When we hear of turmoil in world financial markets, it can be difficult to understand how so much chaos can result from a relatively small number of defaults on individual home mortgages. Paul Solman, the business and economics correspondent for PBS's NewsHour, undertook to explain how those modest defaults could escalate to the point where they "now threaten the entire world financial system."
Solman began by noting that "the money you borrow to buy your home no longer comes from the local bank. It comes from investors from all over the world."
A firm like Bear Stearns buys up the mortgages on lots of houses, combines them into a pool, and sells slices of that pool to investors. This has been an attractive investment, because it offers a high rate of return, and it has also been considered extremely safe, because even if one mortgage defaults that will have little effect on the pool. With the US housing market booming thanks to the easy credit these deals opened up, it seemed there was no way that anyone could lose.
However, the problem was that "the more investors got into the act, the greater the pressure to lend." Lenders were competing with one another to offer more favorable mortgage terms. Eventually, new buyers had so little actually invested in their homes that if any problems arose, it was easiest to just walk away from both house and mortgage.
Making things worse, the return on these mortgage pools was so high that the big lenders began investing in them on their own, often using money borrowed at a lower rate from banks like Citicorp and JP Morgan. And the banks were also investing directly in securities backed by mortgages, credit cards, or auto loans. Even more investments went into so-called "derivatives," essentially side bets on these other loans.
Everybody wanted to get in on the action and nobody was using their own money, so the debts quickly multiplied from billions to trillions. And the only thing of real value holding up the whole house of cards was the homes owned by individual buyers. If the value of those homes drops -- as it now has -- and too many of the buyers walk away, the whole structure can collapse.
If that happens, as Solman explained, there's a further problem. "The world financial system runs on credit -- on paper promises. If big borrowers and lenders don't make good on those promises, panic can set in, and the biggest financial institutions in the world can find themselves under siege."
That sort of panic was the reason Bear Stearns became unsustainable. And if a firm like Bear Stearns goes down, its creditors -- the major banks -- can become unsustainable as well. That is why the federal government has stepped in to try to salvage the situation.
And, Solman concluded, "That's why they call it the domino effect."
The following video is from PBS's Jim Lehrer News Hour, broadcast on March 21, 2008.