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[P]
The Credit Crisis and the Bailout in Plain English

By Liar in Politics
Wed Oct 01, 2008 at 09:49:49 PM EST
Tags: (all tags)

This is an explanation of economics. There's no way to avoid some boring details and glazed eyes when talking about such things. However, I promise to avoid some of the jargon which will send you running to wikipedia, if you in turn forgive me for some oversimplification.

The purpose of this article is to explain specific jargon. It will explain the role of FNMA (Fannie Mae) and FHLMC (Freddie Mac), mortgage-backed securities, Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO), mark to market, prime, subprime, a run, the Community Reinvestment Act, and liquidity in the current situation. These terms will be introduced as gently as possible. There's a lot of ground to cover, but what follows is a resource which will help you to understand these frequently used buzz words.


Banking basics

At the heart of modern economies are banks and investors. People deposit money into banks and expect some small bit of interest. Banks use that money and loan it out to others and expect some bit of interest, too. Banks are only useful and operational as long as they can issue loans and make enough on those investments to run their own operations and pay back those who deposited money with them in the first place.

Banks are required to keep a certain amount of money in reserve, which means that if depositors have put $100K in a bank, a bank with a 5% reserve can only use $95K to issue loans. A high reserve makes it difficult for banks to loan out money and so interest on savings accounts will be lower with higher reserves. However, some amount of a reserve is necessary for a bank to survive if depositors want to withdraw cash. In the Great Depression, many people lost faith with their banks and so they immediately went to the bank to pull out their money. An individual bank wouldn't have enough cash, word would spread, and soon depositors would go to every bank branch to withdraw money. This situation is called a bank run when people run to withdraw cash and the bank runs out of money. Even if a bank has enough cash to cover a small run, they may not have enough cash on hand to pay for operations--banks have to pay their tellers, cover their rent, and any other obligations, after all.

So, while a bank may have more than enough money in loans, because they are relatively cash poor, they are vulnerable to bank runs which can put them out of business. They may try to sell some of their assets (like a loan or a home mortgage) to a neighboring bank, but because they are desperate for cash, they may sell that loan for less than its face value. This creates a downward spiral where deposits are turned into loans and those loans are turned into a smaller amount of money. Many banks in the Great Depression failed even while many investors like JP Morgan were buying up things up cheaply.

The Mortgage Market

Out of the Great Depression came the creation of FNMA often called by the more familiar name of Fannie Mae. Later on, FHLMC (Freddie Mac) appears and improves upon the Fannie Mae concept. Created by the government, these were private organizations until September, 2008, though many investors would act as though they were government entities. This failure to distinguish them as a private organization has a role to play in this current situation. But what are they? Fannie buys loans from banks and then sells them to others as mortgage backed securities (MBS). Imagine that I own 10 loans of $100K each, and each are paying 5% interest. I can create a single collection of all of these loans worth $1,000K and sell portions of it to many different investors, paying them 4.95%. An MBS has several natural advantages in spreading risk around: if there is a single loan and it fails, all of the value is lost; if there is a package of loans and one loan in that package fails, the loss is less severe and the interest on the remaining loans can offset that loss. So, most mortgage backed securities end up creating a profit both for FNMA which created the MBS as well as the investor in that security.

In addition to providing a way for investors to buy into the mortgage market, FNMA provided a guarantee for the MBSs it provided. In any given MBS, if a borrower were to default on payments, FNMA would still pay the full value of the loan. Because FNMA was involved in so many mortgages, it had more than enough good loans to cover the bad loans.

More powerfully, though, this essentially creates a market where loans can be bartered between banks and other investors from around the world. Because there is more money in the mortgage market, loans can be financed more cheaply. In addition to relieving some of the problem of bank runs, it helps banks operate efficiently in providing services to a community. If a bank needs cash, loans can be sold to FNMA, provided that they conform to a set of standards. That bank then can turn around and issue loans for cars, homes, payrolls, or snap up a bargain MBS if it finds one. The result is liquidity in the market: conforming loans have a ready buyer and so loans can be liquidated into cash easily with little loss in value.

FHLMC expands the loan market one step further by being a competitor to FNMA, providing MBSs based on a different class of loans. To be economical with words, from here on I'll just talk about FNMA but everything can be applied to FHLMC as well.

FNMA succeeded as long as it had the ability to buy up loans and then resell them. While it did have a line of credit with the U.S. government to cover short term losses, the operation was designed to pay for itself by shepherding loans through the market. However, in the public and the bankers' minds, FNMA was a government entity, backed up by the full faith and credit of the U.S. government. As a result, the perception of government money meant that people trusted FNMA more than they should. If the mortgages which backed an MBS were to default, FNMA pays the difference. When banks buy from FNMA, they were assuming there was no risk that FNMA itself could default because it's too big to fail. The result is that MBSs were not being priced what they were actually worth considering the risks involved. If they were, it's conceivable that FNMA would never have failed.

Mortgages

The failure of FNMA came about because of larger failures in the mortgage market, largely attributed to risky home loans being issued. So, let's look a little deeper. We already know that banks loan out money so people can buy homes and then sell those loans to FNMA if they conform to FNMA's standard. I keep mentioning conforming loans because not all loans do conform. To conform, the loan must be under a maximum amount and the borrowers must have a reasonable amount of debt in comparison to their income for the type of property they are buying. Because FNMA will buy a conforming loan, there's a bigger demand for these loans and so they end up being fairly cheap for a bank to issue since they can sell them and remove themselves from risk. Non-conforming loans are all of the rest of the loans.

Regardless whether a loan conforms or not, they are also differentiated based on risk into broad categories: prime loans, subprime loans, and Alt-A loans. A prime loan (also called A-Paper) is characterized by a borrower with good credit, reasonable debt, and enough cash to buy 20% of the home for which a loan is needed as well as to pay the mortgage for a couple of months. In other words, a pretty safe bet for the bank. Subprime loans are pretty much everything else except for a narrow band of loans called Alt-A loans which do not meet the standards of A-Paper, making them more risky than prime but are not considered as risky as the worst of the subprime loans. There is not a clear criteria which separates Alt-A and subprime loans and these terms are used only as a general class.

A bank has several reasons to engage in subprime lending: interest rates are higher to offset the risks involved, and there is some legal requirements for banks to engage in it. In 1978, President Carter initiated the Community Reinvestment Act which required banks issue loans across the community and not just to the wealthiest with lowest risk. Banks were averse to doing this but reforms in 1989 and 1993 obliged banks to cooperate. As part of the regulatory requirement, when banks merged or engaged in anything which required oversight, they were obliged to prove they were abiding by the CRA, and this meant issuing riskier loans. As a result, one of the earliest adopters of CRA style lending practices was also one of the first banks to fail when the loans began to go into default: Bearn Stearns. Now, this doesn't mean Bear Stearns was obliged to fail by the U.S. government and we'll come back to Bear in a moment because it played a pivotal part of our story, but let's look at other ways which banks have to manage the risks associated with these loans.

Risk Management

Since subprime loans generally are not sold to FNMA, it's in the bank's interests to find some form of insurance to hedge against the pain of a borrower default. In the case of a default, banks can foreclose on a house and sell it in a public auction. If the original loan was $100K and the house sells at $150K, the banks won't complain too loudly because they'll make a profit. However, if the house dropped in value to $50K instead, the bank stands to lose money. So, they'll buy insurance from someone else in an instrument called a Credit Default Swap (CDS). In a CDS, a bank makes a small payment to a seller and in return the seller will pay the bank what it needs to recoup any losses that come from a default on a particular loan. So, if I'm Bear Stearns, I'm going to want to buy a CDS to hedge against a default. However, a CDS seller bases their price on risk of default, if the likelihood of default is high, a CDS will trade at a higher rate than if the risk is low. This can be used often to gauge the health of lenders and indeed, we saw the spread on Bear Stearns CDSs climb in the days before its eventual collapse. It should be noted, however, that the CDS market is not regulated and as a consequence a seller of a CDS may for years accept a small payment, but when the underlying loan defaults, the seller has to pay out (and this is important) even if they didn't have enough assets in the first place.

Further, if we continue to assume I'm Bear Stearns, I may also want to compete with FNMA a little and offer my own version of their mortgage backed securities. So, I'll pool loans up together and sell them bundled as a Collateralized Debt Obligation (CDO). This increases liquidity in this particular market for subprime loans, helps to distribute the risk to others in the market, and fuels the loan market further. However, CDOs are potentially subject to a style of accounting called mark to market accounting. Under this style of accounting, the value of a thing is priced (marked) according to the current market value. Sound reasonable? Kinda, but not entirely. Imagine the case of Bill Gates who owns a lot of stock in Microsoft. If Bill sold every one of his shares of stock, he wouldn't get
    (Shares) X (Current Market Price)
because the act of selling his shares would increase supply and lower the per-share value. If we were to mark Bill to the market, his own value is inflated over his real worth. There is difficulty in assessing the value of a house; you only really know the value on the day the house is sold. And so, this is what happened with Bear Stearns who priced their CDOs to a value higher than what they were worth.

There are industry watchdogs who monitor CDOs and the market in general: credit ratings agencies. Of these agencies, Moody's, Fitch, and Standard & Poor's are probably the best known. If you've only ever heard of the S&P 500, the is Standard and Poor's yardstick on how they measure the health of a slice of the stock market but they also rate loans, bonds, CDOs and MBSs. It is difficult to fully understand the role of the ratings agencies in all of this mess. It may be that there was no way to accurately gauge the risk involved in these investments at the time when the ratings were issued, but there is speculation that they looked the other way because they are themselves financed by the industry that they're supposed to be monitoring. So, even though it's difficult to determine their level of culpability, they deserve a mention in the context of this article.

