What's Ailing the Markets?

As you might be able to tell, the problems facing the financial markets right now are no joke. The dumping of money into the banking system by the Federal Reserve, along with the cutting of the Fed's discount rate (not to be confused with the more well known Fed Funds Rate) suggest that the even though there's still inflationary risk out there that the Fed sees what's happening as a real threat to economic growth.

But the problems are not particularly straight-forward and I get the feeling that a lot of people watching the markets falter don't really understand the itch that's causing it all. For those savvy types that find their way to this blog (are there any?) this might be just a review of material you already understand. For everyone else, hopefully this, though very simplified, will help elucidate the situation a bit.

The old maid
So to start, I really liked the way The Economist described the old US banking system in a recent article. They compared it to a game of Old Maid, where each player's aim is to not end the game with the maid in his hand. You could similarly compare it to a game of musical chairs -- when everyone goes scrambling for a chair one person is inevitably left standing.

In the past banks basically took on the bulk of the risk when it came to making many loans -- mortgage loans in particular. With all of these loans on the banks' balance sheets, when the music stopped playing after a time of excess it was a scramble to see who was left with enough bad loans to leave them standing. For that/those banks it was game over.

The new, better way
Cleverly enough, financial institutions have found a way to spread the risk from these loans far and wide. What they do is take a whole basket of loans -- it can be all mortgage loans, all student loans, or some combo of various types of loans -- package them up and sell off pieces of the package to investors. Investors are paid interest from the pool of payments that come in through all of the assets backing the package that they bought into. This process of packaging up a bunch of assets and selling off securities backed by the assets is securitization.

What the finance guys found, though, is that without a AAA rating on any of these asset backed securities they were selling, it was tough to spur a whole lot of demand, particularly from conservative institutions like banks and insurance companies. So what they did was employ strategies such as subordination to get higher ratings for some of the securities. The idea of subordination is that the securities sold are split into levels (often called tranches).

The bottom tranche of a securitization usually carries the biggest potential pay-off, but is also the first one to take any losses should defaults start rolling in. Successive tranches on the way up pay out less, but are also protected from losses by the tranches below them. Financial firms structuring securitizations are often able to get a AAA rating for the top tranche.

Passing risk
Now that there was a relatively easy way to take loans and sell them off, lenders were all over it. The reason is that it made it much easier for them to expand business. Instead of having all the loans they took on sit on their balance sheets they could now securitize them, sell them off, and have a fresh batch of capital to loan out. Lenders typically retained exposure to some of the lower tranches of securitizations and also collected fees for managing the securitized assets.

Meanwhile, investors liked the deal because they were able to get a pretty decent return often without having to stoop below AAA securities. Plus, everyone's feeling really warm and fuzzy inside because they think that by passing risk all over the place it makes the world a safer place.

Swallowing the risk
But risk can be a bitter pill to swallow when it comes back home to roost. Whereas in the old game of musical chairs there were a bunch of people left without a chair at all, now there are a few people with no chair, but a whole lot of people that have found themselves in a chair that they thought was good, but is actually missing a leg or two.

It turns out that one of the big problems with spreading the risk is that you lose some of the accountability along the way. Though banks that held mortgage loans on their balance sheets could get carried away and make bad loans, they were more likely to crack the whip on loan terms because they were going to bear the consequences if something went wrong. On the other hand, when the bank doesn't feel like it's bearing full risk of the loans there ends up being a little bit that slides here and there.

When you combine that with the fact that much of the time you have a mortgage broker actually originating the loan and caring only about the origination fee he'll take home, you end up with some corners cut here and some shortcuts taken there.

An illustration
Here's a quick example of how this happens to make it a bit more real. I go to DR Horton (NYSE: DHI) and say I want to buy a home. They're very excited. Though they try to lure me to use their lender, I work with an outside mortgage broker and end up getting a loan through Countrywide (NYSE: CFC).

The mortgage broker helps me decide on the type of loan I'm going to go with and fills out all of the fun paperwork -- for that he gets paid an origination fee. Countrywide then pays DR for my new home and puts it on their books. At some point, Countrywide will likely take my loan, along with a whole bunch of other loans and structure securities base on these loans to sell to investors.

Countrywide will then potentially work with an investment bank like Goldman Sachs (NYSE: GS) to structure the securities and also likely consult with ratings agencies like Moody's (NYSE: MCO) to make sure the highest tranche of the securitization is structured so that it will be able to get a high rating. Investors around the world such as ABN Amro (NYSE: ABN), Deutsche Bank (NYSE: DB), and AIG (NYSE: AIG) then end up buying some pieces of this big securitized pie that includes my dinky little loan.

Suppose, though, that I was buying my home three years ago, when real estate mania was still in full swing. Say I was buying a house that I knew was a little out of my price range so I asked my mortgage broker about doing a stated income loan that had a low initial rate that I could keep up with for the first couple years. What did I care, right? Housing prices were headed up, up, up, so before my payment went up I could just sell and maybe use the nice profit to put a real down payment on my next house.

My mortgage broker didn't push me hard since he wanted his origination fee and figured the same thing I did about housing prices. Countrywide didn't push the mortgage broker hard because it was planning on selling my loan anyway. The investors maybe didn't do as much diligence as they might have because they were relying on the AAA rating that Moody's put on the security they were buying.

Now it's three years later. Interest rates have gone up significantly and my loan has ballooned to where there's no way that I can keep up with the payments. I'm rapidly running through what little emergency funds I have and the house has been languishing on the market for months because there are too many houses for sale right now. Eventually, much to my dismay, I have to walk away from my home because I can't keep up.

Play out this scenario enough times and suddenly the lower tranches of the securitizations out there are getting eaten away. Though the AAA levels haven't been touched yet, there's suddenly much more risk in holding that paper. Not only do market prices for the bonds fall, but bids for them in the open market nearly dry up completely. Financial institutions that have been using these supposedly safe securities as collateral are suddenly finding themselves in need of additional capital and liquidity. This need in many cases is forcing them to sell some stuff at whatever the market will give them -- thus spooking other investors and exacerbating the situation.

Reality
The scenario above is not something that actually happened to me (though I did buy a house fairly recently, I am on a good ol' 30-year fixed rate mortgage), but the ensuing spiral, though a simplified version, is similar to what's going on in real life right now.

Like I said, this is a pretty simple overview, and maybe there are some parts that need clarification, so I encourage feedback. I figure this is something that it's good for investors to have a pretty decent grasp on.

-AvgJoe