By Mike Aivaz and Muriel Kane,
Published: Tuesday March 25, 2008 -
When we hear of turmoil in world financial markets, it can be
difficult to understand how so much chaos can result from a relatively
small number of defaults on individual home mortgages. Paul Solman,
the business and economics correspondent for PBS's NewsHour, undertook
to explain how those modest defaults could escalate to the point where
they "now threaten the entire world financial system."
Solman began by noting 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."
A firm like Bear Stearns buys up the mortgages on lots of houses,
combines them into a pool, and sells slices of that pool to investors.
This has been an attractive investment, because it offers a high rate
of return, and it has also been considered extremely safe, because
even if one mortgage defaults that will have little effect on the
pool. With the US housing market booming thanks to the easy credit
these deals opened up, it seemed there was no way that anyone could
lose.
However, the problem was that "the more investors got into the act,
the greater the pressure to lend." Lenders were competing with one
another to offer more favorable mortgage terms. Eventually, new buyers
had so little actually invested in their homes that if any problems
arose, it was easiest to just walk away from both house and mortgage.
Making things worse, the return on these mortgage pools was so high
that the big lenders began investing in them on their own, often using
money borrowed at a lower rate from banks like Citicorp and JP Morgan.
And the banks were also investing directly in securities backed by
mortgages, credit cards, or auto loans. Even more investments went
into so-called "derivatives," essentially side bets on these other
loans.
Everybody wanted to get in on the action and nobody was using their
own money, so the debts quickly multiplied from billions to trillions.
And the only thing of real value holding up the whole house of cards
was the homes owned by individual buyers. If the value of those homes
drops -- as it now has -- and too many of the buyers walk away, the
whole structure can collapse.
If that happens, as Solman explained, there's a further problem. "The
world 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."
That sort of panic was the reason Bear Stearns became unsustainable.
And if a firm like Bear Stearns goes down, its creditors -- the major
banks -- can become unsustainable as well. That is why the federal
government has stepped in to try to salvage the situation.
And, Solman concluded, "That's why they call it the domino effect."
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