Tuesday, November 18, 2008

Financial Crisis in a Picture

The inimitable Jeffrey Rowland of Overcompensating and Wigu posted on his blog recently an excellent account of the global financial crisis and the housing bubble that precipitated it. Well, he linked to the graphic that lives on Mint.com, the financial blog.

The graphic is here.

And this is why I think it's particularly cool, in addition to explaining so simply an incredibly complex situation. The graphic culminates in the bailout and situates the reasons for it, and it pretty much explains itself. But I think the most interesting element of this graphic is that it shows that purely mechanical processes were not entirely responsible for the housing bubble bursting. In fact, many of these mechanical processes were started by a very contingent human activity: belief.

This was the belief that "Housing prices never fall." So housing is automatically a sound investment, no matter how insane the mortgage package might be. This belief was at the centre of the mania for home ownership, because real estate was seen as a guaranteed investment. There was no real worldly evidence for this perception, only the belief that operated as its premise: "Housing prices never fall."

If you believe that housing prices never fall, then any investment in housing will eventually be profitable. In order to have more real estate to invest in, more and more houses are built. Eventually, the number of houses outweighs the number of people able to buy them, even under subprime paradigms of mortgage. When the supply outstrips the demand, then prices fall. But no one thought about this because there was a belief among so very many people that "Housing prices never fall."

But the supply of houses was outstripping the demand, so housing prices were falling. And when you have to pay more on your mortgage debt than the actual value of your house, you can't afford that debt anymore. You'll have to borrow against your house to pay off the debt on your house. But that just creates more debt on your house. The result of this conundrum is default. And when homeowners default, the banks lose their money. And banks had integrated these mortgage debts into almost every investment package they sold, every investment agency ended up losing a ton of money. Investment agencies including Bear Stearns, Lehman Bros, AIG, Merrill Lynch, for example. With no lenders having any money, there was no source for loans or investments of any kind. Since big purchases are driven by loans and credit, no one could make big purchases, and the economy constituted from those purchasers (us) ground to a halt.

All following from a single concept: "Housing prices never fall." Remember the power of thought.

1 comment:

Chris in NF said...

Suddenly, it all makes sense.