Bear Stearns Collapse and The Beginning of the Credit Crisis

In early 2007 at the beginning of Bear Stearns' collapse, no one knew what the exact value of the overall housing market was, nor could they determine how this should exactly affect the price of Bear's CDOs. People knew it was bad, but it was difficult to assess how bad until 2007 when Merrill Lynch seized the mortgages underlying one of Bear Stearn's CDOs. When they did, the loans which backed the CDO were once valued at $850 million, but Merrill Lynch was only able to auction them for $100 million. Bear Stearns CDO values collapsed and a string of law suits were filed by investors in those funds in order to get to the bottom of what happened. So, in no way can we excuse Bear Stearns because of obligations they were fulfilling in the Community Reinvestment Act, but it's important to recognize that the nature of the act was to encourage riskier investments. Bear Stearns failure, at least as far as I can tell, is that it didn't properly warn investors about the risks involved in their funds and this led to them being over-valued. This in turn led to a loss of confidence in Bear Stearns in general and investors began to pull their money out of Bear's other investment vehicles. In essence, there was a run on Bear Stearns and while they once were able to marshal a liquidity pool of $18.1 billion, this fell to $2 billion. The problems in two funds did not destroy Bear Stearns, who could have otherwise weathered the death of these two funds. Investor confidence is what did the trick. In the end, Bear had no choice but to sell itself to JP Morgan for less than 10% of its net worth.

Wikipedia right now succinctly describes how mortgages are doing, and this is helpful to understand the market in context, especially the role of subprimes:
    The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.

    The U.S. mortgage market is estimated at $12 trillion with approximately 9.2% of loans either delinquent or in foreclosure through August 2008. Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007. During 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006.
The situation is bad for those with loans right now, but how does this affect the banks who issued the loans? Given the above information, the money situation is very tight, but manageable. In a small but risky portion of the market, there are a significant number of defaults, but among the prime loans, matters are steadier (but not exactly exciting either). In addition to the mortgage markets, banks are engaged in many other investments and all of this is designed to mitigate risk. So, in the current economic climate, I wouldn't start a new bank but I wouldn't pull my investments completely out of one either. But there is a fundamental problem: banks cannot do the jobs which they were expected to do.

In a rising economy, liquidity for these loans is easy to come by: a loan for $200K backed by a house whose worth rises above $200K experiences no discrimination. Whether the borrower defaults or if he pays it off, the banks prosper. However, now that a loan for $200K is backed by a house worth $160K, investors are not nearly so interested in buying these loans. In the case of default, an auction won't cover the debt. With the CDS market in general disarray nowadays (due in no small part to the Bear Stearns failure), lenders are having to pay higher rates to hedge these loans. There is also a very real concern that CDS sellers may not be able to pay up. The banks which are hardest hit are those with the greatest exposure to risk, and we've seen New Century and IndyMac go under as well as over a hundred other banks. Many of these banks are regional and were encouraged by the CRA to assist their local communities. But since there is no market for anything touching a subprime loan, the bank's cash is tied up in subprime loans which to an extent they were obliged to issue. The result is a liquidity crisis.

Consider a bank which has five prime loans each at $180K and one subprime loan at $100K, they can only operate at 90% liquidity because of that one loan. This means that banks will be reluctant to issue anything but the safest loans and will increase costs associated with covering payrolls, helping businesses expand their industrial capacity, or for credit worthy borrowers to buy cars or even take out a prime loan to buy a home. The longer banks hold on to subprime loans, the less capital they have to grease the wheels of the economy and the more expensive otherwise routine transactions become. That brings us up to today and the call for government assistance.

Bail out or bailout?

The central feature of the bailout encouraged by both our unpopular President and even less popular congressional leadership is to purchase these subprime loans. This basic premise underlies the heart of the debate. There is not a single person who does not benefit from a bailout. With liquidity returned to the credit markets, there are fewer barriers for a company to expand and create jobs, there are fewer costs associated with issuing otherwise traditional loans and banks will better be able to absorb the punishment that they will take from A-Paper mortgage defaults. So, consumers, banks, and industry all have a benefit in a bailout taking place. Moreover, in absorbing these subprime loans, the U.S. government is placed on the same side as the at-risk borrowers who may go into default. It's in the best interest of both borrower and lender for no default to happen and when the lender is the U.S. government, they do not experience liquidity problems which encourages other banks to aggressively foreclose. As a result, a bailout would almost certainly benefit the borrowers.

We have only to look at the country which holds the most U.S. debt to see if this is the right course of action. China, in the midst of the FNMA and FHLMC takeover declared it was a step in the right direction and encouraged further insulation of the credit crisis from affecting the rest of the global markets.

To raise money for the bailout, the U.S. government likely will turn to a combination of foreign investment and higher interest rates set by the Fed. While $700 billion is a lot of money, US debt would still be less than half of GDP where countries like Germany and Japan have much higher debt ratios. There is no lack of interest from investors.

Popular sentiment is against a bailout for many reasons. From the left come the arguments that bailout money goes to foreign companies as well as U.S. companies, CEOs can still pull down huge paychecks, too many Bush appointees providing oversight, and it provides no direct relief from foreclosure. From the right come the arguments that this is the market acting correctly allowing businesses to fail, a fear of government interference with the markets, and that Americans will need to foot the bill for Wall Street's mismanagement.

Some of these have merit, but only insofar as we hold ideology superior to what helps markets operate best. For example, those who say the government shouldn't bail out the mistakes of Wall Street ignore the role that government had in creating the problem, both in its encouragement in a market with risky loans and in failing to provide sufficient oversight of CDOs. Also, while I'm sympathetic for calls to provide relief against foreclosures, this isn't the problem at hand, and neither are CEO paychecks. Those are pure ideological sentiments removed from the problem at hand, discouraging the credit markets and doing active damage to the economy as a whole in order to make a political point. While my sympathies run Republican, and I can well understand why no Republican would want a part of an unpopular package when they are facing uphill congressional races, this is a time to do the right thing and not the popular thing.

This article makes no guarantees either implied or explicit. It does not constitute financial advice. For concerns about your own situation, please contact a financial advisor. This article represents the view of the author. Special editorial assistance was provided by livus.

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The Credit Crisis and the Bailout in Plain English | 137 comments (120 topical, 17 editorial, 0 hidden)
Let the American infidels bask in their illusion. (1.20 / 5) (#3)
by alba on Tue Sep 30, 2008 at 10:04:00 PM EST

Allahu akbar.

"Bask in the shadows of yesterday triumphs... (none / 0) (#92)
by LodeRunner on Wed Oct 08, 2008 at 08:13:57 PM EST

...and sail on the steel breeze."

Couldn't resist; comes to mind every time I hear that word.

---
"dude, you can't even spell your own name" -- Lode Runner
[ Parent ]

Fall of communism is paved with good intentions (3.00 / 6) (#4)
by conner_bw on Tue Sep 30, 2008 at 10:08:11 PM EST

If you move this to vote you get mine for +FP, I learned a lot. One of the better articles I've read here in a while.

Now my problem, as a non-american, is

I'm a Canadian. We have powerful banks. We pay tons of income taxes. The first time I heard a new yorker say they didn't have to pay taxes if they bought a home on top of barely paying any taxes comparatively (and from what I hear New York is one of the highest taxed states in the US?) i had a WTF moment. Given the same advantages, middle-class Canadians would be buying houses in cash.

This was several years ago. Dollar per dollar with similar population densities, our housing prices are the same. Even more so, compared to other European and asian countries more taxed than Canada, american houses are cheaper.

So my big problem with all of this did "the greatest country in the world" i.e. a beacon for capitalism and free market fuck this one up to the tune of $700 billion?

Oh right, your article explains it...

Tax code as policy tool (2.50 / 8) (#22)
by rusty on Wed Oct 01, 2008 at 09:54:10 AM EST

Our tax system is direly fucked. Unfixably fucked. Some day, the political will will be found to burn it and start over.

What got us here was the eternal American tension between community and individualism. We know what's good for us as a whole, but American Retards refuse to be legislated to. So for the most part, American social policy is made via the tax code.

Rather than fund programs to assist people in buying a house, because people owning homes is good for society, our government writes exemptions into the tax code. Now multiply that by every other social good that ought to be legislated but is instead wedged into the tax code and you have a 300 billion page book that no one understands.

Ir government would grow a pair and start actually making laws, rather than coyly inserting more and more and ever more tax code provisions, we'd be a lot better off.

Probably won't happen in my lifetime, unless this collapse actually turns into a depression and we get the conditions necessary for a serious change of course.

____
Not the real rusty
[ Parent ]

You're too late (none / 0) (#30)
by Ruston Rustov on Wed Oct 01, 2008 at 01:30:31 PM EST

It's on its way back to the people and you can't do a damn thing about it.

I had had incurable open sores all over my feet for sixteen years. The doctors were powerless to do anything about it. I told my psychiatrist that they were psychosomatic Stigmata - the Stigmata are the wounds Jesus suffered when he was nailed to the cross. Three days later all my sores were gone. -- Michael Crawford
Maybe tomorrow. -- Michael Crawford
As soon as she has her first period, fuck your daughter. -- localroger

[ Parent ]
even removing some of them seems difficult (3.00 / 2) (#47)
by Delirium on Thu Oct 02, 2008 at 04:55:17 PM EST

The problem with removing those exemptions is that since they're now the status quo, removing them is easy to spin as raising the taxes on the group that the exemption was there to subsidize, and even you want to remove a whole swath of them, people will pick out some popular ones and complain that you must hate children by raising taxes on parents, hate home ownership by raising taxes on home owners, hate education by raising taxes on university students, etc., etc.

[ Parent ]
It need not be that way (3.00 / 2) (#48)
by Liar on Thu Oct 02, 2008 at 06:08:30 PM EST

one of the successes of the reagan era was the tax reform of '86. You can bribe the people with a lower overall tax rate while getting rid of exemptions and they'll accept that.

