JIM LEHRER: Now, our economics correspondent, Paul Solman takes us step by step through how problems in the housing market spread into the wider economy.
PAUL SOLMAN, NewsHour Economics Correspondent: There’s at least one very basic question behind the current crisis: How can $100 or $200 billion in bad housing debts at most seemingly turn into many hundreds of billions, trillions, it’s said, that now threatens the entire world financial situation with something being called the domino effect, when it’s just delinquencies on home mortgages in certain parts of the United States?
Trying as usual to keep the story as close to home as we can, in part to save the money we get from viewers like you, we begin at my house with some homemade and dollar-store props to explain.
We’ve explained before, and many of you may know by now, that the money you borrow to buy your home no longer comes from the local bank. It comes from investors, from all over the world, private investment groups like hedge funds, institutions like pension funds, government or sovereign funds from countries like China.
It works like this: A Wall Street firm, say Bear Stearns, buys the mortgage on your house. It also buys the mortgages on lots of other houses and puts them all together in a pool.
It then issues and sells slices of the whole pool of mortgages to investors. So, in effect, the investors are lending you the money to buy your house, but instead of getting your monthly interest payment, they get an interest payment from the money coming in from all the mortgages in the pool.
Instead of your note, they get this slice, known as a mortgage-backed security, because it’s backed by the mortgages.
This is a debt instrument, an IOU, but it’s safer than just one mortgage, because one could default. The whole bunch aren’t likely to.
Always looking for help in explaining such arcana, we invited the first President Bush’s undersecretary of the treasury, former securities regulator, and finance professor Robert Glauber to the house. He says mortgage-backed securities can be very appealing financially.
ROBERT GLAUBER, Former Undersecretary of the Treasury: The purpose of them is to give investors a chance to buy securities that will pay somewhat higher yields than they can get in treasury bonds, but at a risk level only slightly higher than they would get in government securities. And, of course, the great benefit of this was it opened up whole new pools of investments to buy mortgages in a way they never was before.
PAUL SOLMAN: No wonder housing boomed in the U.S. in the past few years. Investment capital from all over the world was itching for higher-than-normal, yet seemingly super-safe returns. That helped drive interest rates down and the housing market up, a housing market that had never, ever gone down nationwide since they began keeping official statistics.
William Poorvu, who’s taught real estate at Harvard Business School for 35 years, says the more investors got into the act, the greater the pressure to lend.
WILLIAM POORVU, Professor Emeritus, Harvard Business School: There was a lot of money coming into the mortgage markets from all over the world. This led to a need to find homeowners to borrow this money.
And since there’s so much money, the lenders competed with one another to offer better and better terms for the homeowners.
What used to happen is you would have to put 20 percent down to get your mortgage, 20 percent cash. And now, they would say, “All right, well, maybe 10 percent down.” Then it became 5 percent down. And then it was 3 percent down. And pretty soon, it was then no-down-payment mortgages.
PAUL SOLMAN: And if you’re putting down no money…
WILLIAM POORVU: You really don’t focus too much on how much you’re paying for the house. And if the lender is also willing to tell you that they’re not going to chase you if you default, they’re going to give you a non-recourse loan, who cares?
PAUL SOLMAN: In other words, lending had become so competitive and so unregulated some buyers were only liable for the loan’s collateral, their home. That’s what a non-recourse loan is. And so if housing prices suddenly begin to fall to less than the amount your home was mortgaged for…
WILLIAM POORVU: If it’s non-recourse, you just give them the keys to the house and walk away.
PAUL SOLMAN: And that happened to be how a new term entered the English language: “jingle mail.” If you’d bought a house as a speculation, hoping it would rise in value, or you were unrealistic about your ability to pay, or you were duped by unscrupulous brokers, in any case, one obvious answer was to walk away from home and loan and simply mail in the keys, because you had little or no money of your own in the property. It was almost all debt-financed.
And the same hyper debt-financing, it turns out, was happening with many of the big lenders, like hedge funds. They were borrowing money to lend it to the likes of you.
But how could that be? For yet another answer, we invited yet another expert to the house, Boston University Finance Professor Zvi Bodie. He asked us to imagine a supposedly risk-free mortgage-backed security…
ZVI BODIE, Finance Professor, Boston University: … and it’s offering a rate of return of 6 percent and you can borrow money at 5 percent, OK? You think you have what we call an arbitrage opportunity, OK, because you’re going to get that spread, and there’s no risk. You think, well, how much money would you like to invest in that arbitrage opportunity? The sky’s the limit, OK? The more you invest, the more you’re going to be earning.
PAUL SOLMAN: So investors were borrowing as much money as they could to buy the mortgage-backed securities, many of them $30 borrowed dollars or more for every dollar of their own money.
They borrowed the money from the world’s big banks, Citicorp, JPMorgan, foreign banks. And so the debt chain just kept growing and growing.
For example, I borrowed money to buy this house. The family I bought it from presumably put the money in the bank. The bank could then have loaned the money to hedge funds or investment banks or used the money itself to buy residential mortgage-backed securities or new commercial mortgage-backed securities — these are monopoly hotels, you may remember — or credit card-backed securities, auto loan-backed securities.
And this may be the scariest possibility of all: The money may have been loaned to big investors to make side bets, generically known as derivatives. These derivatives are too exotic to explain in this story, but they themselves appear to be in the trillions of dollars with no real assets backing them at all.
The basic point is the debts can proliferate, and they did. And the less money of their own that everyone put down, the more the debt multiplied. That’s how you go from billions to trillions.
And a crisis can start from something as simple as homeowners failing to make their mortgage payments, the value of the initial collateral on which so much of this is built starting to vanish in thin air.
WILLIAM POORVU: I buy the house with borrowed money. You lend me the money. You borrow the money to lend it to me. The person who lent it to you borrows the money from somebody else to lend it to that person to lend to you to lend to me.
What happens is you get a chain of lenders, all of whom are in a position where they’re dependent upon my ability to pay the loan on my house, because if I can’t do it, the whole thing cascades, and everybody down the line gets hurt.
ZVI BODIE: If the value of the real estate goes down, then all hell breaks loose, because a lot of the homeowners or at least some fraction of the homeowners would deliberately default.
PAUL SOLMAN: But there’s still a question to answer: How does this threaten the world financial system? Why don’t investors and banks take their lump, as homeowners have had to, and move on? IOUs, securities, sides bets, they’re all just paper promises, right?
The problem is the world’s financial system runs on credit on paper promises. If big borrowers and lenders don’t make good on those promises, panic can set in, and the biggest financial institutions in the world can find themselves under siege.
ROBERT GLAUBER: If everybody wants their money back from Bear Stearns at the same time, it’s like everybody wanting their money back from a bank at the same time. They can’t do it.
People fail to understand that when they want to do something, a lot of other people are going to want do the same thing. And it’s going to get very, very crowded trying to get out of the room at the same time.
PAUL SOLMAN: According to our professors, then, that’s why Bear Stearns was unsustainable. Nobody would lend to them anymore. In which case, what would happen to all the huge institutions Bear Stearns owed money to?
Presumably, the Federal Reserve folded Bear Stearns into JPMorgan and guaranteed $30 billion of potential losses to prevent a system-wide seize-up, because if the housing plunge had led to Bear Stearns’ bankruptcy, leading to the bankruptcy of its creditors, all operating on thin-to-no capital cushion, remember, well, then, that’s why they call it the domino effect.
JIM LEHRER: You can ask Paul Solman about recent economic events in our online Insider Forum. To participate, just go to PBS.org.