Note:  The following analysis oversimplifies the origins and conditions of the current credit crisis, but the goal of this blog is to give the reader a framework within which he or she can make sound decisions about personal finances.

To give the reader some perspective, a simple overview using a time line is instructive.  But first, let me offer some necessary background so we can analyze the time line.   This situation has been referred to as a “sub-prime lending crisis.”  I think using that term understates, and really misses, the central problem and the cause of the crisis.  From roughly the mid-1990’s on, banks became more aggressive in residential real estate lending.  The banks did so because they found themselves sitting on a large amount of cash with no good place to invest it – especially after the collapse of Long Term Capital Management in 1998 and the tech-bubble bust, followed by a recession, in 2000.  So they sought the relative safety of real estate lending, but discovered/invented new ways of generating greater profits.  One of those methods was sub-prime lending – basically mortgage loans to borrowers with low credit ratings at much higher rates and fees.

Other methods included what is known as Alt-A mortgage lending – generally, these are loans to borrowers who have relatively good credit, but are unable/unwilling to document their income, employment, and/or assets.  These mortgages too were priced at higher rates and fees than traditional mortgages, albeit lower than what a sub-prime borrower would have been charged.  All of this was possible because the underlying asset in all of these transactions was residential real estate, and the value of those assets was increasing at unprecedented rates, thus ensuring that, regardless of whether the borrower repaid the loan on time, the banks would always be able to get out of the loan – usually by refinancing the mortgage using the newly inflated value of the property.

Eventually, the mortgage industry was generating such tremendous profits that the investment banks wanted a piece of the action.  Thus were born collateralized debt obligations or mortgage-backed securities – newly created investments based on the performance of a certain package of mortgage loans.  These investments became so popular that a large amount of foreign banks and governments bought in.  Credit default swaps were then created as a way to insure the collateralized debt obligations, and a whole new market opened just for the swaps.  How these investment vehicles work is incredibly complicated, and not worth our time to study.  What the reader should take away from this brief outline is that mortgage loans secured by residential real estate in the United States had creditors/investors that stretched around the world and included, small and large U.S. banks, foreign banks, investment banks, Fannie Mae and Freddie Mac, insurances companies, the U.S. government, foreign governments – essentially, every credit channel in the world.

Nothing goes up or down in a straight line forever, and housing values had increased consistently and dramatically over several years.  That ended in 2007.  When housing values ceased to increase and then began to fall, borrowers who had been happily refinancing their mortgages every year based on the increased value of the property, were suddenly stuck in their mortgages.  A large percentage of mortgages issued had adjustable rates.  As these rates increased, borrowers defaulted.  It doesn’t take much imagination to realize that those with the highest rates, sub-prime borrowers, would default first.  But even though the crisis began with those defaults, it has not ended there.  Default rates have risen across all types of mortgages.

Moreover, the current problem is one of credit availability.  When mortgage loan borrowers defaulted, everybody had their hand in the cookie jar.  So, banks stopped lending to each other and the credit system began to seize up.

Now, here is a short time line of what has been done to shore up the credit system:

1. August 17, 2007:  The Federal Reserve Board announced a reduction in the primary credit discount rate from 6.25% to 5.75%.  The primary discount rate is the rate at which banks in sound financial condition may borrow from the Federal Reserve Board’s discount window.  The discount window exists, generally, to help banks maintain liquidity in an emergency.  Banks usually borrow, much more cheaply, from each other on a short-term basis using the federal funds rates or the London Interbank Offered Rate (LIBOR).  The Fed lowered its rate in an effort to encourage banks to use the discount window, since lending between banks had decreased.
2. January 11, 2008:  Bank of America announces that it is purchasing struggling mortgage lender Countrywide Financial Corp.  This move saves Countrywide from going under.
3. January 2008:  The Federal Open Market Committee announces a surprise lowering of its overnight lending rate by .75 percent, and then lowers the rate an additional .50 percent 8 days later at its regularly-scheduled meeting.  This move was aimed at encouraging lending to stimulate an already slowing U.S. economy.
4. March 17/18, 2008:  The Fed brokers the sale of investment bank Bear Stearns to JPMorgan Chase by guaranteeing a large percentage of the purchase price.
5. September 8, 2008:  The U.S. Treasury takes over operations of  Fannie Mae and Freddie Mac and their combined $5.3 trillion of mortgages.
6. September 29, 2008:  Citigroup purchases the banking business of Wachovia Bank. The U.S. House of Representatives begins debate on perhaps the largest government intervention in history.

One can see that over the last year, the moves to try to solve this crisis have only become more dramatic and unprecedented.  The central issue is capital.  Banks cannot raise or borrow enough money to keep their operations going.  No bank will lend to any other bank because there is no accounting for the value of residential mortgages or the securities which they back, and there is no accounting of who is responsible for what portion of the losses.  Thus, the credit market is completely locked up.

The real danger here to the rest of us, is that banks do not have capital to lend to private citizens and businesses.  Without access to lines of credit, letters of credit and other borrowing mechanisms, many businesses will find that they cannot maintain their normal operations.  This means cutting back on production and personnel, which leads us to … layoffs.

In upcoming posts, we will try to focus on corporate defaults and the employment market to see how those areas are holding up in this crisis.  Raw Finance will also include some stock market observations and attempt to draw some analogies between the economy and stock market performance.  I will also add some financial tools to the site, or at least provide appropriate links.

Keep your head up and your debt down!

Cheers.