Description of the process of a bank collapsing?

[KingGheedora]

On the news just now they said something about Washington Mutual being "seized by federal regulators", with parts being immediately sold to JP Morgan. What is the legal process that precipitated this seizure? Did WaMu have to approach the government with some kind of legal declaration about its finances which then prompted the government to seize and sell?

These mortgage backed securities are called "toxic", and apparently WaMu had a lot of them; why did this cause them to fall? Couldn't they have sat on these and waited for whatever payout may come? Exactly how have these pools of mortgage loans caused them to fail at this particular time, and not one year ago, or one month ago? It seems the banks that fell were the ones who had a significant amount of their net worth tied up in these flaky securities, which were bought at prices that reflected the inflated housing market. What provided the elasticity that allowed Wamu to last at least a week longer than the others (Sallie/Freddie/AIG/Lehman)? Did all of these "fall" in the same way? What is the harm in letting these banks fall? Why is credit frozen up by just the fact that these banks have these bad loans? If Microsoft needed to borrow money for a few months to pay for it's employees, who would they normally turn to for the funds, and which of those options would no longer be available if we didn't have a bailout? Are these falling banks the only options for Microsoft in this scenario?

Why were the mortgage security prices inflated? I would think with all the brilliant minds these firms have recruited from top universities every year for decades, that they would have developed by now the practice of understanding all details behind risks they are taking? Why didn't they say "why should I buy these mortgages that were loaned to people with no income?" These "liar loans" come into play here, and the logic here is either stupid or stupider -- anyone buying the mortgage pools should have been aware of the lending practices being employed, no? Why would they put their money into these? Banks are supposed to act in their own self interest, why didn't they do so in this case? Is this why the "free market" did not determine a fair price for the securities?

Jeez. It seems so obvious now that everyone has pointed all these things out. It seems stupid to me that this could have even taken place, so I feel like there has to be something I'm missing. Has everyone involved, from the individuals posting mortgages likely to foreclose, to those who purchased these mortgages (securitized), been playing a game of musical chairs to the tunes of "Real Estate Bubble Rock"?

 

[nerp]

Listen to this. Very good explanation.

http://www.thisamericanlife.or...isode.aspx?episode=355

Remember, this was made a while ago before the problem finally reached critical mass. But it really explains how the fundamental pieces started.

 

[LegendKiller]

If I bought $100 of MBS and held it, it would reasonably give me back $100 within the next 10 years, as the obligors paid down their mortgage.

However, lets say that credit markets don't want that MBS anymore, further, lets say that the interest rate for newly issued, or newly sold MBS, similar to mine, results in a price of $90.

That means that I have to take a $10 write-down. What happens is that write-down hits the equity side of my balance sheet. Remember, Assets = Liabilities + Equity.

If A = L + E, my $100 bond results in this equation. $100 (bond) = $85 (Corporate Liabilitity) + $15 (common stock).


Now, since my bond has to be written down, now the equation goes to $90 = $85 + $5.

Eventually, this squeeze keeps happening, my equity keeps going down, and my capital (equity), which is what keeps me funded, is eroded. Once it is eroded enough, the regulators take over my bank.

Now, if I hold the bond, it will likely pay me back $100. However, since my capital is so low, I may have no choice but to sell it. However, to do so, I will lock in my losses.

Additionally, since i need capital to write more business (loans), I must stop writing new business.

Since people are afraid my bank is becomming insolvent, and my assets are depreciating, they realize there may not be enough assets to pay off the debt ($85). Thus, they panic and stop lending to me. That makes the situation worse, since I have nowhere to turn for *ANY* money.

Then, consumers get scared, they remove deposits ($20 of the $85). That means that I have to sell assets, locking in the loss. I turn around, selling $20 of the $90 bond.

So here you get to the core of the problem. If my capital base is weakened, I cannot write business. If I cannot write business, then the companies that come to me for money will get none. If they get none, then the economy will stop.

I am not talking about credit cards, or auto loans. I am talking about small business loans, or working capital loans for businesses. Eventually, since those businesses can't fund themselves because banks can't fund themselves, the businesses will have to shrink

 

[LegendKiller]

Originally posted by: KingGheedora
On the news just now they said something about Washington Mutual being "seized by federal regulators", with parts being immediately sold to JP Morgan. What is the legal process that precipitated this seizure? Did WaMu have to approach the government with some kind of legal declaration about its finances which then prompted the government to seize and sell?

