The credit crisis began earlier this year first with defaults on mortgages that were packaged into securities and sold to institutional investors. The defaults were simple homeowner defaults on mortgage payments that had adjusted upward and became too expensive for the homeowner to pay. When greater numbers of defaults occurred, it became clear that the securities into which these mortgages were packaged - known generally as structured investment vehicles, collateralized mortgage obligations, or collateralized debt obligations - were of a poorer credit quality than anticipated at the time the securities were originally sold.
With the recognition that the default rates were outside the predicted ranges when the packaged mortgages were sold large investment institutions did not want to purchase new securitized mortgage securities, and therefore banks found it increasingly difficult to sell their mortgages to investment banks that would package them into securities. Banks had to reduce their lending because they could not easily sell their mortgages. Since banks could not sell as many mortgages, the banks' supply of capital for new loans was significantly reduced. The reduction in lending reduced the demand for homes, causing declines in home values, for the first time in decades.
Meanwhile payments on older adjustable rate mortgages were adjusting upward. As payments rose and home values fell, it created an incentive for homeowners to default on their mortgages, putting more homes into foreclosure and more homes on the market for sale by banks that foreclosed on homes. These foreclosed home sales further depressed home values. Soon, even homeowners with fixed rate mortgages were questioning whether to continue paying their mortgages on their homes with falling values. Many such homeowners began to default on their loans, including an increasing number of “prime” borrowers - those who were not considered at risk of default.
Meanwhile, as defaults rose in the packages of mortgages held by banks, insurance companies, and Fannie Mae and Freddie Mac, the value of those securities began to decline, reducing the value of such assets on the books these firms. Furthermore, these institutions were required to “mark the securities to market” meaning carry the mortgage securities at fair market value. With so many sellers of these securities, the market value was significantly below the original cost to purchase these securities, and in some cases there was no market price - there were simply no buyers. Accordingly, those securities had a zero value on the balance sheet of the institutions.
As a result, the debt to asset ratios of these firms began to rise, and some of these institutions became technically insolvent. Many of these institutions found themselves in violation of their loan agreements on their own borrowing. Most corporate borrowing requires the borrower to agree to maintain a certain level of liquidity - cash reserves or securities that can be readily sold. These agreements are called loan covenants. To increase liquidity, many institutions tried to sell their mortgage securities, and as many institutions tried to sell, suddenly there were no buyers, and the value of those assets declined precipitously. Many hedge funds had purchased securitized mortgages with leverage, borrowing up to 30 times the underlying value of the securities on the theory that home prices only go up and very few homeowners would ever rationally default on their loans because the value of their homes would always increase.
As the new reality of homeowner defaults set in, hedge funds began to dump the securitized mortgages in their portfolios at any price, but that often was not sufficient to raise the capital needed to de-leverage the hedge fund. Therefore, hedge funds began selling any of their liquid assets to raise capital. This depressed the value of many other assets. Many hedge funds could not de-leverage, and defaulted on their loans from banks, and the banks could not sell the collateral (the securitized mortgages) for the loans because there were no buyers. These defaults put further pressure on the banks liquidity: their loan portfolios were declining in value and their securities were declining in value. Many banks, other lenders to hedge funds, and holders of securitized mortgages, were forced to begin selling their other liquid assets, and this selling caused the values of those assets to decline as well. The huge decline in stock prices over the past two months was in part caused by the need of firms to find liquidity from the assets on their balance sheets. Many firms had to reduce their debt burden because of loan covenants. As asset values declined, the firms had to reduce their debt by paying it back, and had to raise cash to do that. Thus, there was a massive amount of “de-leveraging” - reduction of debt.
With de-leveraging and efforts to increase liquidity, banks are not lending or not lending in the quantities they did historically. Turning cash into a loan that might go into default is perceived as too risky during this uncertain time. With banks simply not lending, the credit markets are frozen. This is what was meant by the credit markets “seizing up” creating the current credit crisis.
Exacerbating this credit freeze is that the failure to lend is reaching into other banking areas as well. Loans to construction companies, homebuilders, and letters of credit for shippers of goods, are all expensive or non-existent. Even inter-bank lending and short-term borrowing in what is called the commercial paper market has shrunk dramatically, causing many companies to lay off employees to meet short-term cash needs. State and local governments that historically relied on short-term borrowing in between tax receipt periods have been especially hard hit. In many markets, the lack of lending is founded on a mistrust of the borrower's ability or willingness to pay back the loan. Thus, there is a crisis of confidence in the loan market that is making the credit crisis worse.