Not sure if you've ever read Showdown at Gucci Gulch (I had to read it in college) but it's a captivating report of how this went down.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
You get what you pay for, sort of (none / 0) (#118)
by viza on Thu Oct 16, 2008 at 01:16:38 PM EST

>  Given the same advantages, middle-class Canadians would be buying houses in cash.

Given the same advantages you'd be getting eaten alive by healthcare costs and other things all those taxes you pay, finance for you.

Granted, at least you get what you pay for here. I can walk into a doctors office and be seen within an hour with no appointment. It's hella expensive to buy it on your own tho.

The expression "the grass is always greener" comes to mind.

Bottom line is our gov (specifically Carter and Clinton) created this mess by more or less requiring banks to write mortgages and loans to people that couldn't possibly afford them.

In this country you get what you earn, and people seem to have forgotten that. If you don't earn it, you neither deserve, nor should you have it. This is the land of entitlement though and people don't understand what "earn" means. They want it given to them, nay, they demand it.

Here we are.

That's a bitch but that's why you should work your ass off and achieve something instead of electing people that promise to give you handouts. They are lying to get your vote. They can't give you handouts.

Those of us that do work our asses off couldn't pay for it all if we wanted to, because there's too many people looking for handouts. They outnumber us 50:1. Economic Socialism(and marxism, communism etc) is not sustainable for this very simple reason.

The more you get, the more you want and the less you want to work. Eventually it always implodes because there's no more incentive to work hard, so nobody does anything.

-Viz

[ Parent ]

tl;dr (1.00 / 6) (#6)
by Nimey on Tue Sep 30, 2008 at 10:51:29 PM EST


--
Never mind, it was just the dog cumming -- jandev
You Sir, are an Ignorant Motherfucker. -- Crawford
I am arguably too manic to do that. -- Crawford
I already fuck my mother -- trane
Nimey is right -- Blastard
i am in complete agreement with Nimey -- i am a pretty big deal

There is not a single person who does not benefit? (3.00 / 6) (#7)
by sholden on Tue Sep 30, 2008 at 11:23:00 PM EST

You mean other than people who have savings that will be eroded by the resulting inflation of printing a few trillion dollars.

Other than people currently renting a home who would like to buy once a wave of foreclosures and a credit freeze causes prices to drop to reasonable (and under) levels so they can just pay cash for the thing.

But yes if you restrict to those who were involved in rampant fraud and unsustainable consumption then they all benefit.

--
The world's dullest web page


I still say way more at issue than liquidity (3.00 / 5) (#8)
by sholden on Tue Sep 30, 2008 at 11:31:06 PM EST

"If a bank has five prime loans each at $180K and one subprime loan at $100K, they can only operate at 90% liquidity because of that one loan." Sure that's one way to look at it.

Another would be that they have $1,000,000 of loans on the books but they are only going to get paid back $500,000 (assuming the loans are all issued in the last 3 years), but the depositors they borrowed the money from, or the short term credit markets they borrowed from want all the $1,000,000 back, thank you very much.

Of course I see a near 100% default rate on all 2006 and later home loans, and HELOCs once this thing really gets going. Here's one anecdote (hey one more and I have data, right?): http://news.bbc.co.uk/2/hi/business/7529277.stm money quote is:

"""
As a successful professional, Karen could comfortably have managed the higher mortgage payments her bank demanded.

Instead, she decided to stop her mortgage payments altogether and let her bank repossess her apartment.
"""

Only an idiot would pay off a mortgage worth twice what the house is. And since house prices are going to drop over 50% from the peak in enough markets to matter walking away is going to become the norm.

--
The world's dullest web page


No offense (3.00 / 2) (#10)
by Liar on Wed Oct 01, 2008 at 12:45:51 AM EST

but I'm not trying to debate whether the world economy is going to tank. I'm trying to explain the basics of the credit market to those who are curious so that they can decide for themselves how bad the sky really is falling.

Defaults are a real concern, but I think you overstate the case for people who walk away. Most homeowners don't have $200K in negative equity. Besides, those who have such negative equity walk away because home prices are falling. Part of the reason home prices are falling is because the credit market is overleveraged. Fix that liquidity problem, and you allow homes to recover some of their value and the possibility of walk out diminishes.

Oh, also, regarding your other (frankly silly) comment, the government won't print "trillions" more in cash, especially since they're not even asking for a single "trillion" for the bailout. You're right, that would cause inflation but we've learned not to do that from Weimar Germany and every other country which has. If you had read the article, you'd have seen that we'll likely borrow it from foreign investors. As a result, since more of the money supply will be wrapped up in debt, this makes the dollar itself more valuable locally. The result is a reduction in inflation, and that's actually one of the silver linings to the bailout.

It really is a basic money supply issue.

And before you ask, "Who will want to invest in the US?", please read the article where this was answered.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
No home prices are falling (none / 1) (#14)
by sholden on Wed Oct 01, 2008 at 02:21:50 AM EST

because they were in a bubble. Current credit issues and speeding their fall, but they are not going to go backup without epic amounts of inflation.

Prices more than doubled in lots of places in a few years in a speculative bubble. It's not credit issues causing prices to fall, it's falling prices causing credit issues (there is some feedback of course, but you could free up credit tomorrow and home prices would continue to fall).

Prices need to reach 2002 levels, maybe 2000 levels to get back to being in line with fundamentals (like ratio to income, and P/E for renting out). But of course since the went way high, they'll overshoot on the downside too so they could go even lower. That wipes out everyone who took out a new loan with little down, or HELOCed in the last 5 years...

--
The world's dullest web page


[ Parent ]
I never said credit issues caused prices to fall (3.00 / 2) (#18)
by Liar on Wed Oct 01, 2008 at 08:41:44 AM EST

I did say that credit issues inhibit any recovery as well as causing a lot of other problems which you seem to think are immaterial.

Also, when you're dealing with loans, the relevant stat is debt-to-income, not P/E which is a measure for corporations.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
debt-to-income ? (none / 1) (#19)
by sholden on Wed Oct 01, 2008 at 08:56:30 AM EST

debt-to-income is the ratio of your income that goes to paying off debts (well it also includes housing costs which aren't debts, par for the course for English...).

Price to earnings in this context refers to the price of a house versus the rental income it generates.

They are not the same thing. One is about affording a house to live in, the other is about making money being a landlord.

Sure it's not usually called P/E - but it's exactly the same thing so why not use the same term.

I don't think these credit problem don't cause a bunch of other problems. I just think it's a bigger problem and fixing those problems by making the overall problem worse is not going to help. The point of no return has already been past - it's just the ride now...

--
The world's dullest web page


[ Parent ]
Won't print trillions? (none / 0) (#98)
by sholden on Sun Oct 12, 2008 at 01:03:02 AM EST

http://www.bloomberg.com/apps/news?pid=20601087&sid=aDjJYMSphyM0 - there's $40 billion a month of printed money.

http://www.bloomberg.com/apps/news?pid=20601068&sid=a2Oo4vDj6PK0 - another $450 billion via cash auctions, plus an unspecified "substantial" amount to buy commercial paper with.

http://www.bloomberg.com/apps/news?pid=20601068&sid=au4PnE_L1TCQ - skip the paper, just buy the companies.

http://online.wsj.com/article/SB122348485787515823.html - what's $40 billion between friends.

Plus convincing everyone to slash interests rates.

I was hoping I was just joking, but apparently inflation is the chosen path. Of course since stocks/houses/etc were in a bubble they will still experience deflation - unless they push inflation really high...

I understand they want to avoid the deflation of the Great Depression - but I think I'd prefer it over the hyperinflation they risk creating (especially if China and Japan send all those dollars back home).

--
The world's dullest web page


[ Parent ]
So how close are we too trillions now? (none / 0) (#129)
by sholden on Tue Oct 21, 2008 at 10:53:14 AM EST

http://www.bloomberg.com/apps/news?pid=20601087&sid=aoyg2DSy3QVo

--
The world's dullest web page


[ Parent ]
and yet CPI isn't really moving (none / 0) (#132)
by Liar on Wed Oct 22, 2008 at 07:58:31 PM EST

it jumped entirely due to the cost of food and oil and was down in all other sectors. The net effect is no change on prices in spite of this influx of cash.

So much for your inflationary theory.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
Which isn't unexpected (none / 0) (#133)
by sholden on Wed Oct 22, 2008 at 08:26:30 PM EST

The inflation pain comes afterwards.

At the moment we are still in sell off mode, which is deflationary. The problem is all the "liquidity" they keep injecting ends up somewhere.

There's also a flight to safety, and safety is US Treasuries because the idiots haven't realized that's not safe this time round. Once that shoe drops the US dollar is toast and that's when the inflation occurs. There's always lag...

Of course I've been wrong before, I'll be wrong again. And this is one of those cases in which I'd like to be wrong - I do after all live and work in the US and get paid in US dollars for that work. My future earnings far outweigh my current wealth too.

--
The world's dullest web page


[ Parent ]
What do you call it (none / 0) (#134)
by sllort on Thu Oct 23, 2008 at 10:39:48 AM EST

When the dollar goes down in worth compared to other world currencies (inflation) while simultaneously becomes more valuable for buying necessities like food (deflation) on the consumer price index? Because that's what's coming....
--
Warning: On Lawn is a documented liar.
[ Parent ]
Those two things can't happen... (none / 0) (#135)
by sholden on Thu Oct 23, 2008 at 01:16:16 PM EST

The market is global. If you were a farmer why would you sell your product to Americans for a small number of dollars when you could sell it to foreigners for a large amount of dollars. You wouldn't - unless the government interferes and forces you to of course.

Govt intervention (price fixing, etc)  is extremely likely given recent actions - I mean the Republican candidate said he would fix prices! (of houses). But if they do that say hello to Depression II for a decade.

I expect basically the opposite, the price of food will rise due to the dollar falling while the price of lots of assets fall because they are have been so overpriced that the inflation won't catch them up...