I think that WaMu probably was told by the regulators that the jigg was up. They had to accept JPM's deal. Not sure of the specific legal process, other than the regulators can take control of the bank.

These mortgage backed securities are called "toxic", and apparently WaMu had a lot of them; why did this cause them to fall? Couldn't they have sat on these and waited for whatever payout may come? Exactly how have these pools of mortgage loans caused them to fail at this particular time, and not one year ago, or one month ago? It seems the banks that fell were the ones who had a significant amount of their net worth tied up in these flaky securities, which were bought at prices that reflected the inflated housing market. What provided the elasticity that allowed Wamu to last at least a week longer than the others (Sallie/Freddie/AIG/Lehman)? Did all of these "fall" in the same way? What is the harm in letting these banks fall? Why is credit frozen up by just the fact that these banks have these bad loans? If Microsoft needed to borrow money for a few months to pay for it's employees, who would they normally turn to for the funds, and which of those options would no longer be available if we didn't have a bailout? Are these falling banks the only options for Microsoft in this scenario?

WaMu ran out of time. The pools of mortgages keep getting valued lower, and lower, eroding their capital base. Why? Because nobody wants to buy them, if nobody does, the price goes down and the bank is forced to recognize a non-market "market price". It is a vicious circle that is slowly destroying the banks.

WaMu was an actual bank, as opposed to Sallie/Freddie/AIG/Lehman, so they could borrow from the government on a temporary basis. However, time ran out. BSC/LEH died in different ways, but still the same, erosion of capital and loss of confidence resulting in a panic (run on the bank).

Credit is frozen because everybody is afraid of losing money. Why lend money to a bank if you might lose it? Why lend money to the consumer when you might lose it? They already have less capital than they need, so they must preserve it.

More or less, Microsoft would need a bank, unless they get money from somebody else.

Why were the mortgage security prices inflated? I would think with all the brilliant minds these firms have recruited from top universities every year for decades, that they would have developed by now the practice of understanding all details behind risks they are taking? Why didn't they say "why should I buy these mortgages that were loaned to people with no income?" These "liar loans" come into play here, and the logic here is either stupid or stupider -- anyone buying the mortgage pools should have been aware of the lending practices being employed, no? Why would they put their money into these? Banks are supposed to act in their own self interest, why didn't they do so in this case? Is this why the "free market" did not determine a fair price for the securities?

Greed. People were stupid and estimated the wrong things. It happens. The details in understanding this problem were around when it was happening. However, people simply turned a blind eye. It was a lack of regulation, oversight, reporting...etc.

To them, it didn't matter if they were "liar loans", because they thought they were adequately protected by credit enhancement ($110 of loans backing a $100 bond, the extra $10 would absorb the first $10 of losses), or by credit insurance (wraps by AMBAC, MBIA, FGIC, AIG).

Liar Loans weren't evil until recently. THey were mainly used for high-credit self-employed people. However, in the last 7 years they were used as a product for people to get into houses they couldn't afford. Since they were never used for that purpose before, nobody had data on how these loans would perform, so they guessed.

They guessed wrong. Mainly because they had no incentive to guess right.

They put their money into them because they were greedy.

Jeez. It seems so obvious now that everyone has pointed all these things out. It seems stupid to me that this could have even taken place, so I feel like there has to be something I'm missing. Has everyone involved, from the individuals posting mortgages likely to foreclose, to those who purchased these mortgages (securitized), been playing a game of musical chairs to the tunes of "Real Estate Bubble Rock"?

More or less. the NAR kept screaming "Real Estate is an investment, look how fast it is appreciating", or "RE never goes down in price".

Frankly, RE is a home, not an "investment". It was pitched as an "investment" in the last 15 years as a way to get people to buy houses. You ask anybody who bought a house 20 years ago to name the top 3 reasons why they bought. Those would be, in this order.

1. Place to live to call their own.
2. Didn't want to keep renting, it is giving money to somebody else.
3. Money put into the house is equity, which may or may not appreciate and return money.

In the last 7 years that flipped.

1. Money put into the house is equity, which may or may not appreciate and return money.
2. Didn't want to keep renting, it is giving money to somebody else.
3. Place to live to call their own.

People fell for it. Consumers were greedy too.

