Graves: Bring out your collateral

With the collapse of Lehman and the Federal Reserve’s impending bailout of AIG, popular media and, in turn, students at Yale have begun to realize the gravity of our nation’s financial situation. Unlike past recessions, present economic woes were not engendered by declining demand. Rather, a most virulent contagion has struck the very core of our financial system.

Most Yale macroeconomics courses train students in the rudiments of fiscal and monetary policy. Professors offer explanations of rate cuts by the Federal Reserve as well as changes in fiscal policy by the federal government. As evidenced by the Fed’s decision today to maintain the federal funds rate—the rate at which banks can loan to one another—at 2 percent, monetary policy alone will not be a panacea. Many students may wonder why most of their economics courses have left them unprepared to understand the current crisis. No courses address the central question: what exactly has happened to the United States economy?

To find an answer, look no further than mortgages.

Imagine: a couple wants to buy a home but in order to obtain a mortgage, they must offer up the house as collateral—if they default on their loan, the bank can seize the property to recover the value of the mortgage. First, however, the bank must check the family’s credit. After confirming that credit requirements are met, the mortgages are packaged together into an interest-paying security which is often backed by a government enterprise and then sold to an investment bank, hedge fund or another large institution. If, suddenly, many people are unable to make their mortgage payments and default on their promises, the holders of the mortgage-backed securities begin to suffer. The lenders can seize the collateral (homes), but if the homes have dropped in value, the lender will be unable to recover his money.

During the past decade, the United States experienced a tremendous and unsustainable boom in housing. Many Yalies from Southern California to Miami watched as their childhood homes inexplicably doubled in value. It was a classic bubble. And like all bubbles, it popped.

Easy lending to unqualified borrowers, incompetence at rating agencies that misjudged the risk level of various mortgage backed securities, and bizarre mortgages that led to a plethora of defaults all began to eat away at the US credit markets. The first to go were the subprime mortgages, those that involved loans to clients with little to no assets. This led to a chain of events in which mortgage-backed securities and other debt-related instruments began to loose their value, causing problems for lenders like investment banks.

During the crisis, liquidity tightened (it became difficult to obtain credit or trade assets) and banks got stuck with large chunks of these declining securities. Freddie Mac and Fannie Mae, the two government-sponsored enterprises that guarantee half of the country’s mortgage debt, began to fall apart as more and more borrowers defaulted on their loans, leaving only now-depreciated homes to be seized.

This is how banks like Lehman lost billions. And as a bank begins to fall apart, the process accelerates as other institutions deny it loans. Facing enormous debt and a share price battered by the sell-off in the stock market, Lehman was forced to file for bankruptcy. If the government steps in to intervene and save big institutions like Lehman, it creates “moral hazard”: future companies will expect a bailout and take greater risks.

At this point, the government must try to save institutions vital to the economy while allowing the credit crunch to destroy those companies and funds that took foolish risks. If this week is only the first round in a series of collapses, as Yale Professor Robert Shiller believes, we all could be in for rough times. The decaying financial system will eat away at the stock market and further push the economy toward recession. As the crisis has now spread across the world, all Yalies should follow the state of our financial system with as much concern as they track the current presidential election. The price of your apartment after graduation, the value of the Yale endowment, and your future career prospects are all at stake.