This diary is a primer of sorts on the current financial crisis. People are understandably worried about the future, and not having a clear understanding of the nature of the crisis can be frustrating for some. Having a wrong understanding of the crisis can even be dangerous. People sprout tinfoil hats tuned to everything from complete panic to total denial.
Economics and finance have become arcane, and there has been plenty written on some of the new terms we hear such as swaps and CDO's, but many people have a fuzzy picture between cause and effect in this crisis.
Since I stayed at a Holiday Inn last night, I'll take a whack at trying to draw a line between cause and effect. Some of it may be subjective, so I hope any wrong interpretations will be corrected with comments.
First things first:
why does the stock market seem to tank every time the government announces a new fix for the economy?
An analogy is best here: let's say you want to bet on a football game next Sunday. You can bet with your heart or toss a coin, or if you were very serious about making money, you would look for factors that you believe might influence the outcome of the game.
You know one team would normally be a lock to win, but you are a bit concerned because it just lost one of its star players - Bear Stearns. Your trusted friends, Ben and Hank, assure you that the team is still fundamentally sound, and see no reason why they shouldn't win.
Later, you hear that the quarterback for the team has a touch of the flu and you are glad you have not yet placed your bet. The quarterback himself claims he will be fine for game day, but you call Ben and Hank to see what they think. They report that he is getting vitamins and rest and all should be fine, and that if it were their money, they would still bet on the team.
The next day, Ben and Hank call you to tell you that they have it from reliable sources that to be extra safe, the QB is getting an IV drip and that is great news. It should be a sure thing now.
It's Saturday, and you are ready to place your bet, but to be safe you call Ben and Hank for any last-minute news. They report that they heard from their source that the QB's blood transfusion went perfect.
Now, which team will you place your bet on?
What causes some recessions to be worse than others?
A normal recession is caused when supply catches up with demand. Strong demand for something can cause a bubble of oversupply as demand is being met. This excess has to be mopped up by shutting down supply. Recessions are a normal and unavoidable part of the capitalist business cycle.
A healthy economy is one that is increasing the standard of living for everybody. An increase in the standard of living often corresponds with an increase in wealth, so a healthy economy with low unemployment providing decent wages allows more people to safely purchase things such as new homes. If enough people are purchasing homes, the price of homes will rise as more and more people compete for them. The rising cost of homes from increased demand will result in more houses being built which triggers new jobs, which raises wages to attract new workers, and so it goes.
With wages high, a responsible government would encourage people to invest or save money because at some point supply will meet demand, and workers will have to be laid off, which lowers wages because unemployed people are willing to work for less. This is a recession, and it can range in both length and depth.
There is actually such a thing as a healthy recession. With wages low and general price declines, people who saved are more apt to start new businesses, businesses are more apt to invest in new R&D or modernize their operations, and the government might be more inclined to work on the infrastructure. The economy will once again pick up with new businesses and services, better products made more efficiently, and all served by a better infrastructure.
Not all recessions are normal business cycle recessions. Some can be triggered by a crisis such as an oil shortage or a political coup. Sudden recessions like these can be very disruptive. If a recession triggers an economic crisis, then there was a fundamental problem hidden somewhere in the economy, or as Greenspan would say - a dislocation.
What is the nature of this crisis?
House purchases have traditionally taken place by determining if a person with good credit can afford to pay down a long-term loan plus its interest at regular intervals. To reduce risk for the lender, and to save the borrower money due to interest, a down payment was usually required.
This crisis was triggered by short-cycling the lower-risk organic process just mentioned for purchasing a home with a new model fueled by easy credit. Lending institutions would purchase a property and mortgage it out as usual, but then it would turn around and write a bond that would pay some level of interest and be backed by the mortgage. In large lending institutions, a different division or even a different company began offering insurance on these bonds that would pay the face value of the bond in the event the bond writer went bankrupt. They did this because the bonds they were writing were 30 times or more larger than the mortgages that were backing them. This means that every time an institution wrote a mortgage, they could immediately generate up to 30 times the value of the mortgage to buy 30 more just like it and start the process all over again.
Purchasing these bonds was an attractive and simple way to invest very large sums of money. The interest they paid was favorable compared to other long-term investments. Because of their demand, institutions were begging to write new mortgages, but there were not enough people qualifying in the traditional lower-risk model. What do you think they did?
When reputable lenders seek out high-risk borrowers, you know something is wrong.
Because more people were owning houses, they became more scarce and property values rose. This made for a wonderful excuse to convince someone to take on a loan larger than they could handle. They would point to the increase in house prices and mention that the buyer could either sell the house for a profit, or refinance for better terms since the value of the property will have appreciated so much by the time the loan reset to a higher rate. As long as house prices kept going up, then everything would work great.
Then supply caught up with demand.
Suddenly people couldn't sell their homes quickly enough or refinance with new terms they could afford. As interest rates reset up to the higher rates, people began defaulting on their mortgages. This caused an even bigger glut of homes and prices declined even further. The institutions were not only losing their monthly payments, but the underlying assets were rapidly depreciating. The difference between the interest rate which a lender charged a homeowner and what it paid to the bond holders was quite small, so it didn't take too long to reach the point where their outlays exceeded their income, and the market was only getting worse.
Because the bonds are unregulated, there is no secondary market to act as a clearinghouse where they can be traded. In addition, the bonds represent pools of mortgages bundled in complex ways and calculating their value would be very difficult. There actually was a distinct unwillingness to even try to assign a value to the bonds because of the fear that they could be marked down to the point where the owners would be bankrupt.
Nobody wants to buy them, and nobody is willing to write them off, so they are just held, tying up assets. These companies are extremely vulnerable because many of them need to meet reserve requirements and are forced to borrow money to do this. Because of their vulnerability, their costs to borrow soar.
Right now, nobody wants to lend to anybody as they all sit in a potential death spiral. This has generated huge amounts of fear and distrust, virtually seizing up credit.
What is the impact of this crisis?
The fact is, the entire banking system is insolvent unless the mortgage-backed assets can be sold or valued at some level close to face value.
If they are not, there is a much larger problem in the background that involves Credit Default Swaps (CDS). Roughly speaking, these are insurance policies against the bonds defaulting. The estimated total value of these policies is $62 trillion.
The bottom line for banks is that only one large bank would be left standing, and that is the Federal Reserve.
There are some secondary effects going on which are not talked about too much. The large oversupply in housing has brought construction of new homes to a near standstill. The little town I live in has already begun working on the infrastructure changes to handle the planned population increase. This includes new roads into empty developments and upgraded water treatment facilities. The town has written bonds against the future tax revenues which will most certainly be delayed now.
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Part 2 of this will examine how the government plans to prevent a full blown crisis, what a full blown crisis might look like, and ways to help yourself if it does happen.
Like Doug Adams says, Don't Panic!