Financial Crisis 2000s: The Basics of Financial Services

Financial Services companies are a fundamental part of a capitalist economy. These businesses make money by helping their clients (people and businesses) use money productively. There are lots of different kinds of financial services businesses, and they all work together, so it is important to understand what they each do so you can understand why they act the way they do and how the financial system is supposed to work. This won't tell you why the system failed and the crisis unfolded. For that, see the next post.

A bank is a common financial services company that many people interact with. You can deposit your money into a bank, the bank keeps a record of your money and you can get it back when you need it. The bank may also pay you a fee for keeping your money with them. That fee is called interest. The bank may also loan that money to someone else who needs it (collecting a larger fee for loaning the money).

Many large financial companies help their clients borrow money from one or more different clients. The legal framework for this is called a bond, and that bond can be bought and sold until the bond is paid off by whoever borrowed the money. This way of making money is called brokering a bond.

When a bond is created, part of the definition of that bond is how much extra money the borrower will pay for the right to borrow the money. That extra money is also called interest. A second way that financial service firms make money is by agreeing to collect the money that borrowers owe and distributing it to whomever loaned the money (and therefore, owns the right to get that money). This way of making money is called servicing a bond.

A third way that companies make money is by providing an expert opinion on how likely a borrower will fail to pay the interest and the original amount of the loan. This way of making money is called rating a bond. A rating company is profitable as long as the fees it collects to rate bonds is more than the cost to rate those bonds. One important fact in how a rating company makes money is that it is paid by a borrower to rate a bond. So, if you were a rating agency competing to rate lots of bonds, borrowers may be happier the higher you rate their bonds.

A fourth way that companies make money is by providing financial protection against lenders losing their money if a borrower can not pay back his bond. This kind of protection is one form of insurance. An insurance company is profitable as long as the fees it collects to provide this insurance is more than the amount it will have to pay out because borrowers can not pay back their bonds.

So, when everything goes well, all of these different kinds of financial services companies make money. The brokers collect brokerage fees; the rating agencies collect rating fees; the insurance companies collect enough in premiums so that when bonds aren't paid then the insurance companies have enough money to pay instead; the bond service companies are paid enough to take payments from borrowers and distribute the money to lenders. So what went wrong?

Financial Crisis 2000s: Reason number 1

Why did financial crisis of the 2000s occur?

One reason was that people forgot that housing prices do not always go up. Sometimes housing prices go down. Consider a person named Jose, who has a steady job, rents an apartment, but doesn't have any savings.

In the early 2000s, Jose can now get a mortgage that doesn't cost much more each month than his rent. He doesn't have to spend any money buy a house, which is good, because he doesn't have any savings. He just has to pay a small amount each month. He has to pay this amount each month for three years, but after that, he is going to have to pay more each month. At that point he is going to have a problem, because the new amount is more than he can afford.

But Jose doesn't need to worry. His home is probably going to be worth a lot more in three years (since prices for homes will probably keep going up), so he will be able to get a new mortgage with a new low rate that he can continue to afford. No one will have a problem loaning him money as long as his house is worth more than his mortgage.

It is three years later. Jose still makes about the same amount of money, but, home prices stopped rising a year ago. Jose has been making his payments diligently, but he doesn't have much more than he had three years ago because most of the money he gives the bank each month pays the bank. (That part of his payment is called interest.) Very little of the money he pays each month reduces the amount of money loaned to him. (That part of his payment is called the principal).

Now Jose has to pay more, but he can't afford it. So Jose tries to get a new mortgage. When he goes to get a new mortgage, he is told that his house isn't worth as much, so he can only get a mortgage for less money. But, if he gets a new mortgage (for less money), then he has to pay off his old mortgage (for more money), and where is he going to get the money to make up the difference? Jose struggles each month to pay his mortgage, and eventually he can't do it anymore. When he can no longer pay, he has defaulted on his mortgage, and he will lose his house.

In 2005, more than 1.5 million mortgages were created with low rates that were set to have higher rates in 2007 or 2008 according to a paper by the Federal Reserve.

That's why things started to go wrong in 2007 and 2008, but a new way that certain financial services companies tried to make money off of mortgages ended up making things a lot worse. But first, how are financial services companies supposed to work?