--
The world's dullest web page


[ Parent ]
also, predictions are a separate article (none / 1) (#27)
by Liar on Wed Oct 01, 2008 at 10:39:05 AM EST

is possible, let's keep the market speculation to a minimum.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
facts are boring (2.00 / 2) (#28)
by sholden on Wed Oct 01, 2008 at 12:32:01 PM EST

made up crap^W^W^Wpredictions are where it's at.

--
The world's dullest web page


[ Parent ]
lastly: market values have dropped only 21% (none / 1) (#29)
by Liar on Wed Oct 01, 2008 at 12:59:53 PM EST

From it's 2006 high. The vast majority of loans were issued before the high so only a narrow segment would experience even that loss. Some will experience higher losses, but because we're dealing with averages there's an offsetting number of loans that will have lost less than 20%. So, that one story you linked where a lady lost 40% is an aberration.

Also, the price declines have slowed in recent months, at least according to the last Case Schiller. We're pretty close to the bottom of the market now.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
They aren't done yet... (none / 1) (#31)
by sholden on Wed Oct 01, 2008 at 02:52:22 PM EST

The fall in prices is only half way done.

Price declines slowing is just catching breath - it's not a straight line drop. Those who bought at the 2006 peak on 3-1 ARMs haven't had that rate reset yet - the next big drop down occurs then.

Banks are still holding those foreclosures - prices still aren't low enough for them to be offloaded...

Dropping 20% is enough to walk away - nobody was putting 20% down so 20% down is way under water. But 20% is not the bottom...

--
The world's dullest web page


[ Parent ]
if your crystal ball is right (none / 1) (#32)
by Liar on Wed Oct 01, 2008 at 03:09:37 PM EST

the pool of people who will likely walk away is constantly shrinking though. Once they walk out of the market, they can't walk back in.

When you talk about 20%, since the average subprime loan is $170K, you're talking about a loss in equity of $35K. Ruining your credit and losing the right to own a home for a decade over $35K is hardly worth it. By the time their credit is restored the house would likely have gained back all of its lost value.

Regarding ARM resets: if the bailout happens, those high risk ARMs will be owed to the U.S. government who will be much more cooperative with homeowners about getting them to pay than banks ever would. I could even see Congress taking action to soften the rate resets so families can stay in their homes, especially in a Democrat dominated Congress for whom this is a big issue.

I think walkouts are cause for concern, but it's not as much of a concern if a bailout occurs. It actually works to stabilize home prices.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
And I thought I was pessimistic about this! (none / 1) (#52)
by sholden on Fri Oct 03, 2008 at 12:35:38 AM EST

http://europac.net/media/PeterSchiff_10-01-2008.mp3

I'm super optimistic by comparison :)

--
The world's dullest web page


[ Parent ]
Be careful when listening to Schiff (none / 1) (#67)
by Liar on Fri Oct 03, 2008 at 02:20:00 PM EST

He helped his father write a book on why you shouldn't pay your income taxes. As a result, his father is now serving 13+ years in jail for acting on his own misunderstanding of tax law. Others have also suffered because of this misinformation.

Judge for yourself, of course, but I don't have a lot of faith that he's correct. Other more mainstream economists also predicted a housing downturn, why is it only the fringe that gets attention?


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
He doesn't get that much attention surely? (none / 1) (#69)
by sholden on Fri Oct 03, 2008 at 03:29:42 PM EST

But he's damn funny, and that's all that matters. I have no money with him. I just thought "martial law" was quite a call to make - even I don't push it that far...

--
The world's dullest web page


[ Parent ]
I wish that were true... but some have doubled dow (3.00 / 2) (#55)
by inah on Fri Oct 03, 2008 at 02:17:12 AM EST

Unfortunately, people have "doubled down" before the credit crunch. Here's the scenario: Underwater house has yet to be foreclosed on. Stop all payments on the underwater home. Use the still good credit to get a loan on another more reasonably price home. Abandon underwater home and move to the new one. Let their credit rating tank with the foreclosure. No risk, all reward. Guess who gets to pay?

[ Parent ]
rings of the hurricane (none / 0) (#123)
by sllort on Thu Oct 16, 2008 at 05:46:41 PM EST

we're just at the beginning
--
Warning: On Lawn is a documented liar.
[ Parent ]
"No recourse" uniquely American. (3.00 / 3) (#66)
by supine on Fri Oct 03, 2008 at 02:18:11 PM EST

The point of the quote from the BBC is to highlight the distortion created by most American home loans being "no recourse". In foreclosure the lender can't go after the borrower for any shortfall between the value of the debt and the value of the property.

In Australia, where lenders can go after borrowers for any shortfall, those at risk of foreclosure are more likely to try to hold onto any equity in the property till prices improve and they try to work with the lender to renegotiate repayment terms. The reluctance to walk away is to avoid the almost certain bankruptcy that would follow.

So it appears that "no recourse" loans have left the banks and owners of CDOs wearing most of the losses, while the borrower loses the house but keeps their shirt.

--
"No GUI for you! Use lynx!!!, Come back, One year!" -- /avant
[ Parent ]

though true, that was up front (3.00 / 3) (#76)
by Delirium on Fri Oct 03, 2008 at 05:18:37 PM EST

It's not as if banks were surprised by the fact that loans are no-recourse. Since that raises the risk, they ought to have charged interest rates, and maintained reserves, that appropriately compensated them for the risk and allowed them to weather any downturns.

[ Parent ]
Why we do this (none / 0) (#136)
by vectro on Fri Oct 24, 2008 at 01:33:33 AM EST

The goal of the no recourse rule is to discourage banks from making loans that lack adequate down payments or that are based on inflated house prices. The problem is that with securitization, these risks were handed off to other parties, which allowed backs to lend freely and foolishly.

“The problem with that definition is just that it's bullshit.” -- localroger
[ Parent ]
Walk away? (none / 1) (#122)
by tgibbs on Thu Oct 16, 2008 at 05:39:38 PM EST

Only an idiot would pay off a mortgage worth twice what the house is. And since house prices are going to drop over 50% from the peak in enough markets to matter walking away is going to become the norm.

Or somebody who bought the house to live in. If I have a mortgage, and there is no reason why I have to move, why would I want to walk away? The reduction in market value does not make it a less nice place to live, nor does it affect my ability to make my mortgage payment. Perhaps the value of the house will go back up eventually. Even if it doesn't, it is questionable whether the negative equity would exceed what I would have to pay in rent if I walk away. After all, if I walk away, I'll have a bankruptcy on my credit record--probably not the best thing to have if I want to buy another house in the current lending environment.

It is a problem mainly for people need to move, or who lose their jobs, or who were suckered into a mortgage that they really couldn't afford. That's quite a few people, but hardly everybody.

[ Parent ]

nitpick (none / 0) (#127)
by Delirium on Sat Oct 18, 2008 at 09:54:23 PM EST

Almost all U.S. mortgages are non-recourse debt, meaning that the bank can't go after you in any way except by repossessing the collateral. So you won't have to file for bankruptcy or have a bankruptcy on your record even if you do walk away from an underwater mortgage. You will of course still have bad credit as a result of a foreclosure on your credit record.

[ Parent ]
+1 fp (2.00 / 3) (#11)
by circletimessquare on Wed Oct 01, 2008 at 01:26:55 AM EST

95% the size of the original text, and 105% as lucid

The tigers of wrath are wiser than the horses of instruction.

Summarized in plain(er) english. (3.00 / 4) (#35)
by Pentashagon on Wed Oct 01, 2008 at 07:29:44 PM EST

A bank is an institution that gives almost all your hard earned money away to shady people who promise that they will pay it back, and if you want to withdraw "your" money from the bank, you're actually just getting some other dude's deposit from last week.

Bigger banks have so much (of your) money that they can buy entire failfuck companies, just like day traders.  Like day traders, they can lose all that money (that is yours) because they're stupid.

Oh yeah, some guys with a really big printing press say that if the 95% of your money that the bank loans out goes poof, it will print 19 times the value of the 5% so that you can get it back.  Ever hear of inflation?

Bigger than banks are morons who trust the banks to sell them good loans.  Ignoring the possibility of bankruptcy and total FAILure, these morons in turn offer loans based on how much interest the loan gives them.  This is really a lot like stacking a bunch of playing cards into a triangle.  With the narrow part of the triangle at the bottom.

Realizing that banks and morons give out free money, people with houses ask for some more money in the form of a loan from said banks and morons, and said banks and morons are more than happy to oblige.  After all, the more cards you stack on top of the inverted pyramid, the more stable it will be and even more new cards (err, money) will come flowing in.  Since folks were getting a lot of money loaned to them for their cheap-ass house, other people pretended that the house was worth the amount of the loan, offered to buy it from them for a slight profit, and then got yet another loan from the bank (which was then bought by morons) for just a little bit more, thus convincing even more people that a shit-hole apartment downtown was really a $500,000 mansion, and that the mansions were worth millions.  It was "worth" it, because a bank and a moron would buy it for you from some other dude, and then buy it from you again at a profit (to you) for some other dude.