 

[AMCRambler]

Originally posted by: LegendKiller

Originally posted by: KingGheedora
On the news just now they said something about Washington Mutual being "seized by federal regulators", with parts being immediately sold to JP Morgan. What is the legal process that precipitated this seizure? Did WaMu have to approach the government with some kind of legal declaration about its finances which then prompted the government to seize and sell?

I think that WaMu probably was told by the regulators that the jigg was up. They had to accept JPM's deal. Not sure of the specific legal process, other than the regulators can take control of the bank.

These mortgage backed securities are called "toxic", and apparently WaMu had a lot of them; why did this cause them to fall? Couldn't they have sat on these and waited for whatever payout may come? Exactly how have these pools of mortgage loans caused them to fail at this particular time, and not one year ago, or one month ago? It seems the banks that fell were the ones who had a significant amount of their net worth tied up in these flaky securities, which were bought at prices that reflected the inflated housing market. What provided the elasticity that allowed Wamu to last at least a week longer than the others (Sallie/Freddie/AIG/Lehman)? Did all of these "fall" in the same way? What is the harm in letting these banks fall? Why is credit frozen up by just the fact that these banks have these bad loans? If Microsoft needed to borrow money for a few months to pay for it's employees, who would they normally turn to for the funds, and which of those options would no longer be available if we didn't have a bailout? Are these falling banks the only options for Microsoft in this scenario?

WaMu ran out of time. The pools of mortgages keep getting valued lower, and lower, eroding their capital base. Why? Because nobody wants to buy them, if nobody does, the price goes down and the bank is forced to recognize a non-market "market price". It is a vicious circle that is slowly destroying the banks.

WaMu was an actual bank, as opposed to Sallie/Freddie/AIG/Lehman, so they could borrow from the government on a temporary basis. However, time ran out. BSC/LEH died in different ways, but still the same, erosion of capital and loss of confidence resulting in a panic (run on the bank).

Credit is frozen because everybody is afraid of losing money. Why lend money to a bank if you might lose it? Why lend money to the consumer when you might lose it? They already have less capital than they need, so they must preserve it.

More or less, Microsoft would need a bank, unless they get money from somebody else.

Why were the mortgage security prices inflated? I would think with all the brilliant minds these firms have recruited from top universities every year for decades, that they would have developed by now the practice of understanding all details behind risks they are taking? Why didn't they say "why should I buy these mortgages that were loaned to people with no income?" These "liar loans" come into play here, and the logic here is either stupid or stupider -- anyone buying the mortgage pools should have been aware of the lending practices being employed, no? Why would they put their money into these? Banks are supposed to act in their own self interest, why didn't they do so in this case? Is this why the "free market" did not determine a fair price for the securities?

Greed. People were stupid and estimated the wrong things. It happens. The details in understanding this problem were around when it was happening. However, people simply turned a blind eye. It was a lack of regulation, oversight, reporting...etc.

To them, it didn't matter if they were "liar loans", because they thought they were adequately protected by credit enhancement ($110 of loans backing a $100 bond, the extra $10 would absorb the first $10 of losses), or by credit insurance (wraps by AMBAC, MBIA, FGIC, AIG).

Liar Loans weren't evil until recently. THey were mainly used for high-credit self-employed people. However, in the last 7 years they were used as a product for people to get into houses they couldn't afford. Since they were never used for that purpose before, nobody had data on how these loans would perform, so they guessed.

They guessed wrong. Mainly because they had no incentive to guess right.

They put their money into them because they were greedy.

Jeez. It seems so obvious now that everyone has pointed all these things out. It seems stupid to me that this could have even taken place, so I feel like there has to be something I'm missing. Has everyone involved, from the individuals posting mortgages likely to foreclose, to those who purchased these mortgages (securitized), been playing a game of musical chairs to the tunes of "Real Estate Bubble Rock"?

More or less. the NAR kept screaming "Real Estate is an investment, look how fast it is appreciating", or "RE never goes down in price".

Frankly, RE is a home, not an "investment". It was pitched as an "investment" in the last 15 years as a way to get people to buy houses. You ask anybody who bought a house 20 years ago to name the top 3 reasons why they bought. Those would be, in this order.

1. Place to live to call their own.
2. Didn't want to keep renting, it is giving money to somebody else.
3. Money put into the house is equity, which may or may not appreciate and return money.

In the last 7 years that flipped.

