My dad sent me the following explanation of the financial crisis. He is a CPA and retired partner at Price Waterhouse Coopers, and currently does financial consulting. It’s one of the clearest explanations I’ve read.

“How we got into this situation: It started several years ago with mortgages being made to people who didn’t qualify for them, with conditions that made them look very favorable, but contained major adjustment clauses, such as large increases in interest rates after a couple of years.  In addition, many major banks made home equity loans (HELOC’s) to many people in large amounts without much, if any checking on the borrower’s ability to pay, the adequacy of collateral, etc.  The investment banking community then saw opportunities to make alot of money by creating mortgage packages, or bundles of mortgages that they could sell to investors, like overseas banks, insurance companies and others.  The insurance industry got into this as well by issuing, for a fee, guarantees that the mortgage funds would be be made whole in the event of nonpayment of mortgages.

There were no regulations of these, and where there were they were not watched very carefully.  HELOCs for example.  It grew into billions of dollars, not only involving the US but many overseas financial companies as well.

It all started to unravel when the mortgages started to adjust and people realized that they couldn’t make their payments.  They then let the houses go into foreclosure.  That’s when things started to unravel, because these mortgage funds, or pools of mortgages, could not be valued.  Accounting rules requires that assets be marked to market every quarter, which meant that the investment firms, banks, etc had to adjust the value of these pools on their books, which became next to impossible.  They had to take very large writeoffs, which in some cases put them in a negative capital position.  Many of them, when they bought these portfolios, bought them with borrowed money.  When they took the writeoffs their lenders wanted to get repaid, and many of them didn’t have the funds available to pay the lenders.  This created a ripple effect (some call it a sunami)  causing the holders of these funds to try to get liquid and trying to sell this paper for next to nothing.  That forced further writedowns.  Companies were then liquidated (Bear Sterns for example) with the gov’t taking over the bad paper. 

The Treasury and Fed Reserve tried to deal with the situation on a piecemeal basis.  That didn’t work.  Panic was setting in last week, with people trying to pull money out of money market funds, banks and investment firms.  For example, last Thursday we (Mark and I ) tried to put our clients cash into US Treasury paper.  We could not find any 30 Treasuries to buy.  If the word of the US Gov’t bailout had not leaked Thursday afternoon, it is likely that by Friday or Saturday you would not have been able to get money out of your ATM machine, and that all financial accounts would have been frozen.  It was really that bad.
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I (and a few others) have been saying for over 6 months that we needed to have a federal program to deal with this similar to the RTC program that was created in the early 90s when the Savings and Loan industry went through a financial crisis.  If we had done it months ago the number would have been much less.  If it is handled correctly, it shouldn’t end up costing the govt much, if anything.  After all, most people are paying their mortgages every month.  This situation affects a relatively small part of the mortgages out there.  If this is done, it should also help keep the prices of homes from falling, which is important to have this working out ok.  We need to have liquidity, and the only one that can provide it right now is the US Govt. 

Hopefully the members of congress will get this done soon.  I don’t know if I like all of the terms, etc, but that isn’t important.  They can be worked out.  So can future regulation.  But it needs to get done, or we will all be in serious financial trouble.”

I think it’s important to point out the major role of the Bush administration in promoting these bad loans. In June 2002, President Bush issued America’s Homeownership Challenge to the real estate and mortgage finance industries to encourage them to join the effort to close the gap that exists between the homeownership rates of minorities and non-minorities. The administrations Homeownership Policy Book specifically calls for “increased innovation in mortgage products”.

Well, here is the result. Yet another reason we MUST get better leadership.