I am still a little confused as to what exactly is causing this crisis. I looked into the whole sub prime Fannie and Freddie thing and I found some surprising things. The first thing I found was that poor people get home loans through mechanisms other than sub prime lending. They go through the whole Ginnie Mae umbrella, where all the inner city HUD and FHA stuff is handled, along with rural housing, housing for native americans and there is also a special allowance for veterans of the military to cover them under Ginnie. All of these groups use mechanisms OTHER THAN SUB PRIME! Or rather, sub prime or not, these people have loans that are guaranteed EXPLICITLY by the government, unlike the loans backed by Fannie and Freddie which had IMPLICIT guarantees. How can Ginnie Mae be sound and Fannie and Freddie be such basket cases? Even if 100% of the poor people defaulted, Fannie and Freddie would be untouched. Another question is, who, exactly, was using these sub prime mechanisms that Fannie and Freddie ended up backing? The auditors are claiming that they were primarily used by people making between $40000 and $150000 to afford mortgages that they would otherwise be denied. But something is out of place. Why would the middle class be defaulting at such a high rate? There is some money missing here. I have yet to get a really complete understanding of what went on exactly. After reading through all of the financial info, I am left even more confused.

Is there an economist on Hacker News somewhere that can explain these inconsistencies to us? The only thing I could come up with is that these people wanted to live beyond their means. My quandary is that I have either severely underestimated the number of middle class Americans who want to live beyond their means, or overestimated my capacity for financial analysis.

And yes . . . it could be both.

Fannie Mae and Freddie Mac simply packaged debt, and hardly the worst of the stuff. The real culprit was the widespread growth of variable rate mortgages.

Most traditional mortgages are fixed-rate. Homeowners agree to pay the bank __% over the course of the mortgage in return for the bank providing payment up front. The house is collateral so the bank doesn't lose money if the homeowner fails to make payment. Variable rate mortgages are simply promises to pay the bank a certain percentage over its own cost of securing funding. This is usually tied to inter-bank lending rates.

Variable rate loans were popular with banks because they pushed risk onto homeowners. Banks no longer risked losing money if their cost of borrowing spiked (and interest rates were at historic lows....). The same loans were popular with speculators who could get cheap capital to purchase housing in a rising market.

This causes: (1) an explosion of variable rate mortgage products, and lots of people getting them to cover real estate purchases, (2) increased (speculative) demand which drives up housing prices and encourages speculation, (3) people going further into debt using the increased value of their existing property as collateral. In many cases homeowners took out second mortgages just to give themselves more free income. This is a lot like borrowing cash from the bank using your Pets.com stock as collateral back in 1999.

The game becomes untenable in two situations (1) when money stops flowing into the housing market and prices stop rising, or (2) when interest rates rise.

The Republicans have really screwed up here. The Fed is trying to lower the cost of borrowing between banks to help push down the interest rate and keep people from being forced out of their homes by rising payments - a situation that would only exacerbate the financial crisis from the perspective of lenders who have paid $$$$ and are now stuck with the collateral worth $$ and falling. Banks are failing and so banks don't want to lend money to other banks. This causes the inter-bank borrowing rate to shoot up, further exacerbating the problem.

Now that spreads are soaring again we can expect a lot more foreclosures which will push more glut onto housing markets and tank the price of property. Perhaps even the collapse of the banking system. That might have happened anyway though, since no-one has any clue about what sort of money is being lost in derivatives.

This American Life "The Giant Pool of Money" episode offers a good background on the crisis: http://www.thislife.org/extras/radio/355_transcript.pdf

Act I: "Alan Greenspan: 'The FOMC stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance.'...

What he’s technically saying is he’s going to keep the Fed Funds rate at the absurdly low level of one percent. It tells every investor in the world: you are not going to make any money at all on US treasury bonds for a very long time. Go somewhere else. We can’t help you."

