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What Happened? A Summary of the Financial Crisis

By Brian | October 7, 2008 | Share on Facebook

UPDATE: Those who find this post informative should also check out What Happened? A Summary of the Homeowner Affordability and Stability Plan, a similar analysis of President Obama’s plan to re-stabilize the mortgage market

When I was growing up, I remember being told that The New York Times was written at an elementary school reading level, so that any reader could understand it’s content. Now, living in the information age, where The New York Times has morphed into a plethora of newspapers, wire services, aggregation portals, blogs, 24-hour news channels and pundits, it occurs to me that they really do treat us like elementary school children – they speak in simple words, and they lie to us about complex subjects (the storks bring babies, Santa brings presents, stop that or you’ll go blind…) in order to hide the fact that they don’t know the real answer or to save themselves the trouble of explaining a series of uncomfortable details.

I say this as a 15-year veteran of the capital markets industry, an active investor, and an avid consumer of current events news. I say it today, in particular, because we’re going through one of those periods in history that my kids and grandkids will ask me about when they read about it in their textbooks (or whatever textbooks have become when they reach that age). I say it because the information coming from my commonly-used information sources has been so scrubbed, so watered down, so sanitized, and so reduced to inaccurate sound bytes and oft-repeated tag lines that I literally can’t watch it anymore. I’ve resigned myself to learning a college course’s worth of material during each eight hour workday, and then surfing the internet for Hollywood gossip and watching TV for sitcoms and cartoons. In times like this, one struggles to keep one’s sanity.

As you might expect, my friends and family have come to me frequently over the past few weeks with questions about what’s going on at work, and what’s going on in the financial sector in general. I’ve probably written around 5,000 words on the subject in the last couple of weeks, explaining basic terminology, squashing rumors, and reassuring people who are understandably flummoxed by the amazingly complex problem we’re all facing. I don’t claim to understand it all (people much smarter than I have, in the recent past, successfully proven that they don’t understand it all themselves), but I hope I can provide a basic primer to help navigate this ever-changing drama.

This lengthy post is intended to be that primer – a place I can refer people to rather than typing it over and over again in response to frequently asked questions. If you’re interested, I encourage you to click through and read it, and then e-mail me with questions or comments. As time permits, I’ll update it as we go with new information and correct errors that others find in my analysis.

Two warnings, though: first, this comes from me and from me alone. While I’ll do my best to remain factually accurate and politically dispassionate, no one should take this as a statement made by or on behalf of my employer. I haven’t vetted it with anyone at work, and I can’t say with any certainty that some of my colleagues wouldn’t disagree with all or part of it. Second, it’s rather long. I mention this not as an apology, but to reinforce what should be an obvious fact – complex situations require a lot of words to explain them. Our news media, pundits, and politicians have repeatedly tried to violate this basic axiom, and have failed repeatedly. There are no shortcuts here. Get comfy and read awhile. And when we’re done, maybe we’ll talk a bit about the Tooth Fairy and the Easter Bunny…

Background: The Housing Bubble

Where to begin? To understand how we got here, we need to review a little history. I’m going to start in the mid-90s with the economic boom we now know as the “dotcom bubble.” This is a fairly arbitrary decision since everything that happens in the world is influenced by what happened just prior to it (another fact that should be self-evident). Various politicians, past, present and future, will try to convince you that this whole thing started in 2001 or 2004 or 2006 or whenever. They are being just as arbitrary as I am, typically to serve their own purposes. I choose the mid-90s because you’ve got to start somewhere. No other reason.

In the mid-90s, the economic, political and technological stars aligned to produce an economic transformation like nothing this country has seen since we made the move from agriculture to industrial assembly lines. New companies were forming almost daily, and growing at unbelievable (and as was eventually proven, unsustainable) rates. Tens of millions of new jobs were created, inflation and unemployment remained low, and personal wealth swelled for many Americans. In record numbers, people with new-found cash began investing in ways they never had before. When Bill Clinton left office in January of 2001, he cited, among his major accomplishments, the highest percentage of stock ownership in our nation’s history as well as the highest percentage of home ownership.

Many people, some of whom had never been able to afford a home before, used the proceeds from their dotcom investments to buy new, and often expensive, homes. As home prices continued to increase, homeowners would “flip” their properties – selling their current home at a huge profit, and using the cash as a down payment on a larger, more expensive home. Terms like “foreclosure” and “default” were hardly considered, since the constantly increasing value of the homes made it easy to pay off debt – either through flipping, or by securing larger credit lines based on the (now) more valuable homes.

In March of 2000, the dotcom bubble burst. As stock prices returned to earth and money flowed out of the stock market, investors went in search of a new investment vehicle, and the rapidly growing real estate market became the investment of choice. Entrepreneurial investors switched from buying high-flying dotcom stocks to buying multiple, high-flying real estate properties, which they would then sell to willing homeowners who wanted to flip their current property for something newer/nicer/better. And so, born of a stock market bubble and fueled by it’s collapse, a real estate bubble was born.

The Bubble Grows: Predatory Lending and Mortgage-Backed Securities

While consumer banks had little connection to the stock market bubble, the real estate boom was a different story altogether. The sudden rash of home purchases meant demand for thousands of new mortgages, touching off a period of fierce competition. As banks clamored to win market share in this target-rich environment, they began to offer incentives, principally reduced short-term interest rates and relaxed background checks. The result was the now famous “sub-prime” mortgage, in which the bank would lend money to someone who didn’t meet the standard, minimum requirements for a mortgage. The loan would be an “adjustable rate mortgage,” or ARM, which started off below the prime rate (typically, at a level the customer could afford to pay each month), and then increase to a much higher rate several years down the line. The consumer was happy to take such a deal because, as the story went, by the time the higher rate kicked in, the house would be worth significantly more money, and the owner could either re-finance the loan with another variable rate deal, or pay the loan outright by flipping the house, leaving him/her with the profits to use as a down payment on a new, larger home (with a new, larger, variable rate mortgage, no doubt).

I pause here to recognize the first of several controversies to come out of this whole affair. Are the mortgage bankers guilty of excessive greed (a.k.a., predatory lending) for offering these ARM’s to customers who could not afford to pay the future, higher rate? Or are the consumers guilty of excessive greed for taking money that they knew they could not afford to repay? Or were they both blinded by the false promise of an ever-growing housing market, where no one ever had to pay back any loan, because the underlying asset (the home) would perpetually increase in value? As I said in the introduction, I will stick to the facts here and leave those conclusions to the reader. I hope, though, that with this background, you can at least see both sides of the argument.

Alas, the banks had a problem. Despite what you are likely hearing from the media or the politicians these days, banking is a very highly regulated industry. In addition to due diligence requirements such as BASEL-II, Sarbanes-Oxley, OFAC Screening and the USA PATRIOT Act (particularly Title III), banks are also bound by law to maintain a certain ratio of liabilities to assets (also known as “leverage”), in order to ensure their ability to pay if a higher than expected percentage of customers come calling for their money simultaneously. As their mortgage volume increased, many banks, particularly the smaller regional banks, began finding it difficult to keep enough cash on hand to support these requirements. Faced with the prospect of passing up profitable mortgages (and, conversely, making it harder for an average citizen to secure a mortgage), the banks turned to the derivative markets for help.

Some definitions: a derivatives market is like the stock market, except that the securities traded in the derivative market are based on the value of other securities. The most common example is a stock option. The value of a stock option is entirely dependent on the value of the stock, whereas the value of the stock is dependent on the value of the underlying company. So, if you buy a “call” option (the right to buy a stock) at $10/share, and the stock drops to $8/share, then the value of your option (the right to buy at $10/share) is basically zero (it may be a little higher than zero, if someone out there expects the stock to rise above $10 in the future and is willing to buy the option from you).

A mortgage-backed security works the same way, but is based on the value of a group of mortgages, rather than a single stock. Here’s how it works: a group of mortgages are bundled together and viewed as a portfolio. The monthly payments made by the mortgage holders reflect the monthly income expected from the portfolio (like a dividend on a stock). If one or more mortgage holders miss a payment in a given month, then the monthly income of the portfolio drops. If one or more mortgage holders declares bankruptcy, or otherwise defaults on their loan, then the monthly income of the portfolio drops even more (not just for the current month, but for every month left in the defaulted mortgage). A mortgage-backed security, or MBS, is the right to receive a share of this monthly income for a particular price. The price is determined, much like a stock option, on the value of the underlying assets. So, if a higher-than-expected percentage of mortgage owners miss a payment, for example, then the monthly disbursement is lower, and the right to receive that disbursement becomes less valuable (i.e., the price goes down). If, on the other hand, the default percentage is lower than expected, the right to receive that revenue stream becomes more desirable, and the price goes up.

