My friend explains the economic crisis

My friend, Brett Myers, is a professor at Purdue, has a PHD in Finance and is generally one of the smartest guys I know. Recently I asked him what was happening with the crisis. He explained it so even an economic dolt like myself could understand. No doubt someday he will publish an easy and fun to read book on finance and make a tidy sum.

With his permission, here is the e-mail he sent. Just remember, I published him first.

The financial crisis we are currently in is the result of several things:

a) People borrowed more than they could afford, and banks were willing to lend to people who not qualified. Further, banks did a lot of 100% financing.
b) These loans were packaged into bonds (called mortgage backed securities, MBS) and sold to banks, investment funds, pension funds, etc.
c) A lot of people thought they were safe investments and they sold for a high price. By "safe" I mean that most people don't default on their home loans and when they do, the lender can posess the house and sell it and get all its money back so investors didn't think they had much to worry about.
d) People *did* start to default on their homes. Further, they did so when home prices were falling dramatically. So many of these MBS securities were hit by high default rates and lower than expected recovery rates (because home values had fallen and many people didn't have much equity in their house so the lenders got hit with the full loss).
e) In all, MBS lost around 10-20% of their value (guessing here). This is not so bad.
f) However, many banks and MBS owners used leverage with their MBS positions. For example, I might have borrowed money 10:1 to buy "safe" MBS securities, or used $10 worth of MBS securities as collateral for $100 in loans (i.e., leverage), so losses were not small, but very large. Investment banks are sometimes levered 30:1 so they are particularly screwed.
g) this is like putting $10,000 down on a $100,000 house. You have a 10:1 loan, or are levered 10:1. If the house falls in value to $80,000, the house itself had a -20% return. However, you invested $10,000 in home equity, but now have -$10,000 in equity so you lost -200%.
h) So basically, banks lost a ton of money because they were being a little risky with debt.

So whose to blame?

a) Homeowners for borrowing too much
b) Lenders for lending too much
c) Traders and investment bankers for being greedy
d) Unfortunate chance; home values fell.
e) Ratings agencies that rated MBS as safe.

Take away any of the above ingredients and things would have been a lot better. Right now the govt is contemplating buying all the bad MBS so banks can get these questionable securities off their balance sheets. This is important because if banks don't trust the collateral each has, or if banks don't meet certain capital requirements, lending comes to a halt and that will screw basically everybody from farmers to doctors to engineers. Everyone can be screwed. I don't think this is the most likely outcome, but an uncomfortably high possibility.