A simplified story of our economic crisis

The following is a guest post from The Weakonomist, the anonymous blogger behind Weakonomics.com.

The media has tried to explain the current economic crisis. But many of them don’t fully understand it themselves, so elements and details are lost in translation. The ultimate failure is trying to explain it in a matter of minutes – and this is impossible. You have to keep it simple, and then add layers of complexity as each level is understood.

So let me tell you a story.

Meet Ivan. Ivan is an investor. After a recession in the early 2000s, Ivan pulled his money out of the stock market. He wanted a safe investment, but interest rates were very low and because of this, government bonds offered a low return.

Ivan approached his friend Barry to see what other options he had. Barry is a banker. It’s his job to help investors find places to put their money – a broker of sorts. Barry suggested that Ivan invest in mortgages because they’re safe – real estate prices have never had a down year, so loan defaults are rare. Ivan thought this was a perfect solution.

Barry contacted his friend Mort. Mort is a loan officer at a mortgage company. Mort will help someone purchase a home by providing the financing, and then sell the mortgage to Barry. This frees up Mort to go help someone else with a new mortgage.

Mort has a few mortgages to sell to Barry, which Barry gladly purchases. Think of these mortgages as the eggs, flour, and icing needed to make a cake. Barry puts these mortgages together to create an investment product called a mortgage-backed security, or MBS. It’s the same thing as putting the ingredients together to make a cake. Barry sells the cake (the MBS) to Ivan.

three coin stacks
Photo by Jeff Belmonte

At each stage in this process, everyone makes a tiny profit. Mort sells the mortgages for a bit more than he paid, and Barry might charge a fee for putting the mortgage-backed security together. Ivan will now receive income in the form of the monthly payments homeowners make on their mortgages.

Ivan was very happy with these results. So happy, that he came back to Barry with more money, and brought some friends with money too. Barry is happy to oblige their requests for more mortgages, and contacts Mort. Mort tells Barry he doesn’t have enough mortgages to meet everyone’s demand. Because interest rates are so low, everyone who can afford a mortgage already has one.

Then Mort gets an idea. What if he helped unqualified home buyers become qualified? By “exaggerating” reported income, or using mortgages that make payments cheaper up front and more expensive later, Mort was able to put people in homes that previously couldn’t afford one.

These mortgages were riskier than traditional mortgages, so eventually the homeowners would have to pay more each month. Barry was happy to buy them, and packaged them with other mortgages to be sold to Ivan. No one was worried about the occasional default because they could just sell that home. Everyone was happy – for a few years.

Eventually, those people in riskier mortgages started to default because they couldn’t afford the new, expensive payments. At first it was no problem – the house was foreclosed, sold, and everyone moved on. But as more and more homes defaulted, more and more homes were on the market. The abundance of supply, and no increase in demand started make the prices of home fall.

house in foreclosure
Photo by Jeff Turner

Soon enough, Ivan and Barry found they had too many homes for sale, and not enough money coming in from those folks that could make their payments. Ivan stopped buying mortgages from Barry because he didn’t have any more money.

As a result, Barry stopped buying mortgages from Mort. Without the money coming in from selling the mortgages, Mort couldn’t make new ones. Mort found himself sitting on a bunch of foreclosed homes and was no longer making money, so the mortgage company closed.

Barry was no better. He couldn’t sell his foreclosures because there were too many on the market, and Ivan wasn’t buying the good mortgages Barry had because Ivan was out of money, too. The system froze.

There is no happy ending to this story.  No new investors were in sight to bring in new money, and not enough money was coming in from the good mortgages. With no new money, there were no new loans.  This meant that even the most qualified buyers had trouble getting mortgages.

The lesson behind the story

So how did that get me laid off? Well it isn’t me per se, so much as it is the millions of Americans who have lost their jobs. The idea here is to show the connection between the frozen industry above, and whatever it is you or I do to make money. Let’s take a closer look at Ivan.

Ivan is an investor, which is just some generic term. Ivan represents all investors. When Ivan started losing money, he had to retool his operation in order to keep his organization afloat.

So what kind of business was Ivan in? It could be anything. It could be a hedge fund, it could be an insurance company investing premiums, or it could be simply another bank. So we can see how the financial sector was impacted. All these companies had to lay off people to save money and keep their companies alive.

job offers tshirt
Photo by Social is Better

Financial companies weren’t the only investors. You had universities investing endowments, churches investing surpluses, retirement pensions investing for conservative returns, even local governments investing tax revenue.

Why? Because everyone thought (and was told) it was a safe investment. They all lost money, and as a result, they had to cut back. Eventually, the banks themselves lost so much money they couldn’t stay in business anymore. The government stepped in to assist and… you know the rest. Since 2007, we’ve watched a domino effect toppling every industry.

Does this story help explain the crisis?  What other questions do you have about our economic situation?