So how does all of this help a bank that’s struggling to write more mortgages without becoming over leveraged? Simple – the bank bundles up a group of mortgages it’s already written, and sells them to an investment bank in the form of a mortgage-backed security. The cash the bank gets from the sale keeps it leveraged. In return for the cash, the investment bank gets it’s monthly disbursement in the form of the mortgage payments (or lack thereof). The investment bank can then sell shares of this security to clients who wish to invest in such things, or sell them on the open market to other investment banks. Believe it or not, it actually gets more complex than this, as the banks and investment banks start stratifying the mortgages into different risk profiles (sub-prime, standard, jumbo, etc.) and start assigning different risk ratings to each. But for our purposes, this is enough to move forward.

Before we do, though, let’s take a moment to ponder a major implication of this arrangement: once the bank sells a mortgage to an investment bank, it no longer cares if the loan is paid back or not. Like a salesman working for a commission, all the bank now cares about is whether or not it can sell the mortgage to the investment bank. The investment bank assumes that some percentage of the loans will default, and pays the bank a price based on that assumption. Trivial matters like which mortgages fail are irrelevant. If the percentage is lower than expected, the price of the security will rise, and if it’s higher than expected, the price will fall. Either way, though, the bank has already received payment for the mortgage which, depending on the specific rules and regulations, it may already be loaning to another customer in the form of yet another mortgage.

Once again, I pause for another “controversy break.” In the “good old days,” a regional banker would be very careful about who he/she would lend money to, because if they didn’t pay it back, then the banker could be stuck with the loss (or, in the worst case, a repossessed house). As a reseller to the derivatives market, though, the banker is no longer bound by this constraint. Each mortgage now represents raw material for him/her to package and re-sell to the investment bank at a small profit. Bankers become the middlemen, concerned only with moving product through the pipeline, not carefully evaluating each and every loan. Similarly, investment bankers aren’t buying an individual mortgage, but a bundle of thousands. If five out of a hundred mortgages default, the investment banker doesn’t care which five they are – the effect on his mortgage-backed security is the same. Does this system represent greed on the part of the mortgage banker? The investment banker? Does the lack of scrutiny on each loan represent a need for federal regulation to “protect the little guy,” or is it a glorious opportunity to expand the availability of affordable housing in America? Over the past decade or more, all of these arguments have been made by politicians and regulators alike, dependent mostly on whether the economy was doing well or poorly, and which message they were seeking to emphasize. As above, I leave it to you to adjust your level of outrage and then find a comfy home for it.

Crisis: The Credit Markets Run Dry

In the summer of 2007, the housing bubble burst. Much like the stock market of early 2000, investors began to believe that prices had gotten too high. As demand for new homes began to dry up, prices began to fall. People whose ARM’s were switching to the higher, long-term interest rate suddenly found themselves unable to secure additional credit or flip their homes to pay off the mortgage (the value of the home, in some cases, was now less than the value of the loan, so rather than selling it, paying off the loan and walking away with a tidy profit, the sale of the home became insufficient to pay off the loan itself). This led to record levels of mortgage defaults and home foreclosures, which further exacerbated the drop in housing prices, and also drove the price of mortgage-backed securities down dramatically.

This brings us to our first major misconception about the current financial crisis. Companies like Bear Stearns and Lehman Brothers did not get acquired or go out of business because they lost a lot of money in the markets. Market losses happen all the time, and those federally regulated leverage ratios help to minimize their impact. What brought down these and other firms was a combination of an accounting rule and a market function that exists in the stock market, but doesn’t exist in the derivatives market. Let’s look at these one at a time:

The accounting rule to which I refer is called “mark-to-market.” It says that when an institution buys an asset (in this case, a mortgage-backed security), they need to recognize it on their balance sheet at it’s market price, and that periodically, they need to adjust (or “mark”) the value of that balance sheet asset to reflect changes in the market. So, for example, let’s say that Lehman Brothers bought a particular mortgage-backed security for $1 million. This asset is now listed on their balance sheet at that price, and as per regulations, Lehman is now able to take on additional liabilities (e.g., borrowing money), essentially using that asset as collateral.

Now let’s assume that a month later, a surprisingly high number of the underlying mortgage holders miss their monthly payments, driving the price of the security down to $750,000. Without mark-to-market accounting, Lehman would still show a $1 million asset on it’s balance sheet, and could continue to use that asset as collateral for obtaining credit. With mark-to-market, though, Lehman must issue a “write-down” (careful observers of the recent press will recognize this term) and lower the value of the asset to $750,000. Now, their ability to secure credit is reduced by a proportionate amount. As write-downs continue and credit becomes harder and harder to obtain, liabilities begin to build up and eventually the firm can no longer survive. In Lehman’s case, when they filed bankruptcy, their balance sheet showed a whopping $639 billion in assets, with a corresponding $613 billion in liabilities.

Another “controversy break:” those who react to this rule harshly (either with “serves ‘em right for making bad investments” or “Unfair! They haven’t really lost the money until they sell – what if the market comes back?” should remember that in good times, mark-to-market can be used to increase a firm’s liquidity in much the same way. The rule is meant to create transparency in the marketplace, not to punish or reward any particular group. That said, abuse is certainly possible. We now return you to your regularly scheduled crisis…

At this point, some may be wondering, “If these securities kept dropping in price, why didn’t the banks just sell them and invest the cash in something more profitable?” It’s a good question. The answer lies in that mysterious market function I mentioned four paragraphs ago.

In the stock market, many of the large investment banks act as market makers for a given security. This means that if someone wants to sell shares of that security and there are no available buyers (at any price), the market maker agrees to buy the shares (at a price of its choosing). Conversely, if someone wants to buy shares of that security and no one is selling it, the market maker agrees to sell the shares (again, at a price of its choosing). Market makers are even allowed to naked short a stock (which is not as exciting as it sounds – it means they can sell the shares before they buy them). This creates liquidity in the marketplace, which means you’ll probably never find yourself in a situation where you want to buy/sell a stock and your broker tells you, “Sorry, it can’t be done.”

The derivatives markets have no market makers. As the prices of mortgage-backed securities began to free fall, we eventually reached a point of zero liquidity. In other words, no one would buy a mortgage-backed security at any price. This meant that companies like Lehman Brothers were stuck with these “toxic assets” (another term that’s been floating around the news lately) on their balance sheets with no way to get rid of them. The prices continued to drop, the mark-to-market rules made their balance sheets weaker, until eventually, they had to declare bankruptcy or agree to be acquired by another firm who had enough assets to cover their liabilities.

Still with me? If so, then congratulations. You now understand the crux of the financial crisis and how it occurred. Simply put, it’s a burst housing bubble causing a crash in the derivatives market which is enabled and sustained by a liquidity crisis that has frozen the credit markets, causing firms to build up debt that violates regulations and forces them to merge with other, more capitalized banks or declare bankruptcy. Clear as mud, right?

Controversy break: I hope you now understand my frustration with the media and the politicians who sum the whole thing up with “The fat cats on Wall Street destroyed the economy with their corruption and greed.” You may have concluded above that greed played a role on Wall Street or Main Street, or possibly both, as bankers and investment bankers painted themselves into a corner. But without all the facts described herein, I believe a statement like the above makes things sound a lot more sinister than they actually are. Your mileage, as they say, may vary.

The Aftermath: Bailouts and Buyouts and Bankruptcy, oh my!

From here, the dominos began to fall:

Then, there’s the stock market:


That’s a drop of 1,974.88 points (or 17%) in eighteen days. Ten of the eighteen days had a point change of three hundred or more. If you don’t follow the stock market regularly, trust me – these are truly historic levels of volatility. The list above explains most of this movement, of course, but there’s one other factor I haven’t covered yet – the much heralded $700 billion bailout package proposed by Treasury Secretary Hank Paulson, and (eventually) passed by both houses of Congress and signed by President Bush. First, let’s go through what happened when and then address some of the common misconceptions about this highly controversial, and political, piece of legislation:

In keeping with my promise to stay accurate and dispassionate, I’ll note a few things about the bailout and then we’ll move on to the “Controversy Break” (you saw that coming, huh?) First, it’s important to understand that the government is not simply giving these firms $700 billion to do with as they wish. It is investing $700 billion in mortgage-backed securities, many of which are valued at historic lows. It is likely, though not guaranteed, that when liquidity returns to the market, and trading in MBS’s begin again, various companies will be very interested in trading these securities. It is also likely, though not guaranteed, that a significant percentage of the underlying mortgage owners will, in fact, pay their mortgages on time. Since the current estimate reflects that 0% of them will, this suggests that the prices for these securities will go up. If that happens, the government will be able to show a profit on it’s investment by selling the MBS’s for more than their purchase price. When the country saw a rash of Savings & Loan closures in the mid-90s, a similar institution was created (the Resolution Trust Corporation), which did, in fact, turn a profit selling off the assets it purchased under crisis conditions.

The other important thing to note about the bailout package is that the benefit derived from bailing out large investment banks is not relegated to the executives that run them. In addition to holding mortgage-backed securities, these banks also manage pension funds, retirement accounts, and mutual funds that are owned by millions of middle-income Americans. When these banks struggle or fail, these assets drop in value, sometimes very significantly. Incenting these markets to operate normally again benefits ordinary Americans by securing their financial holdings, regardless of their overall wealth.

