Subprime Timelime - could you repeat that?

[Cougar]

Raise your hand if you don't quite understand this whole financial
crisis.
Confused over the credit crisis? You're not the only one
By David Leonhardt The New York Times

It has been going on for seven months now, and many people probably
feel as if they should understand it. But they don't, not really. The part
about the U.S. housing crash seems simple enough. With banks
whispering sweet encouragement, people bought homes they couldn't afford, and
now they are falling behind on their mortgages.

But the overwhelming majority of homeowners are still doing just fine.
So how is it that a mess concentrated in one part of the mortgage
business - subprime loans - has frozen the credit markets, sent stock
markets gyrating, caused the collapse of Bear Stearns, left the U.S. economy
on the brink of the worst recession in a generation and forced the
Federal Reserve to take its boldest action since the Depression?

I'm here to urge you not to feel sheepish. This may not be entirely
comforting, but any confusion you might have is shared by many people who
are in the middle of the crisis.

"We're exposing parts of the capital markets that most of us had never
heard of," Ethan Harris, a top Lehman Brothers economist, said last
week. Robert Rubin, the former Treasury Secretary and current Citigroup
executive, has said that he hadn't heard of "liquidity puts," an obscure
financial contract, until they started causing big problems for
Citigroup.

I spent a good part of the last few days calling people on Wall Street
and in the government to ask one question: "Can you try to explain this
to me?" When they finished, I often had a highly sophisticated
follow-up question: "Can you try again?"

I emerged from it thinking that all the uncertainty has created a panic
that is partly irrational. That said, the crisis isn't close to
ending. Ben Bernanke, the Fed chairman, won't be able to wave a magic wand
and make everything better, no matter how many more times he cuts rates
and cheers Wall Street. As Bernanke himself has suggested, the only
thing that will end the crisis is the end of the housing bust.

So let's go back to the beginning of the boom.

It really began in 1998, when large numbers of people decided that real
estate, which still hadn't recovered from the early 1990s slump, had
become a bargain. At the same time, Wall Street was making it easier for
buyers to get loans. It was transforming the mortgage business from a
local one, centered around banks, to a global one, in which investors
from almost anywhere could pool money to lend. The new competition
brought down mortgage fees and spurred innovation, much of which was
undeniably good. Why, after all, should someone who knows that they're going
to move after just a few years have no choice but to take out a 30-year,
fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much
of a good thing. Those same global investors, flush with cash from
Asia's boom or from rising oil prices, demanded good returns. Wall Street
had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they
come with higher interest rates for the borrowers - even if they're
disguised by low initial rates - and thus higher returns for the lenders.
These mortgages were then sliced into pieces and bundled into
collateralized debt obligations, or CDOs. Once bundled, different types of
mortgages could be sold to different groups of investors.

Investors then goosed their returns further through leverage, the
oldest strategy around. They made $100 million bets with only $1 million of
their own money and $99 million in debt. If the value of the investment
rose to just $101 million, the investors would end up doubling their
money. Home buyers did the same thing, by putting little money down on
new houses, notes Mark Zandi of Moody's Economy.com. The Fed under Alan
Greenspan helped make it all possible, sharply reducing interest rates,
to prevent a double-dip recession after the technology bust of 2000,
and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns
almost always come with greater risk. But people - by "people," I'm
referring here to Greenspan, Bernanke, the top executives of almost every
Wall Street firm and a majority of American homeowners - decided that the
usual rules didn't apply based on the idea that home prices nationwide
always rise. And they did rise ever higher, so high, says Robert
Barbera of ITG, an investment firm, that they were destined to fall. It was a
self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple
effects. The American home seemed like such a sure bet that a huge portion
of the global financial system ended up owning a piece of it. Last
summer, many policy makers were hoping that the crisis wouldn't spread to
traditional banks, like Citibank, because they had sold off the
underlying mortgages to investors. But it turned out that many banks had also
sold complex insurance policies on the mortgage debt. That left them on
the hook when homeowners who had taken out a wishful-thinking mortgage
could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge. But they were often so highly
leveraged that any losses became magnified. If that same $100 million
investment I described above were to lose just $1 million of its value, the
investor who put up only $1 million would lose everything. That's why a
hedge fund associated with the prestigious Carlyle Group collapsed last
week.

"If anything goes awry, these dominos fall very fast," said Charles
Morris, a former banker who tells the story of the crisis in a new book,
"The Trillion Dollar Meltdown."

This toxic combination - the ubiquity of the bad investments and their
potential to mushroom - has shocked Wall Street into a state of deep
conservatism. The soundness of any investment firm rests in large part on
the confidence of other firms that it has real assets standing behind
its bets. So firms are now hoarding cash instead of lending it, until
they understand how bad the housing crash will become and how exposed to
it they are. Any institution that seems to have a high-risk portfolio,
regardless of whether it has enough assets to support the portfolio,
faces the double whammy of investors demanding their money back and
lenders shutting the door in their face. Goodbye, Bear Stearns.

The conservatism has gone so far that it's affecting many solid,
would-be borrowers, which, in turn, is hurting the broader economy and
aggravating Wall Street's fears. A recession could cause automobile loans,
credit card loans and commercial mortgages to start going bad, as well.

Many economists, on the right and the left, now argue the only solution
is for the federal government to step in and buy some of the unwanted
debt, as the Fed began doing last weekend. This is called a bailout,
and there is no doubt that giving a handout to Wall Street lenders or
foolish home buyers - as opposed to, say, laid-off factory workers - is
deeply distasteful. At this point, though, the alternative may, in fact,
be worse.

Bubbles lead to busts. Busts lead to panics. And panics can lead to
long, deep economic downturns, which is why the Fed has been taking
unprecedented actions to restore confidence.

"You say, 'My goodness, how could subprime mortgage loans take out the
whole global financial system?' " Zandi said. "That's how."