Demystifying the Credit Crisis
What the (bleep) is going on with our economy?
If this question plagues you, keeps you up at night, and/or tests your otherwise sound understanding of our financial system, you’re not alone, says New York Times economist David Leonhardt (“Can’t Grasp Credit Crisis? Join the Club,” March 19).
“I’m here to urge you not to feel sheepish,” Leonhardt says. “This may not be entirely comforting, but your confusion is shared by many people who are in the middle of the crisis.”
Yeah, not so comforting. It’s a muddle, for sure, but Leonhardt is one of the few econo-journalists who can make sense of the mess.
Leonhardt sets out to answer this question: “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 economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression?”
Answer: Basically, everyone—from Joe Sixpack to Alan Greenspan to Gordon Gekko—jumped on the housing bandwagon with the silly assumption that home prices would continue to soar into the sky indefinitely. With this faulty notion, people—even normally conservative bank executives—exposed themselves to too much risk. Here’s the money quote:
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.
The traditional banks never fully insulated themselves from the insane amount of risk they took on in lending money to people who had no business borrowing it.