Controversy break: A big part of why the liquidity markets dried up in the MBS market was a lack of investor confidence. Typically, assets that drop in price are more attractive to potential buyers. At some point, though, those buyers decide that the assets are never going to recover, and begin to fear the repercussions of owning them and not being able to sell them if they continue to decline. This creates a self-fulfilling prophecy that dries up the liquidity and makes it impossible to trade.

When the government announced it’s intention to inject liquidity in the markets, it made all of these nervous investors feel more confident, because it suggested that trading would begin again, and buying those cheap assets wouldn’t be such a risky proposition.

But then, a giant marketing campaign began. Emotions took over and hyperbole replaced rational thought. Media pundits began focusing on the compensation of the investment banks’ CEO’s, putting the need to punish someone – anyone – for what had happened above the need to solve it. Politicians seized the opportunity to tell part of this story, in order to blame the opposition party for causing the crisis when, as the above has hopefully demonstrated, it is only tangentially related to politics at all. And our leaders in the Senate, sensing a gravy train approaching, loaded down the revised bill with almost $200 million in unrelated, pork-barrel earmarks, taking the focus away from the benefits of the bill and placing it on one of John McCain’s pet campaign issues – the weeding out of pork-barrel spending.

This deluge of rhetoric and opportunism left most people with a bad taste in their mouth about the bill. The investor confidence that the original bill had inspired had completely dissipated, so that when the bill did pass, the general consensus was that it wouldn’t be enough, and that the economy was headed into a long and deep recession. As is typically the case with investor confidence, widely held beliefs like this one tend to become self-fulfilling prophecies, and all indications point to that occurring here.

Conclusion: Keep Your Eye on the Ball, but Make Sure It’s the Right Ball

In the coming days and weeks, it seems as though the stock market will produce the most fireworks. Watch what happens there with an eye toward what I’ve written above.

But more importantly, watch the credit markets. These are not nearly as widely reported, but if you read market commentary sites (like this one from Yahoo), it will almost always mention how well credit is flowing. Another under-reported item to watch is the LIBOR rate. LIBOR is the London Inter-Bank Offered Rate, or the rate at which banks will lend money to each other. Historically, this rate has served as a reliable barometer for international credit liquidity. When you see credit returning to the market place, that will be the first real sign that this crisis is coming to an end. Also, remember that it will be several weeks or months before the Treasury’s $700 billion starts to get spent. The markets will price it in from an expectations point of view today, but real buying power will not begin to materialize until this starts to happen.

Most of all, try to stay calm. I wouldn’t dare try to offer financial advice to a faceless mass of strangers, but I do suggest you keep a close eye on your investments and make trading decisions (both buy and sell) based on clear, rational thought. Panic and emotion most often lead to bad investment decisions, and the tendency to rely on those feelings these days is way too prevalent.

Good luck everyone, and thanks for reading.

Topics: Money Talk | 30 Comments »

30 Responses to “What Happened? A Summary of the Financial Crisis”

  1. Allen Taylor says at October 7th, 2008 at 11:00 pm :
    Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

  2. Dan Waldron says at October 7th, 2008 at 11:16 pm :
    I discovered your homepage by coincidence.
    Very interesting posts and well written.
    I will put your site on my blogroll.
    :-)

  3. Tony Orlando says at October 7th, 2008 at 11:44 pm :
    Can you tell me who did your layout? I’ve been looking for one kind of like yours. Thank you.

  4. Ilya says at October 8th, 2008 at 9:42 am :
    I applaud your patience in putting this together, Brian! And, boy, am I glad to have friends who can do such heavy lifting for me and leave me to point in their direction with a simple instruction of “go read what he wrote”.

    Actually, this is exactly what I’ll do on my blog: Link to this post more prominently than from a comments thread.

    Thank you for doing this!

  5. Konstantin says at October 8th, 2008 at 12:08 pm :
    Good show. Very educational. It also brought a question to my mind, given that even when i try to understand economics i fail miserably.

    With the bailouts, and goverment intervening into the economy, doesn’t make more sense at this moment to invest into goverment bonds?

  6. Eric says at October 8th, 2008 at 1:33 pm :
    Thank you. I’m more educated, now.

  7. Jeff Porten says at October 9th, 2008 at 12:22 am :
    Excellent post. Stream of consciousness reply.

    FWIW, the shortest televised summaries I’ve seen of the crisis and bailout, that also seem to reflect what I’m reading at greater length, are what Obama is saying in his speeches. This not meant to be a partisan support line — Obama is not saying much in his speeches about bailout alternatives that I’ve read about on DeLong and Krugman that I think I prefer. But what he is saying seems to be more newsy and informative than what I see the pundits saying.

    Question that I didn’t see you address on first read-through: at a 50-1 leverage ratio, the implication is that the average American household should have around $1.5 to $2 million in purchasing power. (Yes, I’m conflating income with assets. That’s because Americans have no savings.) This strikes me as ludicrous. So what is the role of the markets and the regulators in preventing this kind of overheating, or in maintaining DeLong’s proposed sane ratio of 10:1?

    Regarding complexity: it seems to me that the result of much of the derivatives market (explicitly or implicitly, I’m not sure) is to ratchet up the level of complexity such that you can get away with things that are impossible at the “normal” level of doing business. DeLong has an excellent post about Martingale schemes which make high returns seem to have low risk — until the bottom falls out in a big way. I have trouble believing that the smart people who design derivatives don’t understand this and design for it — and at the same time, I’m unable to propose a regulatory standard to prevent excesses and Ponzi schemes.

    Something you don’t address in discussing subprime: several of the articles I’ve read said that many subprime mortgages were sold to people who were eligible for prime — but who were sold on the bigger interest rates in return for the chance to get more house. Likewise, commissions on sales were larger for subprime mortgages. As I see it, since the buyer is usually the underinformed party in these arrangements, I’m more comfortable placing the lion’s share of the blame on the sellers. At the very least, one would expect the bankers to have a better grasp of the tragedy of the commons than an individual buyer.

    Regarding regulations — and having sat through a thousand small business mixers where everyone was talking Sarbanes-Oxley compliance — I think there’s a flaw in your logic. We can agree that some areas are highly regulated, perhaps over-regulated; that said, that doesn’t mean that there is sufficient regulation in all areas of the banking sector. I find it very striking that you can listen to an FDR speech and it sounds like it was given Monday (and equally striking the difference in tone between FDR and GWB), which implies to me that we’ve been collectively asleep at the switch regarding the lessons of history.

    Dennis Kucinich mentioned last week that the size of the derivatives market is $500 trillion, which I find flabbergasting. (And credible, given the number I’m hearing of $50 trillion in credit swaps alone.) Is there a point at which the government has a role in cooling down this sector, purely based on dollar volumes which would swamp the ability to affect a downturn?

    Liquidity question: given that there must be *some* institutions with assets that are theoretically available for lending, why doesn’t a credit crunch create a market opening for high-interest rate loans? Corollary question: why is it so unquestionable that the Fed or the Treasury can’t simply make consumer loans themselves? $700 billion is over $2,000 per capita, which in turn would be a huge jolt into the consumer end with presumably lower interest rates than credit cards — I presume liquidity can trickle up as well as down?

    Re: “the fat cats destroyed the economy”. Yes, that’s an oversimplification. But the core of the argument is that unbridled capitalism (let’s sell as much as we can, at the highest possible margin) collectively bypassed whatever safety valves might have been in place to get us here. I think there’s a public perception that the class of people who got rich doing this are not likely to crash as hard as everyone else who merely did well without getting rich — and so there’s an unfair apportionment of punishment versus culpability. Let me tell you — you want to see these concerns publicly addressed. A return to 1890s-style populism is *not* a healthy place for us to go, unless you’re a fan of class riots, violence, and property destruction (by rioters and police alike).

    Finally — your conclusion doesn’t address the floating concerns about either a full-scale meltdown into Great Depression-style misery, or the potential for this to switch us to a new era of capitalism as different from what we’ve had as that one was from the gold standard. Personally, I think the pundits are ignoring the power of the aforementioned populist revolt if things get really bad — and “really bad” is likely to be a much higher threshold than 1930s numbers, given the higher expectations we have today. Your thinking?

  8. Sharon says at October 9th, 2008 at 11:10 am :
    Brian, no need for you to wonder how I found your site. I simply followed Ilya’s comment on his website to here.

    This was actually quite a succinct blow-by-blow explanation of the credit crisis and I must commend you for taking the effort of laying it all out in one place. Funnily enough, I found myself interjecting aloud at various points as I read, only to scroll down and see that you cover my thoughts later.

    I, too, appreciate your ‘heavy lifting’ and will lazily point friends, family and colleague to your post in future.

    Thanks for a good candid nuts-and-bolts read.

