pm (average). I hated the unending to-do list. That gnawing stress that makes you want to skip bathroom breaks because, hey, you can get a lot done in 5 minutes. I hated having to be the boring sober person on Saturday nights because chances were I would have to go to the office the next day. I hated giving up so much, and no paycheck (six figure or not) could ever make up for it.
I think that my six month stint in investment banking set the tone for the rest of my life—I want to work hard enough to lead a good life. I want a family. I want a husband. I want to have dinner with him every night (or close to it). I want to have the freedom to buy whatever I want, but not necessarily at Gucci. I want a career. I want to turn in projects and feel like I did a good job. I want to lead a team, eventually. But, I don’t want my job to overrun my life. I don’t want to be a banker. And it’s okay if I don’t make as much money as bankers. I still want to be successful. I want to go to business school, do well, and get a good job afterwards. But, I can assure you that I won’t be looking for the consulting or PE gigs everyone else will be clamoring after.
I want a good life.