Some people blame the banks for lending money to poor people to buy houses, because they default at a higher rate.  They can charge more interest for those loans to cover the risk, so it shouldn't have been a problem.  Not only that, they get the house back in most defaults.  At best, a 25% loss or something in my wild out-the-ass guess.  What tanked the market was idiot bankers overvaluing houses (which includes giving poor people "0% for 2 years@!#!@1one" loans)

The banks and morons aren't totally brain-dead, they'll take a good deal when they see one.  When Bear Stearns says they've got money coming out of their ass to cover overinflated house loans going pop, the banks jump at it.  Bear Stearns says, hey, if that rich cunt runs out on this $100,000 house you loaned him $300,000 for, we'll pay you $200,000.  Obviously, Bear Stearns was utterly retarded.  They lost all their money, but before doing so they had taken some investors money and said "dear sir, I am the soon to be widow of an investment banking firm and I will give you x% of your money back every year until the market collapses"

So in the end we have these failures:
a) people with overvalued houses and loans to match.  They also told the bank "hey, this house will be worth more in two years, so for two years I'll pay 1% interest and after that 320949321491% interest."  Now the people want to take their ball and go home, and they can, because no one knows who actually owns their loan, the bank that issued it is bankrupt, and the people can just declare chapter 7 if they feel like it.
b) banks who gave all their money away to people who won't give it back.
c) banks who sold their loans to morons and might make out okay if they never, ever need to get another loan to handle a bank run.
d) morons who owe a lot of banks a shitload of interest and can't get any payments on the shitty loans they own.
e) retards, fools and investors who thought the morons were the right people to hand all their cash to and which is now effectively buried deep under worthless houses..
f) the U.S. economy that can't offer loans to save its life (because that loan is definitely going to be headed right for the dirt under some project housing that got sold as prime real estate)
g) people who have anything whatsoever to do with the U.S. economy.

That about covers it, right?

So, a real bailout should work like this:  Take $700,000,000,000 dollars and divide it up evenly between everyone who does not own a house (or a house loan), has not bought or sold one in the last ten years, and hasn't been investing their money with greedy bastards for the last ten years.  That will put the true blame for the recession squarely on the shoulders of the people responsible and make a whole lot of gangstas and welfare moms very rich.  This is the true solution, and it will fix the economy so well that I can already smell the drugs and SUVs pouring into inner cities.

To a point, you are correct (2.66 / 3) (#36)
by Liar on Wed Oct 01, 2008 at 07:39:15 PM EST

And that point is everything after "A bank is an institution".


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
+1, but not convinced (3.00 / 2) (#37)
by bodza on Wed Oct 01, 2008 at 08:32:05 PM EST

There is not a single person who does not benefit from a bailout
1) Why modify behaviour when there is no penalty. What stops this from just deferring the crisis 6 months and leaving you broke when everything does come crashing down?

2) Why would you not demand a return on your investment by demanding equity in the bailed out parties? How would this stop the bailout from working?
--
"Civilization will not attain to its perfection until the last stone from the last church falls on the last priest." - Émile Zola

equity (none / 1) (#41)
by sesquiped on Thu Oct 02, 2008 at 12:18:06 AM EST

I have no idea what I'm talking about, but I've read arguments that address your second point:

First, you can get a return on your investment without equity in the companies you're buying assets from, just by selling the assets at a higher price later. This isn't guaranteed to make money, but neither is an equity provision.

Second, the fact that the government owns a chunk of those various companies (or warrants to buy a chunk, or whatever) will be reflected in their stock price, which won't rise as high as it would naturally, and won't allow the government to make much or any money on the whole deal.

Third, companies would see an equity provision as a punitive measure, and it would discourage companies that are slightly hurt but could survive without help from participating in the plan. But part of the mechanism of the plan is a reverse auction, which requires broad participation to work. So an equity provision could actually ruin the whole thing.

[ Parent ]

re: 2, it's possible the current plan will do that (3.00 / 2) (#46)
by Delirium on Thu Oct 02, 2008 at 04:50:09 PM EST

It depends on the extent to which this really is a liquidity problem, and how good the government is at managing not to pay inflated prices for the securities it buys. Everyone now agrees that the securities were previously wildly overvalued. The question is now whether they're undervalued as a result of a liquidity crisis, because there is essentially no market for them.

If so, they would be good long-term investments—if the rate of defaults, though high, is not as high as the hugely discounted value of the securities' current prices indicates. Now normal market theory would suggest that if this is true, their prices ought to go up without government intervention, because investors interested in long-term profits would be buying up the depressed securities, taking advantage of the current liquidity crisis to get stuff cheaply. Paulson's bet is that the main reason this isn't happening is that everybody with sufficient money to make a dent in their prices (i.e. by buying up ~$500 billion of them) is currently in panic mode trying to avoid going bankrupt, so is in no condition to buy them. That is, they are worth more, but nobody who thinks so has enough free cash to act on that sentiment. The government, on the other hand, has plenty of liquidity still, a least on the order of $1-2 trillion or so, so could buy up securities cheaply, simultaneously solving a liquidity problem and making a profit on holding the securities to maturity.

Even if all those assumptions are correct, though, it remains to be seen how the execution is carried out. As the article points out w.r.t. Bill Gates hypothetically selling his Microsoft stock depressing its price, in this case, the government buying up $700b of securities will inflate their price simply as a result of producing a massive supply. There are some methods for avoiding the problem, e.g. reverse auctions, but they mostly rely on functioning markets with liquidity, which is the problem in the first place.

[ Parent ]

You don't understand the word ideology: (1.00 / 1) (#38)
by spooked on Wed Oct 01, 2008 at 09:16:51 PM EST

Simply put, it means the imaginary relations to the real conditions of life. "The market" is ideological.

Thus "...but only insofar as we hold ideology superior to what helps markets operate best." = ROR

Seriously.
PWND (1.50 / 2) (#39)
by Hiphopopotamus on Wed Oct 01, 2008 at 09:43:33 PM EST

Didn't read, but I notice you got your ass in gear. Cheers.
_________________

I'm In LOVE!

sunuvabitch (none / 1) (#40)
by Sgt York on Wed Oct 01, 2008 at 10:47:19 PM EST

I missed voting. Thanks for writing it, though...I look forward to reading through it now.

There is a reason for everything. Sometimes, that reason just sucks.

Banks do not loan deposit money (3.00 / 6) (#42)
by Peaker on Thu Oct 02, 2008 at 04:10:30 AM EST

Banks loan money that they create.


Yeah, this is a very important point (3.00 / 4) (#73)
by rusty on Fri Oct 03, 2008 at 04:58:49 PM EST

The assertion that "if depositors have put $100K in a bank, a bank with a 5% reserve can only use $95K to issue loans" is not true. If depositors have put $100k in a bank with a 5% reserve, the bank can then loan out $2,000,000. The $100k of deposits is the 5% reserve. The bank turned that $100,000 into $2,100,000 owed to it just by writing loans. This is why banks are richer than hell.

Except for when it turns out that the $2 million in loans is actually only realistically worth $400,000, but it has meanwhile been treated as $2 million in the vault to guarantee lots of other loans made by lots of other banks. And everyone discovers that they're on the hook for $100 of debt for every $1 of real asset value. Because then no one will (or can afford to) loan anything to anyone to cover any of this clusterfuck.

____
Not the real rusty
[ Parent ]

that's not my understanding (3.00 / 3) (#75)
by Delirium on Fri Oct 03, 2008 at 05:15:48 PM EST

In fractional-reserve banking, at least under US accounting standards, you do really have to maintain a specified fraction of your deposits, e.g. if you have $100k in deposits, you need to maintain $5k in cash to have a 5% reserve, and then have $95k in cash you can give to people.

The way money gets created in this system isn't by a single bank, but by the cascading effect of multiple banks doing this in series. If the first bank keeps $5k and lends out $95k of the $100k in deposits, a second bank can take that $95k and lend out 95% of it, effectively doubling its presence in the economy, etc. Wikipedia has a nice graph of how the money supply expands as that cascades through a series of banks, reaching an asymptote at the value you suggested (a 1/reserve multiplier, i.e. 5x for 20% reserve, 20x for 5% reserve). So in aggregate your summary is more or less how it happens, but not for a specific bank.

[ Parent ]

Yeeees (3.00 / 3) (#79)
by rusty on Fri Oct 03, 2008 at 09:01:31 PM EST

You're right. But I'm right too -- that is, my numbers are correct. My explanation was not. And I do think either of us give a better picture of what actually happens than the original sentence I quoted.

Going by wikipedia's "money multiplier" formula, $100,000 at 5% reserve means m = 1/(1/20), or m = 20. So you still come up with my $2,000,000 number.

I agree that it's not from a single bank though. I see where my confusion came from.

____
Not the real rusty
[ Parent ]

Ignore redundant comment below (none / 1) (#81)
by rusty on Fri Oct 03, 2008 at 09:08:43 PM EST

I should read the whole thing before I respond. Yeah, you said everything I said. So please replace #79 with: "word."

____
Not the real rusty
[ Parent ]
A deceptive movie (none / 0) (#94)
by wildclaw on Sat Oct 11, 2008 at 11:41:29 AM EST

That is because you redefine create.

When you put money into a savings account it is no longer your money. It is just a money-like asset that represents what you deposited, but isn't 100% guaranteed (although goverments usually like to have some kind of guarantee on basic savings accounts). The actual money the bank lends (invests) to someone else while keeping a small reserve so that it can simulate your money-like asset being actually accessible money, which works as long as there isn't runs on the banks.

If you actually want to deposit your money as actually money and not money-like assets, you put them in a bank box. Of course, don't expect to get any interest from that.

And don't tell me that you didn't agree to it all. Unless you went to a bank and specifically said that you wanted a 0% account (plus fees) where you could safe keep your money so they wouldn't get stolen. As soon as you get interest on money you deposit into a bank account, the fractional reserve system (or no reserve if you want a really free market) is implicit. Unless you think your money earns interest from doing nothing.

Btw, the amount of currency a country gives out is specifically balanced against the bank account "currency" that banks "create". It is not some magic multiplication of resources that is meant to swindle the system.

Finally, the absolutly worst part of "Money as Debt" is when they try to fool you into thinking that it is impossible to pay back all debt because of some idiocy about about the total outstanding debt being greater than the total loaned out money. This is simply a lie that fail to mention/consider that money flows. It is always possible to pay back debt as long as the one who owes money provides a service/product that the lender wants.

This is because money circulates. Lets say that Adam owes Eve $10 because he invested in an apple tree. Eve has $1 in real money and the debt paper worth $10. Now Eve buys an apple from Adam for $1. Adam uses the money he earned to pay back Eve who immediatly buys another apple. Repeat a bunch of times and finally Eve got all the apples she needed while Adam managed to repay all his debt. And note that there never existed more than one real dollar.

