Just What Is a Credit Crisis?

An old friend, an 81 year old mathematical physicist, posed that somewhat astonishing question last October by email and again a couple of days ago in London when we visited where he lives. He wanted it in about 750 words.

Here is what he got. He was sufficiently satisfied to suggest that it could be useful if seen by a lot of 'civilians' who he believes, perhaps correctly, are too embarrassed to ask the same dumb question.

The answer begins by explaining that the word credit is derived from the ancient word "credere" meaning to believe, to trust.

For example, your credit card is based on the issuer's, for example Visa, trust that you will pay them what they have advanced on your account to your "creditors" -- the people who sold something to you and trusted you and Visa to pay them for what was sold.

Then the question begins to gets a bit more complicated. The balance in your bank account is called a credit balance because you trust your bank to keep it safe and pay it to you or, on your instruction, to someone else, whenever you want.

In the meanwhile your bank constantly has dealings with lots of borrowers and other banks and lends its depositors' money, including yours, to those banks and other borrowers trusting them to pay fully and in a timely way.

When you buy your car on credit you promise the auto finance company that you will pay monthly over, say, three years the money you borrowed to buy the car. The auto finance company pays the car manufacturer the full purchase price and in turn borrows that money from all sorts of other lenders, who all trust your promise to pay what you owe when you owe it.

Similarly, when you buy a house, you take out a mortgage from a lender, which is a promise secured by your house, to pay over, say, 30 years the full price you had agreed to pay the seller. That lender in turn borrows the money to lend to you from a lot of institutional investors, including government backed companies which specialize in housing finance, all based on everyones' promises to pay. That obviously again involves trust on all sides by everyone involved.

At this point the subject gets pretty complicated. Your promise to pay for your house can get packaged with the mortgage company's promise to pay into another whole different type of loans called "derivatives" because they are derived from your original promise to pay. Those derivatives contain many different types of original buyers [old, young, rich and poor] and different types of mortgages [fixed rate, variable rates of interest etc] which are in turn sold to another different collection of institutional investors who trust that virtually all the participants will pay what they owe on time for years into the future.

And, to add another complication, some of those derivatives divide the risks they contain into different pieces that can be sold separately, for example early versus later pieces or interest versus principal. Believe it or not, simply because those packages contain blends of separated risks, they are presumed or alleged to be overall less risky than all their various separate underlying pieces. Therefore at least parts of them sell for a "better" price [profitable to them] than you paid for your original mortgage. These fancy instruments became very plentiful and supplied 'wonderful' profits for many years to many eager people up and down the marketing chain. Talk about trust!!!

In the meanwhile more housing was being encouraged in every way, by public and private policies, and more and more buyers were lured into the housing market at ever rising prices to the point that many people began to think they were really getting rich from their rising home prices and some started speculating by buying more houses simply to resell them at ever higher prices. Is that trust or greed or what??

And, in the meanwhile bankers of all stripes, conservative and 'modern' alike began senselessly buying more and more of these "riskless" derivatives without taking on more protective capital, because it appears they truly believed there were no real risks involved. They saw what they did as a public good because it helped finance more houses and because, by the way, it also generated giant trading profits for all the intermediaries along the way including lots of needy traders and bankers.

Trust in the power of profit incentive really did its work.

Then, lo and behold, after many years of uninterrupted continued success, suddenly , within about one year, there became many excess houses, cars and credit card overdue balances, and more and more owners/debtors could not meet their obligations and began to default on their promised payments. The overall default rate of broken promises began to rise rapidly and ripple throughout the whole economic system. That, of course, led to drops in sales of houses, cars and everything else everywhere and in turn led to lay-offs of workers, who of course were also borrowers, owners and investors, and, thus many more failed promises to pay on time. Trust in all its forms swiftly began to melt away.

That is a full blown credit crisis. Banks stop trusting each other as well as everyone else. Nearly everyone stops lending because they are all over extended, so that very few people now can borrow to buy a house, car, vacation, or whatever, and the whole economy begins to grind to a halt because there is no credit to supply the cash to power the economy in any direction except down.

Whatever happened to "trust but verify"?

Comments

[Lois Geller]

Frank,
At last, you helped me to understand this whole avalanche of credit problems we're having.
I read your daughter Debbie's Twitter and she sent me here to read what you have to say.

I own a direct marketing advertising agency, formerly in New York City, and now in Hollywood, Florida. Our clients have all pulled back, are scared, having loan issues...and the whole feeling in this state is awful. I spoke at a Luxury Marketing Council event a few weeks ago, and they're really feeling that no one wants to buy luxury items (even if they have the money to do so).

Anyway, I'd like to repost your explanation here (in part) on my blog:
http://www.joyof directmarketing.com Let me know if that's okay with you. I've written many books on direct marketing, and am in the middle of writing a new one...and in this economy, I'm just not sure if I should be advising companies to continue moving their marketing efforts. What do you think?

