Once upon a time there was a crisis

The word "crisis" sells, like "sex" or "money". And as we live surrounded by that word everywhere (mass media that put it in headlines to sell news, politicians that raise it to announce the decline of the world they do not lead and by those who govern to say that it is not so bad), we have stopped asking ourselves what it means and why it is here. It exists, as an axiom, period.

In this article, based on the excellent post by Leopoldo Abadía on his blog "Dynamic Dictionary of Vocabularies"Let's see, superficially and in the simplest way, how we got into this mess... and I say "we", because as you will see later on, you also have your share of the blame.

2001: Bursting of the Internet bubble:

• The U.S. Federal Reserve lowers the price of money from 6.5 % to 1 % in two years.
• This was a boon to a market that was just beginning to take off: the real estate market.

The following 10 years:

• Real home prices are doubling in the United States.
• For years, interest rates on international financial markets have been exceptionally low.
• Banks start lending at low interest rates, thus the net interest margin ("a" minus "b") decreases.

It then occurred to the American banks that they had to give riskier loans, for which they could charge more interest and compensate for the low Margin by increasing the number of operations (1000 x little is more than 100 x little). To put this into practice, they decided:

• A) Offering mortgages to a type of customer, the "ninja" (people with no fixed income, no fixed job, no property).
• B) Charge them more interest, because there was more risk.
• C) Take advantage of the real estate boom.
• D) In addition, full of enthusiasm, they decided to grant mortgage loans for a higher value than the value of the house the ninja was buying, because, with the aforementioned real estate boom, that house, in a few months, would be worth more than the amount given in loan.
• E) These types of mortgages were called "subprime mortgages". (Those with a low risk of default are called "prime mortgages", and those with a higher risk of default are called "subprime mortgages".
• F) Moreover, since the U.S. economy was doing very well, the now insolvent debtor could find a job and pay the debt without problems.
• G) This approach worked well for a few years. In those years, the ninja were paying the mortgage installments and, in addition, as they had been given more money than their house was worth, they had bought a car, had made renovations in the house and had gone on vacation with the family. All this, surely, in installments, with the extra money they had received and, in some cases, with what they were paid in some job or odd jobs they had gotten.

And then:

• As the banks were making a lot of mortgage loans, they were running out of money. The solution was very easy: to turn to foreign banks to lend them money, because globalization is there for a reason. With this, the money that I, this morning, have deposited in the Central Office of the Savings Bank of San Quirico de Safaja can be that same afternoon in Illinois, because there is a Bank there to which my Savings Bank has lent my money to lend it to a ninja. Of course, the one in Illinois does not know that the money is coming from my town, and I do not know that my money, deposited in a serious entity such as my Savings Bank, is beginning to be at a certain risk. Neither does the office manager of my savings bank, who knows -and presumes- that he works in a serious institution. Neither does the President of the Savings Bank, who only knows that he has invested part of his investors' money in a major bank in the United States.

But problems begin, and creative solutions must be sought:

The Basel Standards require that the Capital of that Bank should not be less than a certain percentage of Assets. Then, if the Bank is borrowing money from other Banks and giving many loans, the percentage of Capital over Assets of that Bank drops and it does not comply with the Basel Standards.

Something new has to be invented. And that new thing is called SecuritizationThe Bank of Illinois "packages" mortgages-prime and subprime-into bundles called MBS (Mortgage Backed Securities). In other words, where before it had 1,000 "loose" mortgages, within the "Loans granted" account, now it has 10 packages of 100 mortgages each, in which there is everything, good (prime) and bad (subprime), as in the vineyard of the Lord.

The Bank of Illinois goes and quickly sells those 10 packs:

• Where does the money obtained from these packages go? It goes to Assets, to the "Cash on hand" Account, which increases, decreasing by the same amount the "Loans granted" Account, thus the Capital/Credits granted ratio improves and the Bank's Balance Sheet complies with the Basel Standards.
• Who buys these packages and also buys them quickly so that the Bank of Illinois "cleans" its Balance Sheet immediately? Very good question! The Bank of Illinois creates subsidiary entities, the conduits, which are not companies, but trusts or funds, and therefore are not obliged to consolidate their balance sheets with those of the parent bank. That is to say, suddenly, two types of entities appear in the market: I. The Bank of Illinois, with a clean faceII. The Chicago Trust Corporation (or whatever name you want to call it), with the following Balance Sheet:ASSETS LIABILITIESThe 10 mortgage packages Capital: what it has paid for these packages

 

How are the conduits financed? In other words, where do they get money to buy from the Bank of Illinois for mortgage packages? Several places:

