What Went Wrong In The Economy

Posted by – March 30, 2009

I’ve had an email and a few message board posts asking me “what the…” is going on with the economy.  I’m not an economist (I was an English major) but I’m incredibly curious, and I read a lot.

Here’s my take:

A big part of this whole Wall Street collapse are something called “adjustable-rate mortgages” (ARMs).  Especially problematic are ARMs that “balloon” in cost two or three years down the line.  These mortgage companies sold this crap using the first few years’ “teaser rates” of 1% or 2% interest to lure in lots of new customers, many of whom didn’t read the fine print and didn’t see the 10% (or higher) price hike coming.  When so many borrowers couldn’t pay the ballooning interest, the house of cards fell down, taking the financial sector (and the world economy) down with it.

Yesterday I saw someone ask, “since interest rates have been low, why would anyone sell ARMs instead of fixed-rate mortgages?”  The answer has to do with projected revenues.  That is, these companies sold lots of “balloon” ARMs (mortgages that increase years later) so that they could bundle them into securities, go to Wall Street and brag about their securities’ “projected revenue,” which is a big part of what determines prices.
“Look!  In ’09, earnings on our securities will TRIPLE!!  BUY BUY BUY!!!”

A Dilbert cartoon from Dilbert.com

A Dilbert cartoon from Dilbert.com

Selling “balloon ARMs” was motivated by greed, and the market’s insatiable appetite for these mortgage-backed securities after Greenspan lowered interest during the post-9/11 slump, and thus the return on safe Treasury Bills, to 2%.  An unintended consequence of that was that it drove investors to desperately seek out another safe investment (with better return than 2%).  Pension funds, 401k managers, mutual funds, banking chains, investment banks and even New York City’s MTA, FLOCKED to mortgage-backed securities.  Moody’s rated them AAA!!  STRONG BUY!!  And hey, if something goes wrong, the losses were insured with credit default swaps from AIG!!   Why worry?  BUY BUY BUY!  Sell even more mortgages and create more and more and more securities to sell!  People made a fortune doing this.

Problem is, the “adjusted” rates led to THIS, too many mortgages defaulting.

Around 24% of subprime ARMs were delinquent in 2006… it’s likely much worse now.  The securities held up by these mortgages collapsed, becoming the “toxic assets” that are now all over the news and causing the economy to tank.   EPIC FAIL.

Yes, the Treasury Department is going to help finance the purchase of these worthless assets (congratulations, American taxpayer!)  The plan is to pull them off Corporate America’s balance sheets to try and keep the financial sector afloat.

But I think we’ve let the greedy elite build this particular Tower of Babel so high (a lot like Yertle the Turtle) that it crashing down is completely unavoidable, and we’re essentially screwed, no matter what the government does or doesn’t do.

What goes up, must come down.

Nick

Later this week in the “Nick’s Crusade” blog: federal regulators missed an awful lot of chicanery; what happened?

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