[marinara]

Quoting Frank A. Weil: "That is a full blown credit crisis. Banks stop trusting each other as well as everyone else. Nearly everyone stops lending because they are all over extended, so that very few people now can borrow to buy a house, car, vacation, or whatever, and the whole economy begins to grind to a halt because there is no credit to supply the cash to power the economy in any direction except down."

I think you are confused here.Money is a medium of exchange, not an asset to the economy. And you seem not to understand this error, because you rush it into your final paragraph as you try to explain something you don't have the slightest understanding of.

[marinara]

Why do you think that the housing bubble and the recession are related? Why? Can you explain that in 750 words? Wouldn't the recession have to lag due to the effects of the Housing bubble? But its clear to everyone that the recession started before the effects of the housing bubble were felt. How do you explain that?

[martin2]

Frank,
It's all about stealing, hundred million $ salaries + bonuses
billian $ pensions

[Henry]

Frank,
It is a "credit crisis" for a very simple reason. When a bank makes a loan is creates a deposit which is a "credit". That is the plain and simple of it. The creation of that credit is M-1 type of money. It is what you buy things with. Similarly, a "credit" card permits you to purchase a meal at a restaurant with a "credit" to the merchant demand deposit account that emanates as a loan or advance from the issuing bank. Money other than currency, is all accounting credit entries. It is really that simple. It is a credit crisis, because everything on "margin" has to be paid back. And.... when you pay back a loan, the credit balance in your deposit account is "expunged" in an accounting entry that pays down (expunges) your loan principal balance along with what previously was a credit balance in your checking account. Loans are often referred to as "credits" by bankers and you are aware of the loan crisis etc etc. Banks are not now making loans, right? They are not creating money to finance economic activity. We are in a recession, heading to who knows where.
The metaphor is when there is no water, you experience a drought. No credit (money) the taps need to be turned on somehow.

[KillTheMessenger]

I am not sure anything here is about trust at all. More likely than not it is about risk, which is the statistical answer to the question about the future. Banks do generally not trust their clients (we wouldn't need bankruptcy laws, penalty fees etc. if they did). Instead they categorize people according to risk profiles on which all following calculations pretend to be based (more often than not, I believe, they aren't even based on risk but merely on projected returns, which makes matters even worse).

And risk profiles might actually work quite well (if being faithfully listened to, that is!) until they stop working at all because the necessary preconditions for their application are not met. And since bank's risk profiles are based on "business as usual" i.e. market prices going up, people being employed etc. any inversion of major market variables will make even risk profiles into a gambling game.

Last year we had a major inversion of basically any and all market variables. At that point (latest) risk profiles became invalidated and with that the valuation of previously "safe" assets plummeted. Simple accounting rules take it from there (virtual value being lost) to catastrophe (real value being destroyed).

Did banks fail to foresee this? I am not sure. I tend to believe that plenty of people saw it coming, yet the institutions themselves remained unmoved. You can ask NASA about how that works and why they lost two shuttles to institutional momentum/madness.

[Rule Of Law]

"...after many years..., suddenly, within about one year, there became many excess houses, cars and credit card overdue balances, and more and more owners/debtors could not meet their obligations and began to default on their promised payments."

"suddenly, in one year..." And That caused the credit crisis? Are you sure? Because you make it sound like it started at the bottom, and I'm pretty sure it started at the top, like any Ponzi scheme.

The Great Circle Of Trust--I can hear Disney music in the background--began to unwind when more of those trusting sovereign wealth funds, foreign banks and brokerages, pension funds and other mega buyers of these suspect products began to clamor for their payoffs and found that there wasn't enough money in the world to begin to cover their bets.

That the downstream broker they'd bought from was super leveraged or into some other product himself by then and couldn't come up with the green to satisfy his customers. THAT is when the realization hit the big players that the paper they held was not AAA. And they were upset. And they still wanted their money. And even AIG couldn't cover all the bets. And the artificially inflated (again, from the top down) value of those homes collapsed when the banks who'd played the game were caught without funds to lend, never mind pay off on their debts. That caused the credit crisis.

[AllenPapapetrou]

"Whatever happened to 'trust but verify'?"

Ah! External validation, what any scientist knows well.

In general, when I ask fellow techies for advice and opinions they know and expect that I might do more research and talk to other techie friends to externally validate their advice.

Also, in general, when I ask my non-techie friends for advice and opinions, if they find that I've done more research and talked to others their response is "What you don't trust me?". So I try to explain about external validation.

Another aspect of this is direct experience. If I show someone that a knot is tight my techie friends are morely likely to test it themselves: for the direct experience of my assertion - my opinion.

Without tranparancy verification is mumbo-jumbo.

Nice to see your 81 friend, a scientist, is still sharp as a tack!

Thanks, Frank!