Flotsam & Jetsam

A. A lot of stuff happened to bring the interest rate to record low’s starting in the 1970′s (or earlier if you want to go back that far).  A partial attempt to try and explain what has happened over the past year.

1. You want a loan, but you’re risky.  You go to a mortgage broker who says they can get you a loan, regardless of how much money you make.
2. Sleazy mortgage broker gets you a loan with A
3. A makes a bunch of these loans at X percentage points.
4. In order to diversify their risk, A packages up a bunch of these loans and sells them to consolidator B at a rate of X-Y.  A doesn’t make nearly as much money as they would have, but they’ve off-loaded their risk and make some of would they would have made (and lost less than they would have).
5. Dealer A bundles more of these loans up and sells them to B
6. Repeat step 5, but different B (then move onto step 7)
7. B sells these all the loans they collected as one big bunch to investment bank C
8. C bundles up these loans into a securitized security called a Mortgage Back Security (MBS for short).  C then sells these things on the open market like a stock or bond.
9. D buys some of these MBS’s
10. D takes out loans to buy MBS’s (and other securities)  They borrow upwards of 10x (or more) the amount of cash they have on hand.
11. D, because they have a lot of these MBS’s, decides to hedge their bet and buys these other securities called Credit Default Swaps (CDS’s) from places like AIG.  A CDS guarantees the interest rate of a bond by calculating the risk and charging the appropriate “premium”.  Think of it as bond insurance.
12. AIG writes a lot of these CDS’s because they’re supposed to be fairly low risk based on the diversification algorithms
13. Because places like AIG, Bear Stearns, Lehman … etc are writing lots of CDS’s, which, in theory, should hedge their risk, and they’re greedy, they borrow more money and repeat steps 7 and 8.
14. Because these things have value that can be traced (supposedly), firms use them as collateral in other loans and deals.
15. A War happens and goes longer than anticipated.
16. The price of oil goes up
17. Interest rates start to rise.
18. The LIBOR rate – which most US loans a based on – goes up.
19. 2 and 3 year ARM mortgages expire and the interest rates of these risky mortgages ratches up to what they should be based on the LIBOR spread
20. Mortgages start to go into default.
21. Repeat steps 15, 16, 17, 18, 19
22. April ’07: Countrywide – the largest writer of mortgates in the US starts to fail due to too many defaults on bad debts
23. Between January ’07 and December ’07 many smaller subprime mortgage lenders fail, leaving a lot of debt behind in places like ML, Bear and Morgan Stanley
24. The ratings agencies start to downgrade Countrywide and ratings across the board start to be questioned.  Rumors of Countrywide bankruptcy start to surface.
25. Jan 11, 2008: Bank of America buys Contrywide for $4.1 billion in stock
26. Confidence on Wall St starts to falter
27. March 14, 2008: Bear Stearns gets Federal funding as Bears stock price crashes
28. March 16, 2008: Bear is acquired by JPMorgan Chase for $2/share.  The deal is back by the Fed with a $30B loan to cover potential losses.
29. Repeat steps 15, 16, 17, 18, 19 & 26
30. The interest rates on the MBS’s starts to fall below the rate guaranteed by the CDS
31. AIG and others start to pay out cash to cover the CDS’s
32. Repeat steps 15, 16, 17, 18, 19 & 26
33. Writers of CDS’s start to run out of cash and can’t pay.  The borrowers are having their loans called due to bad debts.  Now both sides of the deal are losing – the writer can’t pay for what they bought, the buyer is out what they paid for the MBS and what they paid for the CDS and the loan
    amount.
34. Sept. 7, 2008: Fanny Mae and Freddie Mac fail.  Citing the impact the failure will have on the economy, the Fed Nationalizes them over and wipes out the equity structure in the process
35. Confidence on Wall St continues to accelerate downward
36. Sept 14, 2008: Merrill Lynch runs out of cash and is sold to Bank of America
37. The pressure goes up.  
38. Sept 15, 2008: Lehman Brothers files for Bankruptcy.  The government doesn’t save them.
39. Sept 16, 2008: AIG is downgraded by Moody’s and S&P – AIG’s stock price crashes
40. Sept 17, 2008: Citing the impact the failure will have on the economy, the Fed lends AIG $85B to keep them afloat
41. Sept 19, 2008: Paulson unveils plan to use $700B of taxpayer money to buy toxic debt
42. Sept 25, 2008: Washington Mutual is seized by the FDIC and sold to JP Morgan Chase
43. Sept 29, 2008: The  Emergency Economic Stabilization Act is defeated 228-205 in the House of Representatives
44. Sept 29, 2008: Wachovia fails in the largest banking crash in history and is purchased by Citibank.
45. The market goes into a free fall
46. Last week
47. Morgan Stanley & Goldman Sachs become traditional commercial banks, ending the history of investment banks on Wall St.