Tuesday, March 29, 2011

Economics Week: Inside Job Movie Review

Last week I watched the movie Inside Job, somewhat on accident. (My sister and her friend rented it not knowing it was a documentary.) The information conveyed is astonishing. I suppose if I read enough news I would know everything in the movie, but I do not read everything and thus do not really know the extent of the 2008-2010 economic disaster. This movie was enlightening.

In short, and really the basics of the entire crisis boil down to a few simple points:
  • Everybody was in on it, economist professors, stock brokers, corporate giants, lending companies, politicians, rating agencies, and the Securities and Exchange Commission.
  • Everyone who was in a position of power during the crisis is either still in the same position of power or in a different well paying or powerful position, none are in jail or destitute.
For example, the merger between Citicorp and Travelers in 1998 was illegal due to a law passed by congress in 1933. Hopefully 1933 rings a bell as a year when the government was taking active steps to ensure that a depression would not happen again in the United States. Repealing those laws seems ridiculous. We are not smarter than they were in 1933. Changing laws that they set up to prevent a depression having seen a rather bad one is a ridiculous thing to do.

Moody's and Standard and Poor's are two rating agencies. In other words they rate mutual funds and bonds among other investment funds so that little investors like you and I can make more informed decisions about the risk of a particular investment. For example, mortgage X taken by two people who both have credit scores over 800 would have a much better rating than mortgage Y taken by one person with a credit score under 700. Mortgage Y would be referred to as sub-prime debt because there is a large risk of the debtor defaulting and not being able to pay. Of course in real life these things are bundled and split and rearranged so that it is not as simple as buying a share of a specific person's mortgage. Also, people with worse credit typically have to pay higher interest rates because there is a higher risk of them not being able to pay the loan.

Consider the fact that Fund X was composed of many mortgage X loans earning 5% interest. Fund Y was composed of many mortgage Y loans earning 12% interest. As a small time investor all that you see on the basic information page about any investment is the rating given by Standard and Poor's and Moody's and the price growth rate. AAA is the highest rating followed by fewer As and Bs. If you are saving for your retirement, and retirement is less than ten or twenty years away, you do not want to be taking risks with your money thus investing primarily in AAA funds is a wise decision. What happened was that the rating agencies were giving both Fund X and Fund Y type funds AAA ratings. So naturally hundreds of thousands of people invested in Fund Y because it had a higher interest rate for the same rating. When the debtors to Fund Y were no longer able to pay their mortgages the investors in Fund Y lost nearly everything. Additionally the debtors to Fund Y lost their house. The banks and investment houses that brokered (sold) Fund Y lost out on commissions and had to lay thousands of people off. So investors in Fund Y, debtors to Fund Y, and former brokers for Fund Y quit spending money, because they didn't have as much money. That affects everyone. When I don't go out for coffee Saturday morning, that's $5 that my local coffee shop will not make. If everyone does that the shop goes out of business and half a dozen people lose their jobs. In a paragraph that was the mortgage crisis. 

Why did people with mortgage Y loans even get loans in the first place if they were such a credit risk? There is a quote by George Bush from 2002 in the movie that explains that. Additionally, lenders and real estate agents are paid on commission for houses at sale, not monthly at payment of mortgage. Secondly, lenders do not own the mortgage, that is owned by large publicly traded banks and funds, like Fund Y. Thus it is better for real estate agents to sell a house and lenders to grant a mortgage to someone who probably can't pay because both of their immediate commissions is high.

In short, the movie is well worth your time and $1.05 from Redbox. I will go into more detail about other aspects of the crisis in the next few days during: Economics Week!

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