There is an important things to note in the above. The circulation can happen at any speed and it is that circulation that determines how much debt a market can manage.

When the speed of circulation slows down the economy gets worse, and the reason for slow downs is usually because of bad and/or fake investments that decrease trust in the market.

[ Parent ]

Money flows *within* the system (none / 1) (#96)
by anaesthetica on Sat Oct 11, 2008 at 10:10:49 PM EST

I agree that the Money as Debt video overstates its case in sensationalized terms, but I don't think that their specific insight on debt and the money supply is incorrect.  Your Adam & Eve example looks just at individual microeconomic interaction.  But if you look at it from the aggregate system level, I think that Money as Debt gets it right, assuming a closed system.

If you have a money supply created by a central bank and used within one economic system, then the fact that it's all created as debt that needs to be repaid with interest means that the amount owed will always be larger than the money supply as a whole.  

First, all money in circulation becomes debt in this scenario.  Even if you start with a money supply of entirely non-debt cash, if you then allow for a central bank and banking system that can create 9:1 debt money to cash reserves, all of the non-debt money will eventually be used to pay interest on the debt money as money flows.  The entire money supply will then become debt based.

Second, the United States federal budget is borrowed from the Fed.  So even the government, which could just print the money or just use tax dollars, instead borrows its budget from the Fed and later pays it back.  So government spending does not inject non-debt money into the money supply--it simply creates more debt money.

If the entire money supply is debt, and all debt carries interest payments, and no non-debt money comes into the system, then the entire money supply is insufficient to pay back the entire amount owed.  Every cash dollar in circulation represents a dollar plus interest of debt.

We can see this problem in the current meltdown of derivatives.  Derivatives are debt instruments backed by assets.  There are about $1200 trillion of derivatives in existence compared to a world GDP of about $55 trillion.  That's over a 20:1 ratio of debt to physical production of new value.

The fact that money circulates does not change the inability to escape debt.  Since all money is debt, the ability of individuals and firms and governments to pay off their debt obligations represents just a temporary concentration of money to pay off debt, but doesn't change the fact that ultimately all debt must flow back to its creators (central banks) and that the entire money supply is not enough to pay the entire debt, since money = debt (principal + interest).

Growth in GDP must increase faster than the interest on the debt in order for the debt-based system not to entire into crisis.  Also, the money supply must be expanded alongside GDP growth (which is why monetarist economic theory argues that money supply should be increased from 3-5% annually).  Finally, this is why inflation can never be beaten--it's a feature inherent in the system, in which more money must be created in order to pay off existing debt from the debt-money money supply.

—I'm the little engine that didn't.
k5: our trolls go to eleven
[A]S FAR AS A PERSON'S ACTIONS ARE CONCERNED, IT IS NOT TRUE THAT NOTHING BUT GOOD COMES FROM GOOD AND NOTHING BUT EVIL COMES FROM EVIL, BUT RATHER QUITE FREQUENTLY THE OPPOSITE IS THE CASE. ANYONE WHO DOES NOT REALIZE THIS IS IN FACT A MERE CHILD IN POLITICAL MATTERS. max weber, politics as a vocation


[ Parent ]
Reluctantly support bailout (3.00 / 2) (#43)
by redelm on Thu Oct 02, 2008 at 09:14:26 AM EST

I do not _want_ to defend Paulson's bailout, but honesty compels me to recognize arguments in its favor. Also, I do not have confidence in any position until I can argue both sides with approximately equal fervor.

We live in a highly interdependant society. The foolishness of some will be visited upon all. Do you really want to cut off your nose to spite your face? Yes, Wall $treet fatcats have stolen shareholder money. Would you punish everyone in the hope they suffer?

Paulson is indubitably correct that subprime and similar toxins have spread to every corner of the financial system. Even Europe where their accountancy forced them to recognize it first.

While the actual losses from bad loans are probably fairly small (a few 100B$), they force asset reclassification and seriously impair bank capital. So the banks stop lending and may need to suspend withdrawals. Bill Heard Chevvy folding is the canary in the coal mine.

Paulson is in a priviliged position (along with Bernanke) to know the precise state of the US banking system. While he might be using this bailout as personal power aggrandizement, it is more likely the Fed has run out of US Treasuries for its oh-so-clever TAF and other swap facilities. The bailout gives the Fed more without clear inflation from buying UST in open market ops.

There is a significant chance the US financial system is on the verge of total lockup if the banks panic: credit cards stop working (no credit granted), debit cards stop working (withdrawal holiday). Checks bounce, etc. Look at the fine print -- the banks _can_ hold withdrawals for at least seven days.

The cost of a total lockup will run into the trillions, especially since re-start will be very difficult. It is by no means certain the lockup would occur without the bailout, nor can be avoided with it. But the bailout looks like it has a pretty good chance.

For the moralizers: justice is fine, but at what cost? There is also the argument that since the US Treasury, FRB and other agencies have broad banking oversight responsibilities (on which they failed), the US government is responsible for the ultimate failures. Regulation implies protection. The best reason to avoid it.



I think that's a point that bears repeating (3.00 / 2) (#50)
by Liar on Thu Oct 02, 2008 at 06:56:46 PM EST

"I work hard, don't build up unnecessary debt, pay my mortgage on time. Why should I as a taxpayer bail out someone who was either greedy or irresponsible." Lots of people are saying this.

Because you mostly likely benefitted from the same exact market structure if you've ever financed anything in the last 15 years. Even though your particular mortgage may not have been lumped in a high risk tranch, because loans were available to more people, there was more cash on the market which means all borrowers were able to benefit from cheaper rates. That's the benefit and the responsibility of an interdependent market.

And if a person rented, they were paying someone else's mortgage, so they too benefitted from the market.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
I disagree (of course) (none / 1) (#53)
by sholden on Fri Oct 03, 2008 at 01:05:07 AM EST

Cheap rates just produced higher prices (hence a housing bubble), so if you weren't willing to do a no money down,  no doc, teaser payments are 40% of your income then you got priced out of what you should have been able to afford.

When the rates are low but the prices are doubled the mortgage end up costing the same or more - and when interests rates rise those borrowers are screwed.

In fact high interest rates are better. Price is determined by what people can afford to pay (in the short term, there's existing stock to put a floor even if cost of production is high), high interests rates mean prices are thus lower and a larger portion of mortgage payments are interest (which has tax advantages).

--
The world's dullest web page


[ Parent ]
Interdependancy (none / 1) (#61)
by redelm on Fri Oct 03, 2008 at 11:35:49 AM EST

Granted the prudent benefit from economies of scale the reckless bring, but this is a small benefit (~20%) compared to the competition the reckless bring. When the reckless go bankrupt, it is not a problem for the prudent. However, when their assets are sold at greatly reduced prices it brings new competitors at a lower cost structure (subsidized by bankruptcy losses). The prudents' assests are similarly devalued. Look up "A Tale of Two Malls" for a nice, concrete example.

BTW, I have shifted position on the bailout after reading the Senate bill that was passed. It is heavily Christmas-treed, so I take it the case is not compelling enough even in private. No-one would dare Xmas tree 911 or Pearl Harbor. This might well be, but Paulson etal could not convince the US Senate even behind closed doors. I take them at their word.



[ Parent ]

The problem with the Tale (none / 1) (#65)
by Liar on Fri Oct 03, 2008 at 12:58:51 PM EST

Even if the less prudent guy didn't get in the market, there was obviously enough demand at one time for two malls, which would attract other investors. So, this market got an imprudent one but just as likely could have had a prudent one.

If there were two prudent investors, the same scenario unfolds. In that case, the better financed one would weather the poor economy better and the poorer one would go out of business first, the opportunists buy the vacated mall for 18 cents on the dollar and undercut the other prudent investor so that when times got harder, they other one falls.

So, it's prudent to have a lot of cash, but it's even more prudent to time the market. That's not exactly helpful or insightful.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
Missed the point: (none / 1) (#70)
by inah on Fri Oct 03, 2008 at 04:11:29 PM EST

The tale has more to do with businesses responding, anticipating and acting in accordance with market conditions.   There is nothing to do with prudence, but poor management.  I've actually been to both of those malls in Dec 2008, and the contrast is quite striking.  One is alive, and the other is dying.

The commercial mall space in a very small area has a glut.  Yet, Galleria has managed to stay ahead of the much larger Southdale.  Galleria is more diversified and well positioned to survive this downturn.  Once the economy bounces back, they will be better positioned to grab a larger market share.  Southdale is headed towards becoming a gutted mall with movie theatre attached.  Even if the mall gets sold at discount, transforming an empty mall will take a tremendous amount of money and time.  In my opinion, this strengthens the Galleria's position, not weaken it.

I agree on the cash point:  cash is king.  The few who will have cash will have some incredibly opportunities down the road.

[ Parent ]

You've seen the future? (none / 1) (#71)
by Liar on Fri Oct 03, 2008 at 04:40:25 PM EST

You're talking about Dec 2008 in the past tense!

All kidding aside, I wasn't sure which story you meant. A specific link would have been helpful. But, unfamiliar with what you meant, I read the first few Google results. The second story seemed to be in accord with your original assessment, where an over-leveraged imprudent investor destroyed even the prudent investor.

Even in the first story, from what I read, there was a boom and so two malls were built. When there was a bust, only one mall could reign supreme. That's a problem of overcapacity which is typical of economic downturns or even cyclical models. So, obviously the company which is better run and better financed will survive, but that would happen even if the mall which failed had competent administration and adequate funding.

So, I'm still not sure what your point is.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
Wish I knew the future! (3.00 / 2) (#74)
by inah on Fri Oct 03, 2008 at 05:09:57 PM EST

Then I'd get some Lotto tickets. ;) You're right, I meant 2007.

Was referring to Star Tribune article.

But in seriousness, Southdale is swirling the drain.

