This article was co-written by Josh Mirkin and Stephen Spitz. 

Note to Reader: I realize that, as I write this article, half the campus is probably preparing for corporate recruiting interviews by checking the most recent prices of 10-year Treasury bonds; the other half probably thinks the credit crisis has to do with fulfilling their distribs before Senior Spring. In light of this dichotomy in financial IQ, the goal of this article is to get the average Dartmouth student up to speed on the ins and outs of the current economic crisis.

NEVER PUT YOUR OWN MONEY IN THE SHOW

Some people may wonder why banks store your money and offer interest. In reality, banks store only a very small fraction of your deposit: they use most of it for loans to people that will pay them back with interest. Mortgages (loans for real-estate acquisitions) are especially profitable for banks.

Before banks grant loans, they (in theory, at least) verify that the borrower can likely repay it. To do this, the bank conducts a review of the borrower's employment and credit history, ideally revealing that the borrower has a stable job, good income, and no previous problems with lenders. In order to insure some return on the loan, banks will demand higher interest from riskier borrowers. For decades, government regulations and bank operating procedures maintained the system's fidelity.

SUBPRIME MORTGAGE CRISIS

As the name implies, the current financial situation began with "subprime mortgages." A subprime mortgage is simply a mortgage given to a borrower whose credit history would normally disqualify him/her from a loan. Naturally, there's a significant risk that these "subprime" borrowers won't be able to repay their mortgages.

So why did banks start giving out these bad mortgages? The answer lies in the increasing popularity of mortgage-backed securities. Securitization is the process of pooling and repackaging any asset, and the process of securitizing mortgages is a bit like the making of smoothies in Collis: numerous mortgages are thrown together, blended, and sold in small portions to corporate investors. Mortgage-backed securities make it possible for companies, even those without lending components, to invest in a wide range of mortgages.

DON'T DRINK THE PUNCH

Unfortunately, instead of serving nutritious Collis smoothies, the financial markets have been dishing up mortgage-backed securities more like Phi Delt's punch: it may look good, but why can't you ask what's in it? Mortgage-backed securities are created and bought with the expectation that there will be a range in the quality of mortgages - some bad mortgages can be sold with the good ones and investors will still buy the lot. Though the inclusion of low quality mortgages increases the risk of the security, it increases the potential reward as well, in the form of interest paid to investors.

With an increasingly active market for these securities and a general underestimation of their risk, banks didn't even need to worry about the quality of the mortgages: they could bundle several together and sell them to someone else. In fact, no one worried about the specifics of the mortgages since the securities in which they were packaged could be traded (and, thus, the risk transferred) an infinite number of times. Operating under the assumption that all mortgages would be sold to a third party, it didn't matter to banks whether the loans were actually repaid - since they made money just by selling the loan, they screened borrowers less effectively in order to increase the volume of securities transactions. Some lenders even went out of their way to convince subprime borrowers that they could afford a mortgage. Shockingly, at certain times mortgage-backed securities seemed to rival the importance of the U.S. Treasury bond - the bread and butter of our financial system.

HOT POTATO

Somewhere amidst the increasingly complex and theoretical transactions intended to hide and transfer risk, the financial sector deluded itself into believing that risk could be eliminated completely. Alas, even in a world of Wall Street wizardry and impossibly convoluted maneuvers, the risk had to land somewhere, no matter how many times it was transferred. Someone had to be holding the hot potato when the music stopped.

And in early 2007, the music finally stopped. The mortgages started failing. When a loan fails (a "default"), the bank collects "collateral": at the outset of a loan, in order to "hedge" the inherent risk the lender takes on, the borrower agrees to give the lender something concrete in the case of default (think of when you "borrow" squash rackets in the gym: they - the lender - make you leave your ID so you have substantial disincentive to steal the racket). Mortgages are collateralized by the houses themselves, so when someone defaults, their house is seized by the owner of the mortgage. In a normal economic climate, lenders can mitigate their losses from defaults by selling these foreclosed homes. But with the housing bubble thoroughly burst, there was no market for any homes - let alone ones stuck with the stigma of a foreclosure. All of the sudden, the final holder of the security was stuck with something that wasn't worth anything at all. Quickly, it became apparent that the "infinite" transfers of risk didn't actually eliminate risk; rather, they ensured that every entity along the line of transactions was tied into it.

THE CREDIT CRUNCH

Financial institutions started realizing that they would be losing a lot of money from bad mortgage-backed securities and the "illiquidity" (un-tradability) of good ones (they predicted that the bad vibes from the failing securities would scare investors away from mortgage-backed securities altogether). Although a few companies did go out of business directly from the failure of these securities, they tended to be small and specialized in the area of subprime mortgages. The largest financial problems (Who thinks they can still apply to Lehman Brothers?) come not from the failure of mortgage-backed securities directly, but rather their shockwaves.

Institutions that lost money from mortgage-backed securities had to be far more conservative in giving out loans. Since the fallout from the mortgage failures was so widespread, it became far more costly for all companies to take out loans. This is commonly referred to as a "credit crunch." Loans that would have been granted before the crunch were now often denied, and companies with no relation whatsoever to finance were suddenly reeling from the mortgage crisis.

Loans are necessary for every business and individual. With few exceptions, every business loses money in its initial years. Even relatively strong companies post negative profits for decent stretches of time. In fact, most retail stores operate in the red the entire year, only to be saved at the last moment by the holiday season. Simply put, companies that can't get loans, go out of business. When companies go out of business, jobs disappear. And when bona fide corporations can't get loans, you can forget about those jobs being recreated by entrepreneurs and startups.

As we have seen with Bear Stearns, Merril Lynch, AIG, and many others, this isn't just a problem for small companies. Some of these companies are over 100 years old, but not even they could not overcome the toxicity of the mortgage-backed securities they owned and the spread of the credit crunch.

TO THE FUTURE

What's being done to remedy the crisis? What can be done? The first attempt at damage control was the slashing of the Federal Funds rate, which is the interest rate at which banks lend money to each other - in other words, the standard for a zero-risk loan by which every other loan is affected. After three straight years of consistent interest rate increases from 2003 to 2006, the Federal Reserve, a quasi-governmental organization that manages monetary policy, aggressively cut the Federal Funds rate in an attempt to make borrowing easier. (I will not go into the exact mechanism of how the Federal Reserve does this, but interested parties are invited to visit the New York Federal Reserve Bank's website.) By lowering the rate at which banks loan to each other, the Federal Reserve lowered the rate at which businesses and individuals can take out loans.

The second and more controversial step which the federal government has been taking is bailing out large companies. The U.S. government has a funny little policy called "Too Big to Fail." Somewhat ironically, the more prominence a financial company has in the economy, the more the U.S. government will do to prevent it from failing. Basically, if the government feels that the failure of a particular company will cause too much chaos in the economy, the government will provide the money the company needs to continue, as we saw in September with AIG, which the federal government now essentially owns approximately 80% of. Although bailing out these large companies does promote stability, some worry that it encourages large financial institutions to take more risks: if a company is assured that they will be bailed out at all costs, they're essentially given free reign to take on high-risk/high-reward endeavors.

Perhaps in our print issue later this month, I will be writing to you about a third and equally controversial step - which may be carried out in a matter of days - the government purchase of those troublesome mortgage-backed securities. I promise the next article will be shorter.