Act II "And they sold so many mortgages that there came a point in 2003 where just about everybody who wanted a mortgage and was qualified to get one .... had gotten one.

But the pool of money had just gotten started. They wanted more mortgage backed securities.

So Wall Street had to find more people to take out mortgages. Which meant lending to people who never would’ve qualified before."

"At the height I was making between 75 and 100 grand a month" -Glen Pizzolorusso, who was an area sales manager at an outfit called WMC mortgage in upstate New York."

Act III: "The global pool of money is avoiding anything with even the slightest hint of risk and that affects everybody, no matter who you are. It's harder to borrow money to buy a house, or build a factory, or bring your country boldly into the 21st century. Take Iceland. A year ago it was easy for them to borrow billions. Now, they're seen as too risky. Their central bank has to pay more than 15 percent interest get anyone to loan them money. They could do better putting their national debt on a credit card."

Here's what i don't understand. If the global pool of money is getting tighter, why aren't interest rates going up?

Some interests are going up: Google "TED Spread". Also, note that 3 month Treasury securities, the safest investments in the world, have been selling to yield less than 1%. LIBOR - the "prime" rate for loans between banks, hit over 5% - for 1 day loans! Banks are very scared of lending to other banks, because they don't have any idea whether the other guy is broke.

Does 'increasing the supply of money' fix this?

The interest rate is not tied to the amount of money available for lending but the amount of lenders out the there. So if there a huge demand for loans the interest rate goes up to counter balance the demand.

With the economy tanking and the money tightening if they raised the interest rates, nobody would borrow and the situation would get even worse.

The best thing is to read a lot of sources yourself and try and make up your own mind. Everyone's trying to sell something, whether it's the libertopians telling you that if there were just no regulations at all, everything would finally work out, or the complete-faith-in-the-government left which thinks that everything will be just great once we regulate everything down to the last detail (caricatures... well, yeah, sorry guys, but reams have been written on this stuff, and I kind of like satirizing it).

Also, the above fundamental philosophical differences are one reason why this stuff just shouldn't be here: people completely disagree and are just going to go on and on and on without really concluding anything.

The problem with the goal of "more home ownership" is that it was a tagline from the GSE's for "increase our deal flow", as they had somewhat of a golden goose with throughput being the only limit. It was and still is political suicide to oppose it. Stroke of genius, if you ask me.

Even worse than non-enforcement has been the active encouragement by the legislature of lots of this stuff. Tightening up the lobbying and revolving doors might help cool off some of that, but I don't really know.

Some of the regulation concepts being floated (not my ideas) are to ban off-balance-sheet vehicles, tighten definitions of what can be put in Level III/model-priced assets, and require that CDSs and other derivatives/wraps be traded on real exchanges so that a market-maker acts as central counterparty).

I'm not a financial expert, just trying to learn about this stuff. Maybe someone more knowledgeable will chime in.

Does it need to be a social change where renting is on equal social footing to home ownership? (I know it varies place to place, but in some places people say "rent money is dead money" - of course so is bank interest ;).

Yes, there really does. Home ownership is the conventional wisdom, and its what got me to buy a house two years ago, and I really wished I hadn't (and I've been wishing that about a year after I bought out the house). Fortunately, the market I am in never really got too much of the housing bubble so unless everything goes to complete shit I'll be ok.

The amount of bad advice in this area is astounding. By far one of the best pieces of advice I've ever been given (and of course, summarily ignored) was to do the math on home ownership vs renting and putting the difference into another investment vehicle.

Played right it 1) can make you more money, although that's tough to quantify right now with everything going to hell 2) make you more flexible, since you're not on the hook for a major life change if you want to change your investment vehicle and 3) diversifies you and provides more security -- your investment is not coupled to where you sleep at night.