My point is, even if someone comes in and gets a killer deal on Southdale, they have a huuuge uphill battle in getting Southdale up to par. I admire the Galleria for having the tenacity to continue pursuing solid tenants. As for Southdale, they've lost a massive anchor (usually held by a department store, but left empty by Mervyn's) that's been empty for four years. Meanwhile, Galleria will only continue to get stronger and has very little to fear from Southdale for quite a while.

So while the median cost of renting in a mall in Edina will probably stay flat or go down, I don't really see the Galleria being devalued. The industry, perhaps, but not the survivors.

[ Parent ]

... not tough enough bankers! (none / 1) (#82)
by redelm on Sat Oct 04, 2008 at 12:43:12 AM EST

No, there was at most enough demand for 1.5 malls, and this at reduced prices. Everyone can see the opportunity. Everyone thinks they will be the winner. Only one will be. The fundamental weakness of market economies is overcapacity. No one makes any money and may not even cover total costs. Prices always head towards marginal cost which may be very low with overcapacity.

What is really needed is a hard-nosed banking community which says "Prudence Goodbuild has already announced a mall there. We don't believe there's room for two. No financing for you!" But this is not remotely popular so all sorts of ways are used to loosen the bankers up. And it works even for the banks until the failure rate comes home to roost. Like now.



[ Parent ]

Two + Two = War; Give bongs a chance. (3.00 / 3) (#44)
by conner_bw on Thu Oct 02, 2008 at 12:03:20 PM EST

I propose that Wallstreet's current economic crisis is a national defense strategy set in motion by moneymen and presidents loosely tied to a fascist conspiracy to overthrow the US government in 1933. The aforementioned overthrow isn't some unsubstantiated lunacy. It was part and parcel of Major General Smedley D. Butler's testimony in front of a US Congressional Committee. Smedly was a trench digging, man killing, military hero. At the time of his death, he was the most decorated Marine in U.S. history. So when he talks I listen. He had a lot to say but i'd like to bring your attention to one paragraph in particular. Let's call this paragraph column A, column B to follow:

[Durring World War I] an allied commission, it may be recalled, came over shortly before the war declaration and called on the President. The President summoned a group of advisers. The head of the commission spoke. Stripped of its diplomatic language, this is what he told the President and his group: "There is no use kidding ourselves any longer. The cause of the allies is lost. We now owe you (American bankers, American munitions makers, American manufacturers, American speculators, American exporters) five or six billion dollars. If we lose (and without the help of the United States we must lose) we, England, France and Italy, cannot pay back this money...and Germany won't. So..."

Obviously, I was privy to Smedly's ideas before today. But the above didn't click until I read Liar's article. Specifically:

To raise money for the bailout, the U.S. government likely will turn to a combination of foreign investment and higher interest rates set by the Fed.

Followed by a a response emphasising:

If you had read the article, you'd have seen that we'll likely borrow it from foreign investors.

This insight falls into column B.

With those two pieces of information clearly juxtaposed, it's not a big leap for me to conclude that if any shit comes raining down on America, they'll have strong leverage to command the armies of other nations. Furthemore, for reasons good or bad, current US foreign policy seems to have a lot to do with invading random middle east countries that other countries would rather stay out of. But if push come to shove, patriotic arabs will make the battle of Stalingrad look like a walk in the park. A little help please?

You may ask yourself, if I own a nuclear jetpack, why would I want to command your fisher price bigwheel? To this I do the Homer Simpson recoil in horror backwards sulk after peeping in your window and watching you have sex.

But honestly, with over a hundred years of American leadership in banking and investment, and over half of it during the cold war; A war with failed ideologues on the other side of the wall predicting this catastrophe over and over, and backing it up with military insanity to boot, you'll forgive me if I don't believe that Wallstreet didn't see this one coming. And for months people have known shit was going to hit the fan, why now? Right at the end of the presidential campaign? Worse possible timing, or best?

Something else is going on here, or at least worth considering.

Dogs of finance, they're after you (3.00 / 2) (#89)
by conner_bw on Tue Oct 07, 2008 at 10:51:16 AM EST

By a nice coincidence, though, the financial rescue package of $700 billion duplicates a number that was also in the news last week - the Pentagon budget. In the fiscal year just beginning, the Defense Department will spend $607 billion on normal military costs, and an additional $100 billion on the wars in Iraq and Afghanistan. (As of June 30, 2008, Congress had appropriated $859 billion for the wars; Congressional Budget Office projections assume further costs of $400 billion to $500 billion as the wars wind down). But for the coming year, $700 billion is the Pentagon's nice round number (this includes neither Homeland Security nor intelligence costs).

http://www.boston.com/bostonglobe/editorial_opinion/oped/articles/2008/10/06/mak ing_some_sense_of_700b/

[ Parent ]

Good for everyone? (3.00 / 10) (#45)
by flargx on Thu Oct 02, 2008 at 01:01:35 PM EST

Thank you for providing an explanation of these things.  I like what you were saying up until you said it was good for everyone.   I'm no expert, so I can't say I disagree, but I have a lot of questions.

So, our government seems to subscribe mainly to Keynesian economics that believes in intervening with the market in all sorts of ways to "smooth out" the cycles.    On the other end of economic thought we have the Austrian School, that is very against intervention.   What gets me here is that several of the folks that subscribe to the Austrian School were very accurately predicting this would happen.  Now they are predicting very bad things if we move forward.   There's even some sort of thing that over 100 academic economists have signed onto saying this bailout is a bad idea.  

So, my question there is, why are we ignoring these guys?   What is wrong with their claims that it is a bad idea?

On the extreme of them we have people like Peter Schiff.   While he is predicting some pretty nasty things, you have to admit he has talked about this happening for a long time with great accuracy.  He believes that we are going to hurt the value of the dollar so much that other countries stop honoring the dollar causing our fiat system to take a severe plunge.   This is serious stuff.  Why shouldn't I be worried about what he is saying?   Why shouldn't I be worried about the inflation caused by this bailout?

I could come up with a lot more questions, but I think that's a start.    I'm really curious why I should ignore the people who support the Austrian school and have predicted the whole thing and listen to the Keynesians who didn't see this coming and got us into this mess through their policies.

To continue a little, the folks on the other side seem to think a recession is a necessary adjustment, and that it could be bad.   At the same time they believe the bailout only would put off the recession for a while, and when it came it would be more severe.  These views are very detailed and technical and seem pretty logical to me.   You say we benefit.   Why are these views wrong?
 

I hear only crickets :( [nt] (3.00 / 2) (#57)
by localman on Fri Oct 03, 2008 at 06:56:00 AM EST



[ Parent ]
I smell fear (3.00 / 3) (#64)
by inah on Fri Oct 03, 2008 at 12:14:40 PM EST

I think people are afraid.  

The problems are correctly identified, but the solutions are wrong.  So in the immortal words of Philip J Fry, people are screaming "Fix it! Fix it! Fix it!"


[ Parent ]

no, it's just too big of a question (none / 1) (#78)
by Liar on Fri Oct 03, 2008 at 06:26:48 PM EST

and outside the scope of what I was trying to say in this article.

I'm not sure I could do the orthodox view justice and engaging this question would be similar to a friend of Galileo trying to field the question "Why not use epicycles if it calculates better?"


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
That's pretty weak (3.00 / 3) (#86)
by flargx on Mon Oct 06, 2008 at 11:10:52 AM EST

So you make a claim, and when the claim is questioned that is outside the scope of the article?   It sounds like you never should have made such a claim if that is the case.

[ Parent ]
This was a market overview (3.00 / 2) (#87)
by Liar on Mon Oct 06, 2008 at 04:39:41 PM EST

There were a lot of people who seemed to have some misunderstandings of what problem was being addressed by this bailout so I was trying to provide a basic vocabulary and a 10,000 foot view of how the market operates so that other people can speak more intelligently about it.

If you want to go deep into the weeds of why a particular economic perspective is valid/invalid, that's a different conversation and probably one worth having.

I don't think my response was weak; it is insufficient, but there are some questions that are too big to answer and I'm smart enough to recognize an impossible task. In this case, it would require a lot more foundation (it would take an article of twice this length to even establish a foundation for discussing the money supply alone) before we can even begin addressing the central claims of Austrian School Economics.

So, I'd rather just say that it's too big of a question rather than even start down that path.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
It's all good (3.00 / 3) (#90)
by flargx on Tue Oct 07, 2008 at 11:59:03 AM EST

I liked the article, and meant no harm by my "weak" comment.  I was just saying that within the article you made a claim that the bailout was good for everyone.  That point was not a conclusion of the article.   It can't be deduced from the prior content.   By placing such a thing in the article it seemed to me that it was included within the scope, though I never really felt like it belonged in the article.   Anyway, no harm done at all.  I think this article was a great contribution to the K5 community and I look forward to your future submissions.

[ Parent ]
Be sure to include in your response: (3.00 / 2) (#121)
by sllort on Thu Oct 16, 2008 at 03:01:22 PM EST

...a detailed explanation of why the Austrian school predicted this perfectly even though they're totally wrong about everything, while simultaneously the Nobel Prize winning Keynes folks failed miserably for years because they're right about everything. Be concise and complete.

Maybe Krugman can use his Nobel money to help bail us out. But only if they paid him in Euros.
--
Warning: On Lawn is a documented liar.
[ Parent ]

You are right to ask questions (none / 1) (#120)
by sllort on Thu Oct 16, 2008 at 02:53:30 PM EST

Those economists were right about this collapse because they actually understand what's going on. Pumping cash into our veins is only going to keep the country high a little longer. We have a very painful detox coming. Best not to make it worse.
--
Warning: On Lawn is a documented liar.
[ Parent ]
Good Article (none / 1) (#49)
by greengrass on Thu Oct 02, 2008 at 06:41:06 PM EST

So the whole problem is investors.

