How did the mortgage mess in the US produce such ripple effects in the global economy? DAVID LEONHARDT explains

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RAISE your hand if you don’t quite understand this whole financial crisis.

In tatters: The belief that nothing can rock the American home market

It has been going on for seven months now, and many people probably feel as if they should understand it. But they don’t, not really. The part about the housing crash seems simple enough. With banks whispering sweet encouragement, people bought homes they couldn’t afford, and now they are falling behind on their mortgages.

But the overwhelming majority of homeowners are still doing just fine. So how is it that a mess concentrated in one part of the mortgage business - sub-prime loans - has frozen up the credit markets, sent stock markets gyrating, caused the collapse of Bear Sterns, left the economy on the brink of the worst recession in a generation and forced the Federal Reserve to take its boldest action since the Depression?

I’m here to urge you not to feel sheepish. This may not be entirely comforting, but your confusion is shared by many people who are in the middle of the crisis.

‘We’re exposing parts of the capital markets that most of us had never heard of,’ Ethan Harris, a top Lehman Brothers economist, said last week. Robert Rubin, the former treasury secretary and current Citigroup executive, has said that he hadn’t heard of ‘liquidity puts’, an obscure financial contract, until they started causing big problems for Citigroup.

I spent a good part of the last few days calling people on Wall Street and in the government to ask one question, ‘Can you try to explain this to me?’ When they finished, I often had a highly sophisticated follow-up question, ‘Can you try again?’ I emerged from it thinking that all the uncertainty has created a panic that is partly irrational.

That said, the crisis isn’t close to ending. Ben Bernanke, the Fed chairman, won’t be able to wave a magic wand and make everything better, no matter how many more times he cuts rates and cheers Wall Street. As Mr Bernanke himself has suggested, the only thing that will end the crisis is the end of the housing bust.

Back to the beginning

So let’s go back to the beginning of the boom. It really began in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain.

At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centred around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred innovation, much of which was undeniably good. Why, after all, should someone who knows that they’re going to move after just a few years have no choice but to take out a 30-year, fixed-rate mortgage? As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: sub-prime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates - even if they’re disguised by low initial rates - and higher returns. These mortgages were then sliced into pieces and bundled into investments, often known as collateralised debt obligations, or CDOs. Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns further through leverage, the oldest strategy around. They made US$100 million bets with only US$1 million of their own money and US$99 million in debt. If the value of the investment rose to just US$101 million, the investors would end up doubling their money.

Homebuyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people - by ‘people,’ I’m referring here to Mr Greenspan, Mr Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners - decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher, so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it.

Last summer, many policymakers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge. But they were often so highly leveraged that any loss became magnified. If that same US$100 million investment I described above were to lose just US$1 million of its value, the investor who put up only US$1 million would lose everything. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.

‘If anything goes awry, these dominos fall very fast,’ said Charles R Morris, a former banker who tells the story of the crisis in a new book, The Trillion Dollar Meltdown. This toxic combination - the ubiquity of the bad investments and their potential to mushroom - has shocked Wall Street into a state of deep conservatism.

The soundness of any investment firm rests in large part on the confidence of other firms that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

The conservatism has gone so far that it’s affecting many solid, would-be borrowers, which, in turn, is hurting the broader economy and aggravating Wall Street’s fears. A recession could cause automobile loans, credit card loans and commercial mortgages to start going bad.

Many economists now argue the only solution is for the federal government to step in and buy some of the unwanted debt, as the Fed began doing last weekend. This is called a bailout, and there is no doubt that giving a handout to Wall Street lenders or foolish homebuyers - as opposed to, say, laid-off factory workers - is deeply distasteful. At this point, though, the alternative may, in fact, be worse.

Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep economic downturns, which is why the Fed has been taking unprecedented actions to restore confidence. ‘You say, my goodness, how could sub-prime mortgage loans take out the whole global financial system?’ Mr Zandi said. ‘That’s how.’ - NYT