Three causes

Posted by on February 25, 2009 @ 9:36 am in economy

Trying to understand the global financial crisis? Confused by derivatives and default swaps and the commercial paper market?

Here are three ideas to explain it all: cheap money, surging debt, and bad credit.

Recipe for financial chaos: Take one large economy. Add cheap money—the lowest yields in 40 years. Encourage households to rack up big debts without any attention to long-term ability to repay. End result: a surge in credit card and mortgage debt, driving a consumption and housing boom in the economy. A big-screen TV, a new car, a bigger house, maybe even a vacation home—all available for “no money down” and with “low monthly payments.”

Commercial banks loved it. They borrowed money from depositors at low yields and made boatloads by investing in credit card and mortgage businesses. Investment banks loved it; they packaged up the debt into securities that institutional investors treasured because of their higher yields. Plus the I-banks minted profits trading the securities bought with borrowed money, at least for a while.

But there were only so many high-quality borrowers to go around. So, in an era of cheap money, the thinking went, surely it’s possible to lend to those with less-than-stellar credit records. Not surprisingly, credit quality deteriorated—not just among the subprime borrowers, where, by definition, credit quality is weak, but even among the prime borrowers.

One day, perhaps sometime in the summer or fall of 2006, somewhere in America, someone threw in the towel. Perhaps that person lost a job, faced big medical bills, or just couldn’t sell his house at a profit. Maybe he just decided to say “enough.” For whatever reason, he simply couldn’t pay his bills: He had too much debt and not enough income. He defaulted.

From one raindrop came a trickle, then a river. And now a flood, wreaking havoc throughout the system that financed it.

We’ve probably just lived through the largest debt-financed binge in American history. (I’m guessing at this, but it seems plausible: Everything is bigger these days.) Not all of us participated. Just enough of us, along with many (although not all) of our leading financial institutions.

A few years ago, the financial sector was producing nearly 40% of the corporate profits in America. We should have asked, “Where are these profits coming from?” The answer now seems obvious: cheap money, surging debt, and bad credit.

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