Same deal here. Bought in 2005 with the intent to live in the house for a few years and move to a different part of the country. Dreamed about a home run, hoped to break even, didn't expect the worst financial crisis since the great depression. Fine time to be holding the bag. :)

Not everyone wants to own a house for investment reasons. House ownership appeals to a lot of people who want to have their own place in the world. My dad is a "builder" -- he barely finished high school and he's never had a non-labor job, but he is very good at designing and building all manner of things. In the 12 or so years he's lived in his current home, he has completely redone the kitchen (a couple times), took an open-area second floor and made three bedrooms and a bathroom out of it, added an addition (an indoor/outdoor backporch area) on the back, converted the old bathroom and backporch downstairs into a beautiful, much larger bathroom, and so on. And that's just in the house, not to mention other changes he's made on the property (fences, a new dog kennel, redone garage, landscaping, etc.).

Some people just like to tinker, and when you don't own something, that's not really a possibility. After renting at my current residence for over a year, there are some things here that annoy me: we have no porch to speak of, we have a huge kitchen that is laid out horribly (not even a dishwasher), there is a nice basement that is just begging to be finished, and all the walls everywhere are white. It sure would be nice to have a place of my own where I could fix these "problems", both adding to the value and increasing my happiness, all without having to move.

And there is just something satisfying about owning something, about working towards a common goal with someone you love, in building something together. When the area you live in is pliable to your wants and needs, happiness is just a little bit of hard work away.

If you want to do the math yourself here is a spreadsheet that will help. http://randolfe.typepad.com/randolfe/2006/04/bubblizer_a_req...

There is a lot of pressure, I remember it when I was younger. Now I have my own home outright, so I feel like I am not really allowed to state an opinion, otherwise its "do as I say not as I do" etc... so I should just shut up. I don't really know what is best. But debt sucks, mostly, but can work for you.

A mortgage is essentially (depending on the rate of amortisation) renting your home form the bank.

Not getting rid of the Glass-Steagall Act would have limited the scope of the crisis. The act was put in place in 1933 to prevent the "too big to fail" problem with banks that led to the Great Depression. In general, we've had a Republican congress for the last 8-10 years that has been slowly deregulating the financial services industry.

Staying on a gold standard would have prevented the crisis. The gold standard was eliminated by Nixon in the 70's. In general, there were many checks and balances in place that had to be removed for us to get to where we are now. All in the name of political expediency.

Edit: I've put a lot of work into the comment below, so I would appreciate if you'd read it and respond to it. I know it's harder to discuss the specific provisions of Glass-Steagall and its affect on the market place than just saying "oh, the Glass-Steagall repeal is responsible for everything wrong". However, if people are going to cite the argument so often that it becomes the commonly accepted viewpoint, then it ought to be incumbent on them to UNDERSTAND it. Anything else is hand-waving.

I hear this a lot, too, but it's hard for me to see how the Glass-Steagall Act repeal had anything to do with the current crisis. In fact, deregulation seems to have mitigated the damage. The reorganization of Bear, Merrill, Morgan, and Goldman would have been impossible were the Glass-Steagall Act still in full force. They would have all gone bankrupt or had to be rescued by the government. Many of the entities that are in good financial shape are the large financial conglomerates that would have been illegal were G-S still in place. Customer bank deposits provide a stable source of funding when lenders are skitish. Reducing the supply of capital in an embattled industry would be the height of stupidity.

Many foreign countries never had any law like Glass-Steagall in place and they don't seem to be suffering the same problems. As logic tells us, the current crisis seems to be orthogonal to the presence or absence of Glass-Steagall.

Mcardle also had a wonderful post FACTUALLY summarizing the provisions of Glass-Steagall and its relation to the current crisis:

http://meganmcardle.theatlantic.com/archives/2008/09/clear_a...

I also addressed this issue on my libertarian blog a while back:

http://distributedrepublic.net/archives/2008/09/22/the-end-e...

