The Financial Crisis: What Went Wrong?

Here is an interesting take on the Financial Crisis and what went wrong.

He puts the largest blame on teaser-rate mortgages.

The media talks about ” sub prime mortgages” ““ by which it means mortgage loans to borrowers with less than stellar credit. The real problem, however, was the advent and widespread use of teaser-rate mortgages in both the prime and sub prime markets. A teaser-rate mortgage allows a borrower to make relatively small payments for several years. At some point, the rate jumps dramatically, and the borrower faces much higher monthly payment obligations.

The teaser-rate aspect is certainly an important one.

Okay, that helps explain why those mortgage companies fell.

But why did Lehman Brothers and AIG go under? After all, they don’t make mortgage loans. I turn next to how the problem spread.

Assume that A borrows from B to buy a home, giving a mortgage on the home to secure her debt. B then borrows from C, using A’s mortgage as security. C in turn borrows from D, using B’s obligation as security. And so on.

Now assume that A’s mortgage goes bad. What happens to B, C, and D? Answer: all the loans up the chain go bad as well.