  9. Brian says at October 9th, 2008 at 10:18 pm :
    Thanks to everyone who commented. It’s gratifying to know that the post was helpful and educational. That was my intent, after all. To some specific questions:

    Konstantin @ #5:

    With the bailouts, and goverment intervening into the economy, doesn’t make more sense at this moment to invest into goverment bonds?

    Government bonds (or “T-Bills”) have always been thought of as the least risky investment in the world, principally because the U.S. Government always services its debt on time and in full. Of course, this is only made possible these days by the fact that the government allows itself to run a deficit if it doesn’t have the cash on hand to make such payments.

    Is this a good time to invest in T-Bills? Well, I would never try to give investment advice to someone who’s portfolio I wasn’t familiar with, and even then, I’m not a financial advisor, so my advice is truly worth what you paid for it (i.e., zero). I will say this: you need to determine how much risk you are willing to take. The stock market is certainly more risky over the last three weeks than it was before that. If you have money to invest and want the lowest possible investment risk, T-Bills aren’t such a bad idea. If you’re talking about selling stocks and putting the money into T-Bills, then I’d truly defer you to someone who knows much better than I. Selling something when it’s price is very low is obviously something you want to avoid. The question is, have we hit the bottom yet? Every day it seems like we must have, and then the next day proves us wrong.

    Sharon @ #8: I’m glad I covered all the points you were curious about. If you ever have any other questions, feel free to reach out here in comments, or via e-mail. I will answer whatever I can here on the blog, Ilya Burlak style…

    Speaking of asking good questions, we turn to Jeff Porten @ #7:

    So what is the role of the markets and the regulators in preventing this kind of overheating, or in maintaining DeLong’s proposed sane ratio of 10:1?

    This is, of course, a matter of opinion. I don’t think the markets, in general, can dictate the leverage ratio of an average American family. That’s up to the family. All the videos and photoblogs of my recent house construction are a clear indication that my family has been increasing it’s leverage ratio lately. Not a great for it with all of this occurring, but I think we’ll be OK. As to the broader question of regulating the leverage ratio en masse, there are definitely things that can be done. The Federal Reserve has been cutting interest rates, injecting billions of dollars into the market at various times & places, and working with other central banks around the world (even China), to try and get the credit markets on equal footing. Everything I’ve seen and read seems to give them pretty high marks for effort, although obviously, nothing has worked as of yet.

    it seems to me that the result of much of the derivatives market (explicitly or implicitly, I’m not sure) is to ratchet up the level of complexity such that you can get away with things that are impossible at the “normal” level of doing business

    It’s true that derivatives markets provide the opportunity for additional gains (and losses) by creating more complex financial products. Also true that more complex instruments are more susceptible to fraud and deception. That said, I’m not sure I’d agree with your implication that derivatives were created to cover up bad behavior. To reach that conclusion, you’d have to say the same about mortgages in general, no? It’s certainly simpler to buy your house with cash, but a vast majority of Americans would wait decades before they could accumulate that much cash.

    schemes which make high returns seem to have low risk — until the bottom falls out in a big way.

    Key word in that sentence is seem. High returns always come at high risk. There’s no getting around that (at least not in a capitalist system). Care to share the link to these articles you’re quoting, by the way? They sound like interesting reads…

    many subprime mortgages were sold to people who were eligible for prime — but who were sold on the bigger interest rates in return for the chance to get more house

    True. Adjustable rate mortgages were designed specifically for people who don’t have enough cash to take a loan right now, but expect to have it in the future. The problem we hit over the last few years were the people who thought they could always generate that future cash by selling (or borrowing against) their existing collateral at appreciated values.

    As I see it, since the buyer is usually the underinformed party in these arrangements, I’m more comfortable placing the lion’s share of the blame on the sellers.

    You and I (predictably, I might add) see this differently. If the buyer is underinformed, I think that’s entirely the buyer’s fault. No one should borrow enough money to bankrupt them later without understanding what they’re getting into. Should the sellers be altruistic and dissaude the buyers from buying? I think that’s a lot to ask at the point of sale. Now, if someone’s a financial advisor (paid to advise their client, not to make commissions on sales), then yes – their role is to advise against such foolhardiness. But the seller? How would you feel if someone at an Apple store told you you couldn’t have the new Mac laptop you wanted because he/she didn’t think you could afford it, even though your credit card hadn’t reached it’s limit yet?

    We can agree that some areas are highly regulated, perhaps over-regulated; that said, that doesn’t mean that there is sufficient regulation in all areas of the banking sector.

    I agree completely. Several politicans of late (including Hank Paulson, I believe) have referred to our 20th century regulations governing a 21st century market. I take this to be in reference to the market conditions I described in my post, and the ineffectiveness of current regulations to deal with that. Where I depart from both Presidential candidates, though, is the nonsense about “deregulation” vs. “more regulation.” You’ll note that no one who is calling for more regulation is describing what sort of regulation they want. What we need is changed regulations – such that the laws are more in line with the markets. I’m a bit nervous that whoever wins the White House will pass regulations for the sake of regulating, and that the burden on the banks will far exceed the benefit. Of course, I hasten to add, I am not unbiased in this regard, so take my comments with a large grain of salt.

    Is there a point at which the government has a role in cooling down this sector, purely based on dollar volumes which would swamp the ability to affect a downturn?

    Funny you should say that. I tried in my post to stay away from my own opinions/ideas, but one of my “on the sidelines” observations in the past has been something along the lines of the stock market curbs for the derivatives markets (definition: if the stock market tanks by a certain amount in a single day – and no, even with all of this, we haven’t hit that yet – the market itself shuts down for an hour or more, in order to let trades settle, let cooler heads prevail, and let companies react appropriately). I think a “time out” would have helped matters in the last few weeks – not solved any problem, mind you, but allowed banks to prepare for what was to come and maybe kept a few banks in business. All of that said, I don’t think the volume itself is the issue – a $500 trillion market is the same as a $100 trillion market, just with five times as many trades…

    why doesn’t a credit crunch create a market opening for high-interest rate loans?

    It’s a confidence issue. The credit markets, in the past few months, have decided that they don’t want to make loans at any price. It’s not so much about ability to pay back – it’s the concern that it would weaken their balance sheet, and they wouldn’t be able to sell them off if a crisis ensued.

    I presume liquidity can trickle up as well as down?

    Possibly, but it trickles down much faster and more effectively than it trickles up. If the Fed (or any bank for that matter) gave everyone $2,000, some would save/invest it with a bank, which would put it back into the economy and benefit employers, markets, etc.. But many of them would spend it or use it to pay down existing debt, which tends to benefit one other party and then stop. Remember George W. Bush’s famous “rebate” checks (once in 2001 and again in 2008?) They kept the retail markets moving and lowered the consumer debt levels a bit, but they didn’t help grease the credit markets like interest rate cuts and (hopefully) the buying of toxic assets will.

    I think there’s a public perception that the class of people who got rich doing this are not likely to crash as hard as everyone else who merely did well without getting rich — and so there’s an unfair apportionment of punishment versus culpability.

    I agree with you about the perception, as well as your conclusion that it’s unfair. If a stock drops 50%, everyone who owns the stock loses 50% of it’s value, regardless of how rich that person is. Not that I’m calling for telethons for CEO’s, but just as a quick example: Dick Fuld (former CEO of Lehman Brothers) personally lost roughly $750 million when Lehman collapsed. And yet, there are many out there who are assuming that somehow, someway, he walked away from this unscathed (or even benefitting). I know some of this in unavoidable (people will always look for scapegoats), but I hold the media (particularly the financial media) and our politicians to a higher standard than that.

    [What about] the potential for this to switch us to a new era of capitalism as different from what we’ve had as that one was from the gold standard. Personally, I think the pundits are ignoring the power of the aforementioned populist revolt if things get really bad…

    Well, I think that given the timing of this, the “populist revolt” will take the form of the 2008 election. There will be a great deal of irony if things meltdown as you’ve described before November 4th, and the incumbnets in Congress lose their seats over it (i.e., we wind up with a Republican controlled House). As to riots in the streets, etc., I think there are two factors today that didn’t exist back then that will prevent that: first, there are more outlets to express frustration (public forums like the internet, talk radio, 24-hour news channels, etc.). Second, the economy has grown complex enough that despite the frustration, I think everyone pretty much agrees that we need to turn to people who can fix this and demand that they do. I don’t see a populist solution appearing any time soon…

  10. Brian says at October 9th, 2008 at 10:26 pm :
    Tony Orlando @ #3: My layout was based on a WordPress theme called “Ad Clerum” by RFDN (click on the link at the bottom of the page for more info). I made many modifications myself, though. If you have specific questions, I’m happy to tell you what I did and how I did it.

    Ad Clerum can be found here. Other themes like it can be found at the Theme Terminal site.

  11. Ilya says at October 10th, 2008 at 12:35 pm :
    If a stock drops 50%, everyone who owns the stock loses 50% of it’s value, regardless of how rich that person is. Not that I’m calling for telethons for CEO’s, but just as a quick example: Dick Fuld (former CEO of Lehman Brothers) personally lost roughly $750 million when Lehman collapsed.