A large problem during the Great Depression was that the United States had laws that artificially limited the size of banks (see "Unitary Branching Laws"). The result was that institutions in the United States had smaller financial cushions in crisis time and were more likely to go under. The United States suffered a FAR higher rate of bank failure than other countries, and states with unitary branching laws had higher failures than those without.

So I know blaming the Glass-Stegall repeal for our current problems is popular(populist) wisdom, but it seems to me that popular wisdom is, as usual, wrong.

> They would have all gone bankrupt or had to be rescued by the government

But isn't the point to separate the investment banks away from the savings banks? There's a fundamental type difference between a dollar earned and saved, and a promissory-based dollar conjured up by a debt instrument.

When an investment bank fails (as it should when it's made a bad mortal investment), the funny money dries up, leaving the holder high and dry. If this holder employed bad accounting (by counting promised dollars as dollars-in-hand), then they may fail as well (and so on). However, this should not continue into the institutions that hold the savings of the people who didn't want to play economic make-believe.

> Many foreign countries never had any law like Glass-Steagall in place and they don't seem to be suffering the same problems

How many other countries have currencies that are used as reserve by the rest of the world? (which greatly lengthens the time for consequence of inflationary policy to be felt)

  If this holder employed bad accounting (by counting promised dollars as dollars-in-hand), then they may fail as well (and so on).

That's called accrual accounting, and is required by United States Generally Accepted Accounting Principles, International Financial Reporting Standards, and the UK's Companies Act.

What I mean is if the holder only employed such accounting. I can see how such figures are normally useful, but the abstraction can break down when you aren't paid (and in this case, did so catastrophically). If your investment bank wants to survive downturns, it should be factoring this possibility into its decisions.

"However, this should not continue into the institutions that hold the savings of the people who didn't want to play economic make-believe."

How are these savings going to provide any interest if they are not redistributed as loans? The whole point of a bank is to allow your money to work for you while also providing loan capital to those who have a good use for it. It's impossible to have a non-negative (due to administrative costs) savings account without loaning the money to someone.

Or am I completely missing your point?

Home/business loans made by a savings bank are subject to the reserve requirements. If these loans turn out to be bad and cause bank insolvency, the amount isn't huge because we're dealing with first-order numbers mostly backed by collateral. When the FDIC steps in to repay depositors, no money is lost (besides the bank's investors).

Okay, I hoped that's what you meant, and not that savings banks should not be allowed to invest or loan money at all.

I didn't say Glass-Steagall being repealed was responsible for everything that was wrong. But having it in place would have kept our institutions smaller with fewer entanglements, therefore fewer firms would be in the "too big to fail" category. True, it would have prevented a few of the mergers that are happening now but they may not have been necessary. Once you eliminate the problem of one institution bringing down the entire financial system, the existing bankruptcy courts are a better mechanism for unwinding bad assets.

> "Many foreign countries never had any law like Glass-Steagall in place and they don't seem to be suffering the same problems. As logic tells us, the current crisis seems to be orthogonal to the presence or absence of Glass-Steagall."

I don't buy into that logic. Just because every financial system in the world hasn't failed due to too much deregulation, doesn't mean deregulation is bad or not the cause of our current crisis. There are a multitude of things contributing to the current problem, but excessive regulation and checks and balances aren't one of them.

We don't necessarily need to reinstate Glass-Steagall, but we need a modern-day equivalent. We need to ensure financial institutions can fail without jeopardizing the entire economic system. I'm personally in favor of something along the lines of the DoJ anti-trust mechanism, with an independent body that analyzes financial mergers and assets from the perspective of whether they are dangerous to the economy and citizens. On the other hand, I don't feel that our current DoJ is working very well so maybe that's not the best idea. I'm open to suggestions.

In Canada, the average Debt-to-Equity ratio for banks is 3:1. We only have a few. Large, heavily regulated, safe as hell.

Agreed Prrometheus. More regulation is just going to push more of the business overseas. If Congress screws this one up they could create a situation where there will be no investment capital industry in the United States in the near future.