A House of Cards: Part 1

The current credit crisis has impacted multiple sectors of our financial economy. Home foreclosures are on the rise. Credit-worthy consumers struggle to secure mortgages. Investment banks are brought to their knees. Foreign and domestic stock markets experience gut-wrenching volatility. The Federal Reserve is forced to take historical steps to maintain liquidity. And the list goes on.

In an effort to help the ordinary investor make sense of it all, here's the first part of a simplified explanation of the credit crisis that has overtaken our economy. Hopefully you'll come away with a better understanding of the situation, along with some lessons you can apply to your own personal finances.

As with all true disasters, a series of mistakes are made that culminate into a full-fledged crisis. History provides us with many examples, including the sinking of the Titanic, the stock market crash of the 1920s, and more recently, 9/11 and Hurricane Katrina. In each case, a series of circumstances, along with multiple human errors, combined to bring about a true disaster.

Such is the case here. We can't just blame the banks, or the mortgage companies or the housing market or the Federal Government. This was a real group effort and there's plenty of blame to go around in this chain of events.

Let's start the story at the beginning of the chain, with the American home-buyer. We all know how to buy a home. If your income and credit score are high enough, and your outstanding debts are low enough, you can get home loan from a bank or mortgage company. And many people do. But as home prices continue to rise and the supply of credit-worthy consumers dwindles, a way has to be found to keep the mortgage profits flowing.

So loan requirements are relaxed. Adjustable rate mortgages, with low initial teaser rates, are introduced. Down payments are lowered or eliminated altogether. Documents proving credit worthiness, like income tax returns, are no longer required. Loans for more than the price of the house are given. Suddenly almost anyone can get a loan for more house than they can really afford. But that's no problem, certainly not in the middle of one of the hottest housing markets in recent memory. House prices are going up like a rocket and everyone wants to go along for the ride.

Once a bank or mortgage company gets a loan, they turn around and sell it to investment banks, freeing up capital so they can loan even more money. The investment banks, believing that these mortgages have been given to credit-worthy consumers, in turn sell groups of mortgages to shell companies they create. This way these mortgage loan assets are off their books, freeing up capital they can reinvest to earn even more profits.

The shell-companies don't have the capital requirements that banks do, so they can leverage these loans even more by issuing short-term commercial loans to institutional buyers and hedge funds. They are earning more off the mortgages than they are paying on the commercial loans, so they make a profit. The rates offered on the commercial loans aren't high because the mortgage bonds collateralizing them are AAA rated.

The institutional buyers like the AAA ratings of the underlying bonds, and buy large amounts of the short-term loans they're based on as a secure source of income. Everyone believes that these groups of mortgages are well diversified and are from credit-worthy consumers, hence the AAA rating. As long as house prices keep climbing, everyone is happy and keeps making money.

So far, our chain of events is all about leverage. The home-buyer leverages a small (or no) down payment and monthly house payments to fund a substantial mortgage. The bank or mortgage company leverages the profits from these loans to loan even more money. The investment banks that purchase these mortgages from the original lenders are able to move them off their balance sheets and into shell companies they create, leveraging them even further. The shell companies leverage them yet again, allowing them to make even more loans and helping institutional investors increase profits.

In our next article, we'll see the tragic consequences when all this leverage is turned on its head and the house of cards based on a booming housing markets collapses.