The Weakonomist is an anonymous blogger responsible for everything at Weakonomics.com. With a financial background and a passion for learning, he brings others into the light of economics and personal finance. As a banking insider he’s witnessed this economic crisis from the inside-out. You can usually find him at the corner of Wall Street and Main Street throwing rocks at traffic.

top photo source

Tsh Oxenreider

Tsh is the founder of this blog and just finished traveling around the world with her husband and 3 kids. Her latest book is Notes From a Blue Bike, and believes a passport is one of the world's greatest textbooks.

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  1. I think that this is a good assessment of the current crisis. To take it a step further we should mention that with the bailouts and “investment” over-spending in health care, education, etc. we are running the value of our dollar into the ground. Which means that if we keep printing money out of thin air at some point inflation will be so high that our dollar collapses. We will be Zimbabwe, carrying wheel barrows full of cash in order to buy a loaf of bread.

    Shannon´s last blog post…Non-Dairy Calcium Sources

  2. This post is helpful in explaining the crisis, but at several points I still felt myself asking – “why did anyone think THAT was a good idea?”

    Here’s to a much more healthy economy based on actuality rather than speculation!

  3. Theses are great questions and comments. Perhaps they can be addressed in a follow-up post down the road. I hope this was helpful in providing an introduction into the subject.

    the weakonomist´s last blog post…Value Added Tax (VAT):  The Pros and Cons

  4. this post is great. it actually reminded me of a great slideshow that’s provided here: http://www.mymoneyblog.com/archives/2009/02/nice-simple-explanation-of-the-credit-crisis.html
    i shared this with simple mom a few weeks back and it was in her link love, but you may have missed it. if you’re a visual or audio learner, these two short clips help sum up what you’ve said here.

    i’m talking about my tendency toward greed today at my blog. it seems a little bit of greed unmonitored is the cause of the whole story.

    Nicole´s last blog post…Judas had Sticky Fingers?

  5. You’ve done a great job at simplifying a complex situation.

    Miko’s Girl´s last blog post…Cinnamon Bun Perspective

  6. That was awesome! Nice explanation!

  7. Caroline says:

    That was a good explanation. As a CPA, I would add a couple of things, though. Layoffs were caused more from the “freezing” of the credit markets. Businesses have operated very similarly to consumers – highly dependent on debt for everything from daily cash flow to expansion. When banks quit lending money, many businesses were no longer able to obtain cash for daily operations and were forced to lay off.

    Second, in this example, “Mort” was able to make these loans because of a HUGE weakness in what accountants refer to as “Internal Control”. Mort got paid every time he was able to close on a mortgage. If the mortgage didn’t close, he didn’t get paid. Once Mort sold the mortgage to Barry, he suffered no consequence when the borrower defaulted. So, Mort had no incentive at all to do any due diligence on borrowers.

    The “Barrys” in this story thought it was a good idea because of the great track record of mortgage investements. They did not consider the impact of the deregulation that was done in the 90’s. And, they truly did not believe that real estate prices would decline nationwide.

  8. that’s a great post, thanks for explaining it a little better for those of us who want enough knowledge to understand it but not too much to get confused. 🙂

  9. Actually, one small (but major) omission. Mort didn’t just “get this idea”. His friend, Gary, made him do it. Gary is the government. You see, the government actually forced mortgage companies to offer loans to unqualified home buyers, through the Community Reinvestment Act, which mandated that banks would provide mortgages to “underserved communities”.

    Now, don’t get me started on Gary’s best buds, Freddie and Fannie…

    SM´s last blog post…Donuts and Books

  10. This is a great explanation…but what about the people buying those risky mortgages. The greed of those not willing to buy the starter home that they really could afford vs the buying the dream home that these risky mortgage ‘afforded’ them. And the ones who simply didn’t do their research in order to understand the mortgage product they were signing onto. There is level of personal responsibility involved when you make any decision, especially one as big as a home purchase. That’s one of the many reasons the bailout annoys me…but that’s another topic.

    MB´s last blog post…To Save Money, Know Your Weaknesses

  11. Well put for those of us who are “outsiders.” It is tough because both the professionals and the “people” are at fault. Now we just need to be smart and fix it instead of pointing fingers.

    AllisonD´s last blog post…#27 How Many Sizes of Clothes Does One Mother Need?

  12. Will my husband get a paycheck this month? Will he have to close his business? How many resumes will I have to send out before I get an interview? These are just a few of the questions that fill my thoughts as I go about my days taking care of our kids. But I know you don’t have the answers – so I’ll just stop there.

    Thanks for your easy-to-read explanation of how we arrived in our current predicament! If only there was an easy-to-read solution!!

  13. It’s a complex situation. I’ve posted a few excellent articles and videos on the subject if your interested.

  14. Great breakdown of what is a very complicated problem, I’d love to read a debate about whether more government regulation is the answer or not.

    Adrian´s last blog post…The Best Self Help Book Ever Written

  15. Samantha says:

    Another great explanation is at http://www.crisisofcredit.com.

  16. Caroline says:

    I’ve heard many bankers blame their predicament on the government , specifically the Reinvestment Act (CRA) which requires bankers to make loans to low income individuals. This act was passed in the 70’s by President Carter’s administration. Banks found ways to comply with this law through the late 70’s, the 80’s and into the mid 90’s without going into all of the “creative loans”. I was in banking in the late 80’s and early 90’s. We had our own CRA officer who tracked our compliance, and we were able to make good loans to individuals and businesses able to repay. I really think this is more of an excuse than an actual reason.

