The Dummy’s Guide to the US Banking Crisis

Whenever I wade into a new topic like digital photography, gardening or what have you, I visit the local bookstore and get a "For Dummies" book to guide me. I figure that it’s the best way to get up-to-speed quickly without actually looking like a dummy.

So, for those of you who want the 3-minute version of the present crisis, here it is in 20 short steps:

1. In 2001, following a massive stock market and capital spending bubble, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0.25% at a time thereafter.
2. With interest rates so low, the financial services industry sensed a lot of money could be made and went all in on real estate, seemingly unaware that low interest rates were masking large risks.
3. Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst. But, they soon realized that money lost in the stock market was more than offset by rising home prices. So, Americans continued to spend freely.
4. As Americans spent freely, the U.S. went further into debt with the rest of the world. Foreigners, used their dollar IOUs from these debts to start their own bubbles too.
5. Eventually, things started to unravel in 2006 when those that could least afford to purchase homes — so called subprime borrowers — started to default in the U.S., prices having run well out of their range of affordability.
6. In February 2007, HSBC issued the first major warning, a harbinger of things to come, writing down tens of billions in losses from their ill-timed 2002 acquisition of U.S. subprime lender Household International. At first things looked fine and policy makers convinced themselves and the wider public that the problem was contained to subprime.
7. However, when two Bear Stearns hedge funds with exposure to the U.S. housing market blew up in June 2007, people became worried that the risks had been underestimated.
8. It was in August 2007 when BNP Paribas, a large French bank, froze withdrawals in three investment funds that people began to panic. If a bank with zero obvious exposure to the U.S. mortgage sector could have this measure of difficulty, anyone could be hiding untold losses. This marked the official beginning of the credit crisis. The result was mutual distrust amongst large banks operating in the global market for interbank loans which meant credit was hard to come by for many banks.
9. By September, liquidity in the interbank market was so bad that rumours were swirling about various institutions which received most of their funding in wholesale markets. One of these was Northern Rock, an aggressive British mortgage lender. The British public panicked and began lining up to pull their money out of the institution. The Bank of England was forced to bail out the company, subsequently nationalizing it altogether.
10. Meanwhile U.S. housing prices continued to decline. The result was massive losses in the alphabet soup of mortgage-related derivative assets held by large global banks. These instruments are called derivatives because their value is derived from the value in underlying assets like mortgages. The first wave of mortgage-related losses were concentrated in these instruments and investing vehicles: RMBSs (Residential Mortgage Backed Securities) CDOs (Collateralized Debt Obligations), and SIVs (Structured Investment Vehicles) and CDOs of CDOs. Merrill Lynch was the first to report a large loss, at $5.5 billion on 5 Oct 2007. Only to come back less than three weeks later on 24 Oct 2007 to say that the losses were now over $8 billion. Eventually, losses reached $500 billion a year into the crisis for all global institutions.
11. The Merrill losses were followed by losses at most of the large global financial institutions. Many CEOs lost their jobs and the companies were forced to raise capital. By August 2008, the amount raised was to reach $350 billion.
12. The situation seemed to quiet down in early 2008. However, in March the failures of hedge funds Peloton and Carlyle Capital put the credit crisis back in full view. Another 2nd period of panic resulted in the sudden collapse of Bear Stearns, America’s 5th largest investment bank. The Fed organized a takeover by JP Morgan Chase that was a catastrophic 90% loss for Bear’s shareholders.
13. Eventually the collapse of Bear Stearns faded and, for the third time, we were lulled into a false sense of security that the worst was over. Nevertheless, writedowns continued unabated as did capital raising. When Lehman Brothers announced a massive $3 billion loss 0n 9 Jun 2008, the crisis came into full view yet again — much as it had when Bear Stearns’ hedge funds collapsed the previous June.
14. This time, market fears did not recede and the financial markets remained in a constant state of stress. Things started to unravel very quickly. IndyMac, an aggressive mortgage lender, an American version of Northern Rock, was taken over by the FDIC. And a panic was on for the third time.
15. Next were the GSEs. The end result of the market panic was a questioning of the viability of Fannie Mae and Freddie Mac, the two largest mortgage lenders in the United States and at the core of the residential property market. Eventually the U.S. Government was forced to take the two companies into conservatorship.
16. Afterwards, all financial shares generally came under assault. The ones considered the weakest came under the heaviest selling pressure, resulting in the collapse of Lehman Brothers. Without government support and unable to close a merger in around-the-clock negotiations at the weekend, the company filed for bankruptcy on Sep. 15.
17. Merrill Lynch, the venerated U.S. investment bank, sensing trouble, sought and received cover in a takeover by Bank of America that very same weekend.
18. Financial markets smelled blood after Lehman collapsed. Apparently no company was too big to fail. So, the assault on financial service companies continued. Eventually, AIG, the largest insurance company in the world, succumbed to this pressure. The Federal Reserve, citing special considerations, bailed out the non-depositary institution.
19. At this stage, we were in free fall and the entire banking system was on the verge of collapse in the United States. Global shocks had not ended either, as UK institutions were increasingly under attack as well, having been damaged by their own property bubble. At the urging of the British Prime Minister and the UK regulatory authorities, Lloyds TSB bought Britain’s largest mortgage lender HBOS, which was in jeopardy of failing.
20. By this time, the Feds had had enough. The time for ad hoc crisis management was at an end. Hank Paulson moved decisively and put forward his $700 billion bailout plan. It awaits congressional approval.

And that’s where we stand.

UPDATE: Since I wrote this a number of significant events have occurred. So, let me make an addendum to "The Guide."

1. Before Congress could approve the Paulson Plan, the credit crisis had moved to Europe where several banks were nationalized. Markets around the world suffered.
2. Congress eventually approved the Paulson Plan after much debate and initial setbacks. The Plan was augmented to include $100 billion in relief from the Alternative Minimum Tax and offer tax breaks for specific businesses as well. In addition, it raised the limit on federal bank deposit insurance from $100,000 to $250,000.
3. Meanwhile, turmoil in both the credit markets and the stock markets continued. Europe was still the focus as French President Sarkozy called a European crisis summit to address the situation. As the crisis worsened, National governments were forced to react and Ireland, Greece, Denmark, Austria, and Germany all offered sweeping deposit guarantees. Britain partially nationalized its banking system in a £400 Billion bailout of the UK’s financial system. Iceland was forced to nationalize its largest banks and teetered on the verge of bankruptcy as it received financial assistance from Russia in return for a 75-year lease to an Icelandic air base.
4. Central Banks around the world acted in a coordinated fashion, cutting rates and injecting massive amounts of liquidity into the markets. However, the markets were still unhappy and plunged anew. With the U.S. markets flirting with 2003 lows and financial stocks down by half on the year, U.S. Treasury Secretary Paulson admitted that he might inject capital directly into American banks.

And that is now where we stand.

For the full timeline of news, visit my credit crisis timeline. I believe it to be the most comprehensive data set of credit crisis events on the web. And I update it often.