    There is one problem with an attempted objectivity in regards of who loses most: Absolute values matter a lot more on the low end than at the high end. regardless of how much Fuld has lost overall, I have a feeling that he is still a comparatively rich person. A multi-millionaire, no doubt. Whereas if I lose “only” 50%, I slide from having been comfortable to just one step above struggling.

    I think the perception discussed herein is perfectly valid: Those who made it big are losing huge amounts of money, but will end up relatively in one piece, whereas those less fortunate are and will be awfully insecure for the foreseeable future.

  12. Will Fenton says at October 14th, 2008 at 6:36 pm :
    Nicely done, Brian. I’m probably going to send this out to all of my colleagues, as well as many of my students who may be wondering what all the fuss is about. We may disagree on a variety of points (I’m with Rico et al, on the actual validity of trickle-down economics), but I really appreciate the work you do to make sure you’re both understood, and that your readers understand. Keep up the amazing work, and I hope the family is well.

    Cheers!

  13. Brian says at October 15th, 2008 at 10:46 am :
    Will – please feel free to distribute to anyone & everyone who might be interested.

    Our e-mail discussions around trickle-down economics ventures well into the realm of opinion, so it doesn’t surprise me that we have disagreements there.

    In this post, I attempted to stay away from opinion and stick to facts (except for the “controversy breaks”), so that it could apply to a much wider audience & a much wider purpose. From your comments, it seems to have succeeded.

    If anyone has any questions, please tell them to feel free to reach out to me, either here in comments or directly via e-mail.

  14. Jeff Porten says at October 18th, 2008 at 1:52 am :
    That said, I’m not sure I’d agree with your implication that derivatives were created to cover up bad behavior. To reach that conclusion, you’d have to say the same about mortgages in general, no?

    I didn’t say that about all derivatives; it seems to me that futures and options markets are perfectly useful things to have around. But my guess is that if we could review a master list of “all derivatives invented since 1998″, there’d be a much higher percentage of dodgy stuff going down in those securities than in the rest of the market.

    Likewise, I think most mortgages are a good thing. Where I think the mortgage market went sour was that the entire system was rigged in favor of building new and trading up. Bankers make money by selling debt. The government gives tax breaks on ownership, but nothing to renters. People like to live beyond their means. Somewhere in that cycle you have to put on some brakes.

    Key word in that sentence is seem. High returns always come at high risk. There’s no getting around that (at least not in a capitalist system).

    Sure, but I don’t think people were widely disseminating this essential truth until a few months ago.

    Here’s an analogy: let’s say you’re designing a casino game. Most games that become successful do a great job of what’s called “hiding the losses”; the casino’s edge is always in operation, but a good game won’t make that obvious. In poker, you don’t notice the $4 rake when you take down a $40 pot of other people’s money. In blackjack, you don’t pay attention that you still lose your bet when both of you bust. A game that paid you 225-1 only when you rolled 6-6-6 on three dice would fail immediately; no one wants to lose 99.5% of the time, even though it’s a net-positive game for the player.

    I think that’s what we’re seeing here. The banking industry (and, let’s face it, many others) played “hide the risk.” You can do that for a while, but the longer you play the game, the bigger the losses when the casino edge kicks in.

    The nut of the problem is that there’s some risks we can tolerate and some risks we can’t. But it’s unclear to pretty much everyone when we’re taking a risk with consequences beyond what we can handle.

    Care to share the link to these articles you’re quoting, by the way? They sound like interesting reads…

    The two economists I’m reading religiously these days are Paul Krugman and Brad DeLong. I have a dozen other bloggers moved up into my “top reads” folder who get read daily, who have also sent me to plenty of interesting tidbits. Will gladly enumerate those if you like.

    If the buyer is underinformed, I think that’s entirely the buyer’s fault. No one should borrow enough money to bankrupt them later without understanding what they’re getting into.

    Easy to say this, hard to disagree, and yet when there are millions of people out there who have massive credit card debt accruing loanshark interest, I think it’s a problem that goes beyond “stupid people have to fend for themselves.” I have no idea where that tipping point is, though.

    How would you feel if someone at an Apple store told you you couldn’t have the new Mac laptop you wanted because he/she didn’t think you could afford it, even though your credit card hadn’t reached it’s limit yet?

    I’ll give you a better analogy: how would I feel if 7-11 stopped selling me cigarettes because they’re bad for me? Yeah, that would suck — and I definitely see the relationship between what I’m advocating and this.

    That said, the key here is “credit limit.” The industry wants to set this high enough to, frankly, max out their customers to the edge of what they can afford. That limit is going to be a lot higher than what people can sensibly buy. That doesn’t strike you as a systemic problem? I don’t particularly want to rely on a system where every American must practice constant self-control and delayed gratification.

    I’m a bit nervous that whoever wins the White House will pass regulations for the sake of regulating, and that the burden on the banks will far exceed the benefit.

    Care to share examples of worst-case scenarios here? I’m having trouble seeing how this plays out.

    The credit markets, in the past few months, have decided that they don’t want to make loans at any price. It’s not so much about ability to pay back – it’s the concern that it would weaken their balance sheet, and they wouldn’t be able to sell them off if a crisis ensued.

    Right — which is why my question concerned non-banks filling the market opening for loans. Say a small business needs working capital to stay in business while its customers are slow-paying; they go to the banks, but the banks aren’t helping. The business is facing bankruptcy over a short-term capital problem; why haven’t pools of private investors surfaced to front them this cash when the interest rates they could make would likely be quite high?

    If the Fed (or any bank for that matter) gave everyone $2,000, some would save/invest it with a bank, which would put it back into the economy and benefit employers, markets, etc.. But many of them would spend it or use it to pay down existing debt, which tends to benefit one other party and then stop.

    I find this laughable. So if you put money into a bank, that’s good for the economy. But when you give money to people, and they spend it, the money vanishes forever, because the businesses that sell them things take that money and use it to make bonfires and toast marshmallows.

    You say that 100% of bank money goes into good economic stuff. Is that actually true? Banks never lend money that “goes one place and stops”? Or invest in bad businesses?

    Let me rephrase the question — you’re the Wharton guy. Money moves around, right? Give me the macroeconomics 101 lecture which I missed on why money moves better from the top-down than the bottom-up. Or send me to a link I might trust. Because where I’m sitting, what you’re arguing might be economics orthodoxy, but the forty-year sociology experiment has shown different results. On the other hand, when writing the preceding paragraphs, I realized that I am genuinely befuddled on how a dollar can “stop”, and how a dollar spent at the bottom or the top can have differing effects. Despite the sarcastic tone, the request for a long answer (a new blog post, maybe?) is sincere.

    I agree with you about the perception, as well as your conclusion that it’s unfair…. Dick Fuld (former CEO of Lehman Brothers) personally lost roughly $750 million when Lehman collapsed. And yet, there are many out there who are assuming that somehow, someway, he walked away from this unscathed (or even benefitting).

    Here’s the thing, though: 10 seconds in Google tells me that if he lost $750 million, he’s down to having $250 million left over. You misread my intention when I said “unfair” — the “unfair” part that I meant is that I don’t see it as “punishment” that poor Dick Fuld is going to have to learn to make ends meet with a net worth of only a quarter-billion dollars.

    Corollary example from yesterday’s Post: page A1, a story about people with cancer and MS who are skipping treatments they can’t afford, or trying to home-treat their kids using the Internet. Page A2, Dick Cheney’s latest government-insured hospitalization. Logical correlation between these two stories: zero. Emotional correlation: the deciders aren’t hurting the way other people are.

    I think that given the timing of this, the “populist revolt” will take the form of the 2008 election. There will be a great deal of irony if things meltdown as you’ve described before November 4th, and the incumbnets in Congress lose their seats over it (i.e., we wind up with a Republican controlled House).

    Hardly. The American dynamic of “throw the bums out, but I love my own particular bum” is riding high this year. The Democrats are largely protected by the narrative that George W. Bush has mephistophelean powers that prevent the Good Ms. Pelosi from doing her job. (If you infer from my sarcasm that I think the 2000-2008 Democrats are ineffectual opposition who will be trashed by history nearly as badly as W, you’re correct.)

    That said, I see this going one of two ways in the next few years. On the one hand, Obama could be the greatest president since FDR, for precisely the same reasons FDR was — he’s got the same mix of foreign and domestic crises and the same opportunity to radically change the American political system for the better. (And if the narrative becomes that the first African-American president is also a great president, it will be all the more easier to put him up there in the historic rankings with FDR and the Mount Rushmore types.)

    On the other, if things go badly — and the Republicans resume their Clinton-era tactics of throwing Vince Foster and Travelgate mud at him at every opportunity — you run the risk of disengaging wide swaths of both parties from the political system entirely. That plus an economic meltdown is precisely what leads to the political nightmare I described earlier. The most powerful revolutionary movements have come when a large middle-class lost their privileges and edged into poverty; you’ll pardon me if I see a resemblance to current demographics.

