Credit Crisis 101 - The Financial Alchemy of Donuts

See Also: Part 2, Part 3

In order to connect the dots from today's financial crisis to tomorrow's new energy economy, I thought it would be worthwhile to write a three part series to explain 1) how the credit crisis began, 2) what the crisis will mean to business as usual, and 3) why putting a price on carbon emissions can begin to help re-invigorate our economy starting right now.    

Credit Crisis 101 - How It All Began

If We Build it, They Will Come.

The credit crisis has its roots in the aftermath of the dot.com bubble when interest rates fell to very low levels to help revive the economy.

Real estate developers, recognizing that the first wave of America's 78 million baby boomers was set to begin drawing Social Security in 2005, took advantage of these low interest rates to begin building a massive number of retirement homes to meet an expected surge in demand.

The banks, who helped finance these developments, quickly adopted the logic of this new housing trend as well and began marketing these retirement homes to their clients as "investment properties".  

In a matter of months, the surge of fresh capital into the real estate market worked to push up home prices in these areas, creating demand for even more housing developments and even more housing loans.

Turning Real Estate into a National Obsession

Higher real estate prices in selected areas convinced banks to market real estate investing nationwide as a retail product. This decision completely ignored 40 years of data suggesting that housing is at best an average long-term investment.

This nationwide retail push for real estate lending was further fueled by the introduction of low or no down payment mortgages. These loans, which combined with low interest rates, gave buyers an enormous amount of leverage when they "purchased" their property.

While it can be argued that these low interest rate, low down payment mortgages benefited consumers by helping to raise home ownership to record high levels, these mortgages also provided two questionable benefits to the banking industry, 1) they allowed homes to appear more affordable to the home buyer than they actually were, ushering in a rise in sub-prime lending, and 2) ensured that the new home owner could make at least the first six months of mortgage payments, qualifying the loans for placement into asset pools for further distribution.

The Financial Alchemy of Donuts

Instead of holding a piece of these home loans on their books, the banks decided to re-package all the risk from these loans together and sell them to institutional investors looking for high yielding bond investments. These institutional investors gobbled up these pools of loans, known as collateralized debt obligations (CDOs), like glazed donuts, giving the banks the green light to source more and more high risk loans to package together.

The secret ingredient used in making these CDOs was loads and loads of leverage, which like yeast, made these investment donuts rise like other investment products. These donuts may not have tasted as good as regular donuts because they used poorer ingredients, but the banks were able to hide the taste by giving them an extra coating of icing to sweeten the bond's yield.     

The banks even looked to use this type of leverage to create their own structured investment vehicles (SIVs) which used the glazed donut approach to borrow massive amounts of short-term money to fund even more leveraged investments. Investors bought these SIV notes as well, creating confidence that the good times would continue to roll on and on and on.

Investors continued to buy these SIVs and CDOs at break neck pace, relying on the ratings agencies to tell them when they had had their fill. The only problem was that the rating agencies were also in on the charade. They had begun rubber-stamping these CDO and SIV programs for the banks in exchange for fees, justifying this conflict of interest with the incorrect assumption that if the market could digest one glazed donut it could handle a thousand more glazed donuts just like it.

The race to make more glazed donuts was on, and while the banks made a fortune every year re-packaging hundreds of billions of dollars worth of SIVs and CDOs, over time they got lazier and lazier about quality control.  They began using yeast or leverage as the primary ingredient instead of dough or actual cash flows, making the donuts taste pretty awful. As time went on and investors paid less and less attention to the ingredients, the banks even decided to stop cooking the donuts and instead just scooped the batter into the donut boxes directly.

The Donuts Rise Up

Things carried on for a while as investors kept buying donuts and putting them in their portfolios without really checking the contents. Then one day, the brown stuff being served up as donuts really started to smell and investors decided they couldn't wait any longer for the rating agencies to step in and ask the obvious question, "What was actually in these "donuts" they were buying?".  

The bankers had what they thought was a pretty witty response to that question, but the investors disagreed.

Pretty soon no one wanted to buy the CDOs and SIVs the banks were packaging together and in fact were now looking to liquidate what they had. This made the banks very nervous. They needed to do something and fast. The banks then had the idea that if they could just put all this brown stuff into a big pot, cook it, and coat it with even more icing they could unload it quickly to distressed asset buyers.

It wasn't a sure thing but it was the best idea they could come up with. So the banks threw all their SIVs and CDOs into the pot and nervously watched what would happen, each bank secretly hoping that they would be able to get their glazed donuts out of the oven first, sell them off, and be done with this business.

Instead of rising like donuts, however, the insane amount of yeast in the SIVs and CDOs came alive and started to bubble right out of the giant pot. The brown stuff came out of the pot so fast in fact that the banks that were closest to the pot (Bear Stearns and Lehman) completely disappeared from view and were later pronounced lost.

Pretty soon the remaining banks were stuck in the brown stuff that the banks were passing off as donuts and couldn't leave the kitchen. They all stood around looking at each other in disbelief that there could have been so little dough and so much yeast in these investment products.

The Cleanup Crew Arrives

And here we are today. The banks are stuck in the kitchen, the government has now arrived on the scene with the mop and the American taxpayer is being asked to hold the bucket.

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