    • You miss 2 key elements that most in government (both sides of the aisle) refuse to acknowledge (because the vast majority of politicians took advantage of the system and took huge donations from the GSE\’s and banks who profited, all the while pushing the notion that they helped promote \”affordable housing\” and increased minority home ownership): 1) In 1992, Congress also passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which amongst it\’s other provisions, REQUIRED the government GSE\’s to devote a measurably higher percentage of their lending for purchasing and securitizing loans to \”affordable housing\”; and 2) Beginning in 1993 and extending through most of his presidency, President Clinton pushed strongly (and achieved) greater regulatory enforcement of the original CRA. He successfully got the Treasury to write stricter regulations regarding the notion of affordable housing mandates in order to further a political agenda to \”deal with the problems of the inner city and distressed rural communities.\” It was a brilliant and shrewd political move that helped him to be viewed as an advocate for those in need, and enshrined him as the \”first black President,\” (this, of course, before President Obama was a twinkle in the press\’ eye). Then, the Justice Department led by Janet Reno, at the behest of President Clinton, began pushing literal enforcement of these tougher regulations under threat of penalty against lenders. To ignore this as a HUGE element to the problem is HIGHLY irresponsible, and is one reason we are nowhere near fixing the underlying issues that created are current circumstances. In the Weakonomist\’s story here (in the early 2000\’s), it is floated that some bankers/lenders got together and developed the idea to give subprime loans. That is simply not the case. They were threatened to give subprime loans (which weren\’t called that yet) by the government, or face regulatory penalties on a daily basis. This is not to fully excuse the lenders/brokers/etc. who made money on all this. When they began acquiescing (as if they had a choice) to the new Justice Department threats, they shrewdly realized that they could sell most of their soon to be called \”subprime loans\” to Fannie and Freddie as a result of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (referred to above). So whereas most lenders were willfully staying out of the subprime market, not desiring any of the exposure to risk that comes with lending to low income borrowers, the government absolutely forced them all into the market by the mid-1990\’s. Once forced in, they found the loophole that had been created by the 1992 Act allowing them to package up the securities by writing them under GSE guidelines. That way, they were complying with new federal regulations, able to avoid justice department scrutiny, and oh, by the way, actually make more money by offering such loans and immediately passing them off to GSE\’s. ONLY THEN, did the banks take it to the next level described in this post. Once it was evident how much extra money could be made by seeemingly making risky loans without much risk to their own balance sheets (since they could package the loans and sell them as securities to someone else), banks started getting more and more irresponsible in their lending standards. They took it to the next level by skipping the GSE\’s alot of the time. Essentially, what happened was they said, \”hey this thing we were forced to do by the government has actually worked out pretty well for us financially, why not skip the whole government involvement with a portion of our business and just offer these loans as investments to private investors? After all, we can take the same concept we\’ve used to avoid the exposure to our own books and apply it to private investors, and we\’ll all make tons of money.\” So yes, they are part of the problem, and need to be held accountable. BUT, the government created the environment in the first place. And NONE of this ever would have existed had they not stepped in and forced lending to people banks otherwise would not have been interested in lending to because of the risk associated with having to hold those assets on their books. To ignore the increased regulation and enforcement of the CRA in the Clinton years, and the new securitization options available after the 1992 Act with Freddie and Fannie, is either a continued \”head in the sand\” attempt to ignore the first domino that HAD to be put into place for this entire failure to have occurred, OR it is just another political attempt to mislead and lie to avoid responsibility for the bad decisions that helped create this mess! Government involvement an excuse?? Give me a break. It is THE ONLY factor (and there are many factors, and many people, including the lenders who share in the blame) that if removed, probably would have avoided the entire crisis we find ourselves in. The banks followed the lead of the government, the regulators, and the GSE\’s… not the other way around.

  17. I liked this explanation, and think it was helpful. Thanks for taking the time to post it.

    Taylor at Household Management 101´s last blog post…Mar 23, How To Clean A Toilet

  18. Great post! Very well-design with great content. Provides an easy-to-relate-to overview of the meltdown as a whole!

    Baker @ ManVsDebt´s last blog post…49 Reasons You Make Less Hourly Than You Think

  19. Great post. It is simple and easy to understand the point. Thank for sharing this great article.

    Horlic´s last blog post…Free Online Consultant’s Advice for Home Loans, Property Legal Aid, Interior Design Ideas and Home Insurance

  20. I love your blog but I have to point out that this is a total ripoff of This American Life’s fabulous “Giant Pool of Money” show that was done by Alex Blumberg and Adam Davidson. I realize this is a guest blogger, but plagiarism is plagiarism, even if the orignal was published on the radio.

  21. All very sensible comments. We need to be educated on the process as a whole to be able to give educated opinions on the subject of what creates a crisis and hopefully learn that Greed & Fear are not good advisers. The best advise is that which is valid in the good and bad times alike.

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