    As to riots in the streets, etc., I think there are two factors today that didn’t exist back then that will prevent that: first, there are more outlets to express frustration (public forums like the internet, talk radio, 24-hour news channels, etc.).

    That’s a very interesting point, and I agree that this can act as a safety valve. It can also act as a fantastic grassroots organizing tool for speeding the revolution. How’s this for a scenario: DHS monitors online planning for a major protest and sends the 1st Brigade Combat Team to break it up. People die in the process, which sparks a huge “insurgency” out of what had previously been a chaotic but peaceful organization.

    My gut feeling is, “let’s vent about it” works great when people are merely angry. It doesn’t cut the mustard when they move into desperation.

    Second, the economy has grown complex enough that despite the frustration, I think everyone pretty much agrees that we need to turn to people who can fix this and demand that they do. I don’t see a populist solution appearing any time soon…

    That presumes a trust that the leaders in question care enough and have the capability to make that fix. I think that trust is thin now, and might snap entirely. I also tend to think that the offhand dismissal of “populist solutions” by the mainstream elite has quite a lot to do with the amount of heat that’s being added to the simmer.

    Truth is, we don’t have revolutionary movements here often, and the ones we do have tend to be smallish and fizzle quickly. The danger is in the perception that American exceptionalism will magically protect us from this forever — and really, I’d rather see policies in place, with a populist impulse, that are aimed at avoiding answering that question.

  15. FamilyGreenberg.Com - Buried in the financial news - a positive sign? says at October 20th, 2008 at 9:17 am :
    [...] What Happened? A Summary of the Financial Crisis [...]

  16. FamilyGreenberg.Com - When will we learn? says at October 29th, 2008 at 12:25 am :
    [...] If the banks are not lending because they are gun-shy to do so, even though there are qualified borrowers out there looking for money, then the White House is right to apply pressure. That pressure should be based on good business practices and benefits to the banks/economy, not some veiled threat about federal power over the banking industry. If, however, banks are not lending because they’ve toughened up their rules about who they’ll lend money to, then the White House should be encouraging solvent potential borrowers to step up and borrow money (and subsequently invest it in the economy), rather than back-handedly suggesting that we put ourselves right back in the same situation that caused the Current Financial Crisis(TM). [...]

  17. Jimmy Iaccobucci says at February 9th, 2009 at 6:34 pm :
    Just a quick question. But feel free to give a long answer, you’re the first one I’ve seen that actually understands what happened and gives a full explanation instead of giving sound bites like “the fat cats are greedy” or “people didn’t pay their bills.”

    Lets take Capital One for example, I’ve read their ABS stuff online and their 10-K statements. Every month they sell all their credit card loans to a Special Purpose Entity, I think its Capital One Multi-Asset Execution Trust now.

    a.) If you’re trading debt for cash at 99.87% of its cash value every month, doesn’t that effectively eliminate the efficacy of the reserve requirement? Wouldn’t that eliminate one of the Fed’s most important tools for controlling the money supply?

    b.) When people default, the amount of the default comes out of interest payments due the investors of the asset backed security. So how can Capital One then turn around and try to collect the full amount plus interest and fees from the debtor? Isn’t that double dipping, selling a note to a third party and then turning around and trying to collect on the note from the borrower? It repeatedly states in their own investment literature that they are not obligated to collect on default accounts and pass the proceeds to investors.

    I was just wondering if any of this makes sense to you or not. I’ve tried explaining this stuff to my friends but their eyes glaze over before I even start to explain tranches and subordinated debt.

    Thanks

  18. Brian says at February 10th, 2009 at 1:48 am :
    Jimmy @17:

    Glad you enjoyed the post. I don’t have complete answers for you, but I’ll do my best:

    a) I don’t know anything at all about Capital One’s corporate structure, but I can only assume that their Special Purpose Entity is fully disclosed (unlike, say, Enron, who hid their SPE’s offshore to make their balance sheet look healthier than it was, duping thousands of investors into buying the stock with a false sense of leverage). Assuming that’s the case, the parent entity would still fall subject to the reserve requirements. Then again, they must have a reason for doing things this way, so perhaps this is a complex way of avoiding regulation? If so, I would hope that investors like yourself, who have done their research, would factor their excess risk into the price of the stock.

    Also, and this is probably a nit, but these regulations don’t (directly) control the money supply – they control the aggregate risk in the marketplace. Of course, healthy banks increase the money supply more quickly, so yes – everything affects everything else – but I thought I’d make that point clear, just in case.

    b) If Capital One did, indeed, collect the full amount plus interest and fees from the debtor, and then made less than full payment to the asset-backed security, then yes – that would be double-dipping (or worse, fraud). But “default” means that the debtor did not make a full payment, so the question kind of collapses in on itself.

    As for the glazed over eyes of your friends, believe me – I know of what you speak. Especially nowadays, when the rhetoric around executive compensation and corporate jets has gotten so loud, it’s almost impossible to discuss the crisis in terms of what it actually is – a credit crisis.

    Thanks for reading & good luck…

  19. Jimmy Iaccobucci says at February 10th, 2009 at 3:13 pm :
    Thank you for taking the time to answer my question, I haven’t had much luck finding anyone to bounce my theories off of.

    Essentially this is why I’m interested:

    I went to college for engineering and racked up close to $100,000 in debt in getting just a bachelors degree in biochemical engineering. Being naive I thought I would be earning at least 50k a year, in fact I’m making 30k with no end in sight. To make a long story short I can’t fulfill my debt obligations, I pay everything I can but after taxes, a $500 a month apartment and $200 in heat and electric I simply can’t afford to meet all obligations. I’m just saying this so you know I’m not a scumbag and looking for an easy way out.

    Anyway, most of my creditors cut my interest rates, work with me so I can pay what I can, stopped late fees, etc. However, Capital One decided the best course of action would be to sue me in civil court. So I had 30 days to file an answer with the court. After a little research on some chat boards about dealing with credit collectors it seems some people have stumbled on to the fact that if you challenge them to produce the note they will drop the case. I found that interesting, especially since some of these people owe upwards of 20k, that they can’t or won’t produce a piece of paper for 20k. People chalk it up to not being worth the time for the creditor to show up to court, however that doesn’t make much sense, seeing as how when people hire a lawyer the creditors do show up and fight it, and they fight it every time unless you challenge them to produce the note.

    So that’s when I started to research the debt securitization structure to see if there was more to it than that. Its turns out that in late 2007 in either the Northern or Southern District Of Ohio Federal Court (I can’t exactly remember which one) Deutsche Bank started foreclosure proceedings against someone. When judge Bloyko noticed that there was no note attached to the complaint he asked the Plaintiff’s attorney to produce the note. They came back with something like “an intent to convey” the note, the judge was like what the heck is this? Eventually the judge dismissed the complaint and the Deutsche Bank people got all fired up and proffered from disparaging remarks after the trial basically saying the judge is just too stupid to understand the complexities of debt securitization.

    So, me being curious and all, I filed my answer and admitted every paragragh of the complaint.

    1. Yes, Capital One bank is a national Banking Association.

    2. Yes, I reside in the city where this court has jurisdiction.

    3. Yes, plaintiff offered me credit.

    4. Yes, I accepted the offer.

    5. Yes, I fell behind on payments.

    6. Yes, plaintiff made due demand for the debt.

    7. No, I don’t I owe the plaintiff a few grand plus attorney’s fees. Capital One securitizes some or all of their loans. As soon as they transfer the loan to the SPE for cash it constitutes a sale of the underlying debt according to the FDIC. Therefore the Plaintiff lacks standing. (The plaintiff is listed as Capital One Bank not Capital One Multi-Asset Execution Trust or anyone else)
    Further the Trust then sells them to Investment Banks who hold onto the highest rated classes and more senior notes, then sell the more the junior notes to other investors. Those Investors may have standing, but certainly not Capital One. Further, Capital One is committing fraud by bringing this complaint seeking the full amount plus fees.

    Obviously, the actually answer was a little more formal and in legalese. But the above was the gist of it.

    I filed my answer a few weeks ago and still haven’t heard from them, I’ll be filing a motion to dismiss with predjudice next week. If they really did have standing, and I admitted everything, making it real easy for them. Why wouldn’t they take the 20 minutes to show up in court? The attorney’s fees would be about $300 and it would be tacked onto my debt.

    Have I stumbled onto something, or is there something I’m missing that jumps right out to you? I’m just not sure if I should bother seeking damages in Federal Court to compel them to stop this practice. If they are “double-dipping” its fraud. But is there something I don’t understand? Plus its gonna be a real challenge for an engineer with no legal training to bring this thing Pro Se. I wouldn’t sue if they hadn’t sued me first, heck I never would have known about ABS. I’m not a scumbag looking for a payday, I just think that since I am capable of understanding the complexity and now that I do have legal standing to pursue this that I should pursue it even for moral reasons. I don’t care if I lose, I’ll pay them, I fully intended to pay them anyway.

