How did the Credit Crisis start?
The credit crisis started when people who had taken out mortgages they could not afford, or that had been incorrectly marketed to them, began to default on their mortgage payments. In the old days, when banks held people's mortgages this would have been bad for the banks. But, today, these mortgages have been pooled together and "sliced" by brokerage firms and other financial services companies into bond-like securities that were then sold on to institutional investors. The prevailing marketing point of view was that these securities were "safe." However, as interest rates rose and more and more people defaulted (stopped making regular payments) on their mortgages, there was no money flowing into the pool to pay the institutions who bought the bond-like securities. Huge amounts of these securities began to drop in value because there would be no money to make the payments. Then it was revealed which companies held the most of these securities. And the huge write downs began. In reaction to the staggering losses, banks and other financial services began to tighten credit for everyone. The period of easy credit came to an end.
Why did one part of the mortgage business — subprime loans — have such a widespread effect?
While, statistically, subprime mortgages represent a small part of the overall market, when people began to default on them, the markets got scared, and with reason. All of the securities were, at least in terms of the financial models on which they were created, supposed to be safe. They proved not to be. What if similar securities, using the same or similar mathematical models, were also not as safe? Would they also began to lose value soon? The domino effect began as people left the market and banks decided to reduce their risk by demanding the people who bought securities on margin (credit) deposit more money to maintain the position.
Why did Bear Stearns take such a hit?
Like many financial institutions Bear Stearns funds much of its day-to-day operations pledging securities that it owns with the promise of buying the back later at a higher, pre-negotiated price. It also is the counter-party (opposite side) in some trades, for which it may earn a fee. When the rumor started that Bear was in trouble, firms stopped wanting to trade with Bear Stearns because its creditworthiness had been compromised. With no one to trade with, the cash flows that normally sustain a firm came to an abrupt and unexpected halt. It was either merge, or go bankrupt. And if a firm the size of Bear Stearns, the fifth largest investment bank in America, went bankrupt, the repercussions in the financial markets in the U.S. and around the world would have been unpredictable, which is a nice way of saying it would not have been pretty for any of us.
What has the Federal Reserve done to ease the crunch?
The Fed has lowered interest rates in an attempt to avert more defaults on the variable rate subprime and other mortgages. And it has opened the "window" through which Federal Reserve banks have traditionally borrowed money to the brokerage firms. In short, the investment banks can now borrow money directly from the Fed. This will hopefully prevent the cash flow problems that Bear Stearns encountered with its counterparties.
How long will it last?
Who knows? The Fed and the government hope it begins to improve by the summer. But just look at all of the people who have lost their jobs, or been laid off as a result of this, and you have to wonder if his big, complex situation can be turned around in a few months. It took more than a few months to create.
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