• Through loans from other banks
• Contracting the services of Investment Banks that can sell these MBS to Investment Funds, Private Equity Companies, Insurance Companies, Financial Companies, Family Wealth Management Companies, etc.
• What happens is that, in order to be "financially sound"The conduits or MBS had to be well rated by the rating agencies, which give ratings based on creditworthiness. These ratings say: "this company, this State, this organization can be lent money without risk", or "be careful with these others because you risk not being repaid".
• I include here what the term ".RatingWe are pleased to present you the "Dictionary", so that you can have it all in the same block:RATING. Credit rating of a Company or an Institution, made by a specialized agency. In Spain, the leading agency in this field is Fitch Ratings.
  
  The levels are:AAA, the maximum
  AA
  A
  BBB
  BB
  Others, but they are very badIn general:A large bank or savings bank usually has an AA rating.
  A medium-sized bank or savings bank, a rating of A
• The rating agencies awarded these ratings or gave them other, more sophisticated names, but which, in the end, say the same thing: they called:Investment grade to MBSs representing prime mortgages, i.e. those with the lowest risk (AAA, AA and A)Mezzanineto the intermediate ones (I guess the BBB and maybe the BB).Equity to the bad, high-risk ones, i.e., subprime loans, which are the main players in this
• The Investment Banks easily placed the best (investment grade), to conservative investors, and at low interest rates.
• Other fund managers, venture capital companies, etc., more aggressive, tried to obtain, at all costs, higher returns, among other reasons because they receive a year-end bonus based on the returns obtained.
• Problem: How do you sell bad MBS to these latter managers without being overly conspicuous as taking excessive risk?
• Some investment banks have obtained from the rating agencies a re-rating (one re-ratingIf a trust rating system is compromised... what is the basis for trusting something or someone?

As we arrive here and trusting that you have not missed too much, I would like to remind you of one thing that you may have forgotten, given the complexity of the operations described: that everything is based on the fact that the ninjas will pay their mortgages and that the U.S. housing market will continue to rise.

But 2007 arrives:

• U.S. home prices plummet.
• Many of the ninjas realized that they were paying more for their home than it was now worth and decided (or were unable) to continue paying their mortgages.
• Automatically, nobody wanted to buy MBS and substitutes (due to the loss of confidence mentioned above) and those who already had them could not sell them.
• The whole setup went down the drain and one day, the Director of the San Quirico Office called a neighbor to tell him that well, that money was gone, or, at best, had lost 60 % of its value.
• But things go beyond that. Because no one -not even they- knows the crap that the Banks have in the mortgage packages they bought, and since no one knows it, the Banks begin not to trust each other.
• Because they do not trust each other, when they need money and go to the INTERBANK MARKETwhich is where the Banks lend money to each other, or do not lend it to each other or lend it to each other at a high rate. The interest at which the Banks lend money to each other in the Interbank Market is the Euribor (Europe Interbank Offered Rate), a rate whose evolution (in general, upwards) can be seen in the term EURIBOR of this Dictionary.

Therefore, the banks now have no money. Consequences:

1. No credits are given
2. They do not give mortgages, so Colonial, Habitat, etc. are starting to have a bad time, VERY BAD. And the shareholders who bought shares of these companies, see that the share prices of these companies are falling steeply.
3. The 12-month Euriborwhich is the reference index for mortgages, has been rising (v. Term 12 MONTH EURIBOR in this Dictionary), which makes the average Spaniard, who has a mortgage, start to sweat to pay the monthly installments.
4. As the banks have no money: they sell their shares in companies, they sell their buildings, they campaign to get us to put money in, offering us better conditions.
5. As people start to feel squeezed by the mortgage payment, they are going less to the Corte Inglés.
6. As the Corte Inglés notices, it buys less from the sock manufacturer in Mataró, who also didn't know that ninjas existed.
7. The sock manufacturer thinks that, as he sells fewer socks, he is starting to overstaff and lays off a few people.
8. And this is reflected in the unemployment rate, mainly in Mataró, where people are starting to buy less in the stores.
9. And like a virus... the crisis spreads.

Conclusion:

Experts say that there is money, but what there is not is confidence. In other words, the liquidity crisis is a genuine crisis of not trusting others.

And this is the crisis we are in. Explained in a very superficial way because everything is full of strange words and much, much economic creativity to "invent" money, since in the end what we call money is actually DEBT. Long gone are the days when gold governed the value of money, now, money is debt, and that is the basis of the current disaster.

Image: https://www.flickr.com/photos/rh2ox/6414119147