    But if you see something you know is wrong with my arguments please let me know.

    Thanks Again

  20. Brian says at February 10th, 2009 at 4:46 pm :
    Jimmy @ 19:

    Well, the first thing I feel compelled to say is that I’m not a lawyer, so I wouldn’t recommend you depend on my opinion for your legal proceeding. That said, I can tell you what I think, and maybe it can help you seek out professional legal advice.

    First, I think that if it were as simple as Capital One Bank not having standing because they sold the note to Capital One Multi-Asset Execution Trust, then the suit would be dropped, and Capital One Multi-Asste Execution Trust would file suit the very same day. Like I said, I don’t fully understand the Capital One corporate structure or the legal mechanisms behind any of this, so maybe your maneuver is enough to say, “heck with it – nevermind.” But on the face of it, it sounds easily solvable on their end.

    Second, your theory that once the loan is securitized (i.e., sold in portfolios of asset-backed securities), then the seller is no longer allowed to collect sounds dubious to me (remember, I’m not a lawyer, so I could easily be wrong). My understanding of securitization is that the owner of the note is selling the revenue stream to the i-bank, not the note itself. I say this only because I assume the homeowner still pays the bank (not the i-bank) his/her monthly payment, so they must own the loan, no? Again, I’m just guessing. If you’re right, though, then once again, you’d think that the i-bank could file suit, but at that point you may have wiggled your way out, because your loan is now one of thousands in a portfolio, and pursuing each and every default is probably not worth it for the i-bank.

    As to your assertion of fraud or “double-dipping,” it seems to me that you took the loan and aren’t paying it back (best of intentions aside – I understand that you’re not a scumbag looking for a free ride), then you owe someone the money. If the various banks involved are going about getting that money the wrong way, that’s a procedural problem, not fraud. Again, IANAL and I could easily be wrong.

    I’d strongly suggest you talk to a professional lawyer who can help you out. Despite my best intentions, I could easily be wasting your time…

    Good luck!

  21. Jeff Porten says at February 11th, 2009 at 12:14 am :
    Jimmy — I’m not a lawyer either, but I also come at your problem from a different perspective from Brian, so I thought I’d share.

    First, I’m not as quick as Brian to assume that everything Capital One has done here is kosher. It sounds possible to me that steps they took in commoditizing your debt violated federal or state creditor/debtor laws, unwittingly or not. But it sounds much more likely to me that the question of whether they have is in a realm of law that’s beyond what you can figure out without professional training. (I can describe the work you do as a biochemical engineer, but that doesn’t mean that I’m sequencing DNA in my basement.)

    Second, it’s possible that they haven’t replied to you because you’ve found a legal defense that blows them apart. But I can think of two Occam’s Razor alternatives: 1) you’ve fallen through the cracks of an overworked legal team on their side, or 2) they figured out that answering you would cost more than the $20K cost of answering your claim.

    That said, if you are right, and you’re filing pro se, then suddenly it is very much in their interest to eat you alive, because there are a whole lotta people with a whole lotta debt in exactly your situation. I don’t recommend going this alone. Suggestions for places to turn for help that you might not have considered:

    1) You can call Legal Aid, but I’d say forget it. They’re overworked and likely to blow you off. That said, the phone call can’t hurt.

    2) Next call is to national nonprofit organizations who field lawyers on consumer issues; the first one who comes to mind is Consumers Union. Explain that you need help with a legal strategy; if it has merit and it’s applicable to many people, they’ll damn well get on your side.

    3) Likewise, writing this up for your Congresspersons (House and Senate) is a very good idea; you might want to cc the heads of various banking committees just to see if you get any traction. This is a low-likelihood but huge oooomph tactic.

    4) Finally, if your claim has any merit, well, we’re talking the biggest class action since the storming of the Bastille, so running this by a few private attorneys in that realm is probably also worthwhile.

  22. Jimmy Iaccobucci says at February 11th, 2009 at 12:53 pm :
    Brian,
    I definitely owe somebody, but what I’m thinking is that I owe the investors who took the hit when Capital One declared that I was in default. But now I’m not so sure, it does say something about Defaulted Accounts being deducted from the money owed investors, but it also says that monies collected on defaulted accounts are treated as Service Charges, it also says that defaulted accounts are pulled from the pool and transferred back to the Transferor (Capital One is actually much more complicated than simple securitization, they have several trusts, a commercial bank, an investment bank, a Funding LLC, and more…) Their investor literature basically gives every possible scenario for how it treats defaulted accounts and makes it as clear as mud. I don’t think I’ll pursue the countersuit, its such a muddled mess I can’t really be sure there is a moral argument.

    But I think my defense of their complaint is rock solid.

    You asked…
    ———————————————————–
    “My understanding of securitization is that the owner of the note is selling the revenue stream to the i-bank, not the note itself. I say this only because I assume the homeowner still pays the bank (not the i-bank) his/her monthly payment, so they must own the loan, no?”
    ————————————————————–
    ————————————————————-

    To answer your question, at least as far as Capital One is concerned, I excerpted the following from CO’s ABS pricing supplement, you can get a copy online here if you want
    http://media.corporate-ir.net/media_files/IROL/70/70667/abs/comet/Comet_Class_A_2007-3_Pricing_Supplement.pdf

    (Capital One Funding is yet another entity between the bank and the trust)

    ————————————————————-
    Prior to August 1, 2002, the bank treated its transfer of the receivables to the master trust trustee as a
    sale for accounting purposes. From and after August 1, 2002, the bank treats its transfer of the receivables to Capital One Funding as a sale. Arguments may be made, however, that any of these transfers constitutes only the grant of a security interest under applicable law.

    Nevertheless, the FDIC has issued a regulation surrendering certain rights to reclaim, recover, or
    recharacterize a financial institution’s transfer of financial assets such as the receivables if:
    • the transfer involved a securitization of the financial assets and meets specified conditions for
    treatment as a sale under relevant accounting principles;
    • the financial institution received adequate consideration for the transfer;
    • the parties intended that the transfer constitute a sale for accounting purposes; and
    • the financial assets were not transferred fraudulently, in contemplation of the financial institution’s
    insolvency, or with the intent to hinder, delay, or defraud the financial institution or its creditors.
    The bank’s transfer of the receivables is intended to satisfy all of these conditions.
    ————————————————————–

    So legally speaking (not morally speaking) Capital One Bank N.A. lacks standing, plain and simple.

    I’m wondering why they don’t file the suit naming COF, COMET, COMT as the plaintiff? Like in November 2007 when Judge Bloyko halted the foreclosure of 14 house in Federal court because the originators didn’t have the notes. Why wouldn’t the Trust then just refile the suit? Trust me city civil court is not Law and Order, these hearings usually last about 20 minutes with a hack lawyer
    from a diploma mill who just fills out forms, the guy would probably take their case for a tainted peanut butter sandwich and a smack in the face. You don’t even have to any law background to be a darn JUDGE! The guy who fixes our printers at work is judge in the next town over, I don’t think he finished high school. It seems like it would be worth the $200 in lawyer fees for Capital One to have someone show up to court.

    Oh well, I let you guys know what happens if anything. But I don’t think I’ll counter sue, I’ll just stick to defending against the complaint.

    Take it easy, and Thank You

  23. Brian says at February 12th, 2009 at 12:01 am :
    Jimmy @22:

    Thanks for sharing your story, and for sharing that research. I find it fascinating that, according to what I’m reading above, the bank that wrote the mortgage (Capital One, in this case) actually benefits financially if you default and then they collect, as opposed to if you simply pay on time. They have no way of incenting you to default, mind you, so the opportunity for abuse is low, but it’s still a strange set of rules.

    Anyway, best of luck in your defense, and please do let us know how it all turned out.

    I hope to see you around the blog in the future as well…

  24. Jimmy Iaccobucci says at February 25th, 2009 at 12:10 pm :
    Yup, they still haven’t done anything. Just a concilliatory letter asking me to call them and settle out of court for an extremely reduced price. And this time it was actually written and signed by a human being. The tone was much more subdued than their previous letters and the summons.

    Also, ABC News ran a piece today about how if you ask the loan servicer to produce the note they can’t and you can keep your house.

    http://www.yahoo.com/s/1035029

    Looks like my theory may be right, they definitely would show up to court for a $200,000 house if they could. They almost definitely have the original paperwork, the people in the news piece think its because when they sold their mortgage they sent the paperwork along with it, so the mortgagee no longer physically has it. But I think its almost surely all sold electronically, the loan servicer knows they would be committing fraud if they brought the original paperwork to court and tried to make it out like they never sold it.

    I guess we’ll see what happens but I definitely wouldn’t be investing in these asset backed securities right now.

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  26. jimmy iaccobucci says at October 15th, 2010 at 2:29 am :
    Looks much like a much more likely legal theory nowadays, eh?