1. Money put into the house is equity, which may or may not appreciate and return money.
2. Didn't want to keep renting, it is giving money to somebody else.
3. Place to live to call their own.

People fell for it. Consumers were greedy too.

Damn, LegendKiller is wicked smart! I've never heard it explained so well and succinctly. Nice job. More evidence of what you describe in the last few paragraphs there would be all these stupid houose flipping shows on TV. These knuckleheads who would by an older house on a nice piece of property and would throw $30,000-$100,000 into fixing it up and then sell it for $200,000 more than it was really worth. I guess they weren't knuckleheads, it was the people that would actually buy the house that were the knuckleheads because they were the ones taking out the sub-prime mortgage to pay for it. The ones doing the flipping were just reaping the benefits that the banks would eventually pay for.

I got a question for you Legend. I've got my money in a local credit union rather than one of these big banks. Did these smaller local banks engage in these risky lending practices the same as the big banks? I keep hearing all these doomsayers saying you wont be able to get your money out of the bank, yada yada. But I haven't heard anything along those lines for the smaller banks. Are they just too small for them to make the news when they go under or were they smarter with their lending?

 

[Drekce]

But, understanding all of that implies to me that if the Government (via the bailout money) purchases a large number of those loans it probably won't cost anywhere near $700B in the long run. A lot of those mortgages will be paid, and even those that aren't paid are backed by real property. The Government would then have to sell the property, probably for a loss, but that loss won't be anywhere near 100%, probably not even 50%.

The way I see it, the difference is that the Gov. doesn't have to worry about having capital (in the same sense as the businesses), which means that the near term effects will be mitigated. Giving this nearly blank check to the treasury dept. is definately not a good thing, but I see it as necessary right now, and not nearly as costly in the long term as people are generally thinking.

I am an engineer, not an economist, so please let me know if I am thinking about this incorrectly. I am not too closed minded to listen and learn from other people.

 

[dullard]

Originally posted by: Drekce
But, understanding all of that implies to me that if the Government (via the bailout money) purchases a large number of those loans it probably won't cost anywhere near $700B in the long run. A lot of those mortgages will be paid, and even those that aren't paid are backed by real property. The Government would then have to sell the property, probably for a loss, but that loss won't be anywhere near 100%, probably not even 50%.

Since we don't have a bailout plan agreed upon yet, we cannot say what will happen with the bailout.

The option that I hear the most about is the government buying the crappiest of the crappy loans. That purchase will instantly take the pressure of the bad loans off of the banks. Like you said though, the government won't lose all $700 billion, since at least some payments will come through on some loans and the foreclosed homes still have some value in most cases. However, it likely won't be profitable since they are buying the crappy loans, not necessarilly the good loans. However, there is a big potential problem with this solution. The banks don't learn their lesson. They can still write crappy loans. And it doesn't mean that anyone will buy any of their loans (even if they write good ones). The banks are still castrated until someone steps up to buy the future loans.

I'd rather see the opposite. I'd rather see that the government step up and promise to buy FUTURE loans (with proper regulation to keep them from being so toxic). The banks can keep doing business and be profitable (profitable on these future loans). The profits can help offset the bad loans that they keep on their books. The small businesses can still get their loans to do business. People can still get loans to buy houses, cars, and credit card purchases. The economy doesn't crash. Sure, some banks won't survive this process. But we've known for many years that we have too many banks in the country for them to be always profitable. Some contraction may be painful, but it is necessary. If the contraction is TOO severe, then the government can step in and buy some of those toxic loans.

Note: since the government will be taking loans to buy these loans, even if the toxic loans returned 100%, the government still loses big time due to the interest the government pays. The toxic loans need to pay well above 100% in order for the government to break even.

 

[43st]

Credit Unions can be at just as much risk.. it all depends on the percentage of activity involved in the loan market. CU's are insured similar to the FDIC, but from a separate fund. This can be a major benefit in certain cases because the largest CU is a tiny fraction of the size of a large bank.

 

[AMCRambler]

Originally posted by: 43st
Credit Unions can be at just as much risk.. it all depends on the percentage of activity involved in the loan market. CU's are insured similar to the FDIC, but from a separate fund. This can be a major benefit in certain cases because the largest CU is a tiny fraction of the size of a large bank.

Yeah, I would think a small credit union with less capital available to them would be less likely to take risky loans, but I'm no expert.