    They’re starting to use words like “standing” to describe the securitization debacle in the mainstream press, no doubt the government will step in and ex post facto clear up this little minor paperwork error, sweep it under the the rug like a good little house boy cuts corners to please the plantation master so he may remain in the house and not be relegated to the fields.

    But allow me the juvenile satisfaction of saying “I told you so.” And having been emboldened by recent events,allow me unfurl before you the next logical conclusions I had in store back in early ’09.

    First of all, it is NOT a paperwork error as the media outlets who fall under same corporate umbrella as several banks would like you to believe, it is a question of legal “standing”. Standing means I have a right to sue you because you caused me injury. Lets say me, you, and guy named “Bob” exist. Bob steals your TV, I can’t sue Bob just because I’m aware that he stole your TV because Bob didn’t cause me any injury. Only you can sue Bob, because you suffered the injury. This is such a settled point of law that it is what i would characterize as fundamental to our legal system, to abrogate a question of standing in order to suit a particular purpose would have to override an immense and long settled corpus of law. It would be a “clusterfuck” if you will. Further, it would set precedent and cause a further “can of worms” to be opened down the line.

    Now, my financial status has changed significantly since the time I wrote of battles with Capital One. I could easily pay the debt now within a months salary, however, those that suffered the injury may not be party to the claim anymore given the tumultuous and uncertain nature of my now ethereal debt being held at various times and circumstances by unknown parties. Only those parties that suffered an injury, and only for the amount of injury can anyone seek relief. So each “investor” (I added quotes as evidence of my disdain for the term “investor” to characterize the purchasers of the pools, in fact I bet the unsuspecting common man’s pension or 401k is largely comprised of these unenforceable obligations unbeknownst to them) is allowed to sue the defaulting party for the specific amount of injury, after posting court fees and such which would generally exceed the amount of the claim by orders of magnitude.

    What my beef was in ’09

    1.) it is not that i owe, my own stupidity is my responsibility
    2.) it is not in the typographical errors of clerks
    3.) i seek only only to pay the rightful owners as if i pay the wrongful owner i’m still on the hook if the rightful one should he ever surface in the future
    4.) i wonder, given my newfound, yet still tenuous, burgeoning faith in the the American people to put 2 and 2 together and realize, “Hey, wait a minute, the Dow Jones is higher than before the crash yet my pension/401k/IRA/hedge fund/college savings/(insert government sanctioned yet administered by JP Morgan/Goldman Sachs/etc. investment vehicle designed to “assist” you simple folk here) is still off by 40% or more and is still bleeding like a stuck pig

    I think if #4 ever happens, if people ever realize their “retirement” is just mine and a pool of other crackhead’s bullcrap credit card debt, despite the knuckle-dragging union minded moron that toils in endless slavery and yet lacks the grit to confront the oppressor, if he ever found it in himself to steel his nerves and join fellow endentured folks en masse and not in isolation as I have, then i would count the other shoe as having been dropped. Until then, the American will continue to play host to this parasite and only seek to blame those nearest to himself without ever looking at the true nature of those things deemed outside the capabilities of his reasoning, even by the most foreign of laws, which continue to keep him as its supplicant.

    I never thought anyone, anywhere in mainstream media would ever have gotten as far as to even mutter merely the word “standing” in an article. Ah well, times change I guess, but if it ever gets to the point where the commoner realizes what he has been cheated from, nah, actually that would ever happen, Americans are sheep, born into slavery and forever content with that role.

  27. Brian says at October 15th, 2010 at 5:34 pm :
    @Jimmy #26:


    Lets say me, you, and guy named “Bob” exist. Bob steals your TV, I can’t sue Bob just because I’m aware that he stole your TV because Bob didn’t cause me any injury. Only you can sue Bob, because you suffered the injury. This is such a settled point of law that it is what i would characterize as fundamental to our legal system

    I am (still) not a lawyer, but what you say makes perfect sense to me. I will hasten to add, though, that the appropriate analogy would be more along the lines of: I borrow money from you to buy the TV and promise to give you the TV if I can’t pay you back, and then Bob steals my TV. You are not injured unless I go out and buy another TV with the money I would have given you.

    My problem with the rest of it is I don’t know all the rules. If you hadn’t defaulted, would Capital One still be legally able to collect payments from you, even though they sold the loan to an i-bank? If so, then I’d say they still lost something when you defaulted (even if they have no standing to sue). And if the i-bank’s contract is with Capital One, and not you, then I would think they’d sue Capital One if they felt they’d been wronged, not you. But again, I’m not a lawyer, and I don’t know the rules.

    Last point: The Dow Jones Industrial Average is an average of the prices of thirty of the most popular stocks on the NYSE & Nasdaq stock markets. If your pension/401k/IRA/etc. is invested in an index fund that tracks to the DJIA, then it is as high, relative to pre-crash levels, as the DJIA itself. That’s just simple math. If you’re invested in other things (riskier stocks, derivatives like options & futures, etc.) that didn’t do as well as the DJIA, then you may still see a 40% (or any other rate) loss. These times are not unique in that sense…

    In any case, I’m glad you’re back on your (financial) feet. And thanks for stopping back and keeping us updated. Come visit again soon!

  28. jimmy iaccobucci says at October 18th, 2010 at 5:05 am :
    Quick point of note on the proposed amendment to my analogy:

    You own a house worth $1,000,000

    I purchase the house from you for a promise to pay the $1,000,000

    You agree and an exchange is made.

    You then turn around and sell interest in the note on a pro pro rated basis to 10,000 other “investors” (i.e. hapless saps)

    I default

    you then stop payment to the investors, claim you are not liable to them because of stipulations set forth in your contracts

    you then turn to me, and in the same breath say I injured you and I must make you whole

    unfortunately, the law, no matter how downtrodden in recent times, actually makes sense despite the legalese, you can’t compel the court to action unless an injury has has been suffered by you specifically

    however, you broke up it up and sold interest to 10,000 people, now where are we:

    1.) each of those 10,000 people may come to my jurisdiction and file the court fees and serve me and i file my answer and then lo and behold they get their 1/10,000th of that million dollar mortgage which amounts to $100, and thats only assuming they can prove that you granted them 1/10,000th interest in it

    2.) the other scenario is you realize the legal ramifications and try to run a blitkrieg operation on the court and foreclose before you think i wise up to the scam your pulling. you see, the investors already paid you in full, now you are trying to collect the same from me, see the problem yet? probably not, i’m sure this is just a bunch of scumbags trying to wiggle out of an obligation, right?

    the problem is that you’re not seeing the big picture, which is understandable given the relative dearth of sentient conversation transacted via blogs and chatboards and in many respects is a fault is of my explanatory powers, however, i think i’m right, and actually it makes alot of sense

    A few common sense tenets of common law:
    1.) you can’t sue someone who hasn’t caused you harm
    2.) you can only sue for the amount of injury plus some clearly defined court costs

    this was designed over the centuries to prevent wackos like me from just filing a claim for every injustice i saw without being party to it, and now it just blew up in the faces of those classes of people who drafted it, and with astonishing effect i might add

  29. Brian says at October 20th, 2010 at 1:09 pm :
    @jimmy #28:

    I do understand what you’re saying, and I do agree that it makes sense. When I say “I don’t know all the rules,” I’m referring to the terms of the note you describe above.

    If the investors who bought that note are buying a share of the underlying mortgage owners’ payments, and the bank in question is simply reduced to earning a commission on the transaction, then I agree that going after the defaulting mortgage owner is fraudulent. The bank in question is no longer a party to the loan, and it suffers no damage from the default. Hence, it shouldn’t be able to collect.

    If, on the other hand, the two transactions are separate (other than one serving as collateral to the other), then things are very different. In that case, the investors have invested with the bank (not the underlying mortgage owners), and the bank has agreed to pay them based on a set of circumstances (in this case, the receipt of payment from the mortgage owners). If the mortgage owners default, then the bank doesn’t have to pay these investors their interest payment; after all, those were the terms of the deal. But separately, the bank is still owed payment from the mortgage holder, and the fact that the other note exists doesn’t change that. The bank would still be owed those mortgage payments, and should be able to recover them if they don’t arrive.

    These are legal technicalities and, like I keep saying, I am not a lawyer. The important thing, in my opinion, is that all of the investors know what they’re buying up front, and know what will happen in each eventuality. Once the rules are established and money changes hands, the rules should be followed, even if the wealthier of the two parties (in this case, the bank) comes out ahead.

    The mass vilification of the banks in the public sphere makes me question the latest spate of news stories, since none of them clear up the above point. Your comments seem to suggest that the first scenario is the truth, which would make the media coverage more accurate. And while you sound like you know what you’re talking about, this isn’t one of those situations where I can look to the media to validate your theory. Each case is likely unique, and the wording of the original contracts is (or should be) the ultimate arbiter.

  30. Collin Feraco says at March 25th, 2011 at 1:25 pm :
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