Oh, I get it.

even tho- (3.00 / 5) (#51)
by nononoitaintmebabe on Thu Oct 02, 2008 at 10:28:25 PM EST

i don't agree with everything you said, i think this is a terrific article.  i appreciate the time you took to write.

my major disagreement with you is that i don't believe that everybody wins.  i'm in the lower middle class and i have "prime" loan and i've done everything (financial) responsibly over the years. so how exactly do i personally win?  

i'm being asked to bail out an irresponsible government, irresponsible bankers, irresponsible investors, and irresponsible borrowers.  

now, do i believe that it has to be done. yeah, i guess.  however i'm going to be damn grumpy about it.  

How you win (none / 0) (#102)
by flimflam on Tue Oct 14, 2008 at 09:13:22 AM EST

The argument is that if we fail to act and the whole economy goes into a deep recession or depression, then you lose through no fault of your own. So consider the bailout the lesser of two evils.


-- I am always optimistic, but frankly there is no hope. --Hosni Mubarek
[ Parent ]
How do I lose in a depression? (3.00 / 2) (#104)
by sllort on Tue Oct 14, 2008 at 12:10:14 PM EST

I live in a place where I cannot afford a single family home because an entry level house is $900,000. This is because of the inflated amount of credit available to borrowers and their choice to use it. I have made all the preparations I need to keep myself safe through a ten year depression, I am READY. I have been ready since May. A bailout, quite simply, is an attempt to punish the prudent, to strangle our cash with inflation and keep the thieves afloat. I am ready for the depression. Let the assholes who drowned my city in easy money shoot themselves in their homes, bankrupt and alone. That is the fate they have chosen for themselves. It is a good thing for America.
--
Warning: On Lawn is a documented liar.
[ Parent ]
i hope you lose your job. (none / 0) (#110)
by lostincali on Tue Oct 14, 2008 at 09:56:59 PM EST

"bring on the Depression," my ass. what a callous thing to say.

"The least busy day [at McDonalds] is Monday, and then sales increase throughout the week, I guess as enthusiasm for life dwindles."
[ Parent ]

it's a matter of perspective (none / 1) (#113)
by sllort on Wed Oct 15, 2008 at 01:11:12 PM EST

you think of all the suffering of the imprudent that will arise in a depression. what you don't see is the suffering of the prudent that has already occurred. the last six years has been a depression for those of us squeezed out by our refusal to participate in ruining the economy. the first half of a depression has already happened, to the prudent. i only wish for the second half to happen to those who caused it, rather than have the consequences of their foolishness shifted into my taxes. cheers.
--
Warning: On Lawn is a documented liar.
[ Parent ]
no. (none / 0) (#114)
by lostincali on Wed Oct 15, 2008 at 06:25:45 PM EST

you simply make the false assumption that the guilty are always the ones who get punished. if we move into a period like the Great Depression, people are going to lose their jobs irrespective of how they handled their personal finances. if you want to fantasize about the wicked getting their due punishment, maybe you should spend more time in church.

"The least busy day [at McDonalds] is Monday, and then sales increase throughout the week, I guess as enthusiasm for life dwindles."
[ Parent ]

you're right (none / 0) (#116)
by sllort on Thu Oct 16, 2008 at 10:22:03 AM EST

the guilty are not always punished. for instance, if any one person is responsible for all of this, it's barney frank.

however, that doesn't mean we shouldn't try.

http://www.youtube.com/watch?v=9BIWolWKsO0
--
Warning: On Lawn is a documented liar.
[ Parent ]

so, the opposite of blackstone's formulation, then (none / 0) (#124)
by lostincali on Thu Oct 16, 2008 at 05:50:29 PM EST

"better that millions of innocents get mowed down than one guilty man go free"

"The least busy day [at McDonalds] is Monday, and then sales increase throughout the week, I guess as enthusiasm for life dwindles."
[ Parent ]

i don't think the nubmbers are that lopsided (none / 0) (#125)
by sllort on Thu Oct 16, 2008 at 06:18:40 PM EST

certainly the UBS 20,000 need to go to prison first.
--
Warning: On Lawn is a documented liar.
[ Parent ]
grumpiness is reasonable (3.00 / 2) (#111)
by Liar on Wed Oct 15, 2008 at 04:08:14 AM EST

Short version:

Assuming you work, you avoid facing the worst effects of a frozen credit market.



Long version:

My biggest concern when I wrote this article is starting to make its presence clear: a lockup of the credit market and increasing unemployment.

Money funds are supposed to maintain a value of $1.00 Net Asset Value (like a share, but applied to mutual funds and the like). For a money fund, this isn't a huge hurdle in an otherwise stable economy: you give someone a dollar and they return to you a dollar and a penny in a week. You do this a hundred times and if one guy flakes, you'll still break even. If you loan a dollar to banks and stable companies with excellent credit ratings, you'll be fine. When you give Warren Buffet a dollar, you can be pretty certain that he won't default.

Now, why would Warren want to borrow money? Well, to make payroll for instance. He has 230,000 employees and even if each were making minimum wage, that's still a big amount to store up in the bank and pay off every two weeks. It makes accounting highly volatile to build up a huge stockpile of cash that gets dispersed all at once and FDIC won't cover those big deposits if something goes wrong at the bank. So, when you have a big company like Warren does, you'll engage in some form of short term debt and repay it daily. This smooths out that cycle and makes the finances of a business manageable.

You can relate this to the logistical difficulty between getting paid at the beginning of the month versus getting paid every other week. Even at the same pay, people dislike monthly since they inevitably will find a reason to spend their paycheck before the full month has passed and so they wind up short at the end of the month. As businesses are run by humans, they face the same issues. Smoothing out the payment cycles does incur a cost to employees (the payroll department is twice as active so it's twice the expense) but the cost is tiny compared to the benefit to employees.

Even if it's not a big Warren Buffet sized company, a business typically has a line of credit to achieve this end. But that means that banks go through boom and shrink periods where they are cash heavy especially near month end and paying it out all at once at the end of the month. So, banks themselves use the same techniques to smooth out their own cycles such as by issuing commercial paper.

Something like 1600 companies use the commercial paper market to finance their operations, and they're all huge. The market for commercial paper is so boring that there's only been 2 incidents in the last 40 when there have been failures in the commercial paper market. The first was in 1994 but due to its nature it was confined to institutional investors like brokerage firms. The second was less than a month ago when Lehman Brothers went under and was unable to pay back its commercial paper obligations. The owners of this paper who lost money: almost everyone with a money market account.

As a result of Lehman going under, the money market has dried up. No one is buying commercial paper because no one knows which bank is going to be around in the next 9 months. Most critically, payrolls are not being financed. For many companies, they won't have the debt instruments to finance routine operational costs. Banks which are willing to take the risk and buy a company's debt are doing so at much higher interest rates than before (because they themselves cannot finance it so they have to issue it with their existing cash on hands; the inherent risk of betting one's own money naturally increases the cost). This is a direct cost to all businesses in America and under these conditions the typical response of business is to reduce their largest single expenses.

This means we can expect jobs to be cut.

In my article, I made mention of payroll loans, and that's how the average person will most likely be adversely affected, either because more of their company's resources are going to higher operational costs or else they and their friend's jobs are put in greater jeopardy. The longer the credit markets remain frozen, there will be two classes of people: those whose businesses will have higher operating costs and those who are out of work.

But I'll warn you, watch out for October 21. That's the day that the Credit Default Swap market will have to settle their accounts on Lehman Brothers going under. This could very well be astounding as somewhere between $100-$400 billion will need to be paid out by CDS owners who may not even have the assets to fulfill their obligations. But even though that is looming over us, we need to cross each bridge one at a time and the first step is easing the pain of the mortgage market and the burden of that failed debt.

You don't have to enjoy doing it. Lord knows, I don't enjoy my dentist appointments, but I do it because it's the important thing to do. So, be grumpy but recognize that the livelihood you protect may be your own.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
Japan holds most of US debt (3.00 / 3) (#54)
by inah on Fri Oct 03, 2008 at 02:10:32 AM EST

2007 US Debtors

Moral Hazard (2.60 / 5) (#56)
by inah on Fri Oct 03, 2008 at 02:57:58 AM EST

If you take the risks out of any system, chaos will ensue. By propping up these failed loans, the economy will go down much harder than the Great Depression.

The crisis is being worsened by:

  • Cheap money (keep those presses printing)
  • Banning of shorts
  • Government policy meddling
  • Over-leveraging (everyone, individual to multinationals)
Want to know how much Chinese Yuan is printed every year? Sorry, you can't. It's a state secret. The Federal Reserve now has opened the credit window to Goldman and Morgan Stanley. Ironically, this is the access investment banks had revoked after the Great Depression. Start those presses.

Shorts were designed to help people hedge, as in minimize their losses. Now that the SEC has made this illegal, it is nearly impossible to gauge risk in the stock market.

Fanny/Freddie were a time bomb. How could they be both a publicly traded company and a Government Sponsored Entity? How does the government unilaterally take over AIG and run it?

Everyone is over-leveraged: the friend with 50k in credit card debt, that new home owner that wants to get granite counters in the kitchen, the banker who wants to squeeze more returns on deposits, the foreign banks that wanted better yields than Treasury bills... the list goes on and on.

They're breaking to system to keep it from falling down. Instead, it'll collapse, or something worse. By letting the market wind down, and letting the fittest survive, thing will bounce back. There was no bailout for the tech bubble, and yet the tech industry still exists.

The bailout will most definitely prolong this crisis. Instead of pouring water into a leaking tub, why not plug the hole?

What's the hole? Cheap credit.

I can see you made a real solid attempt, but your understanding is a bit superficial. The economy is not a closed system. Macroeconomics is not for the faint of heart.

I don't think (3.00 / 2) (#58)
by TDS on Fri Oct 03, 2008 at 07:15:35 AM EST

someone with 50k on credit cards or really the granite counters (unless you solidly believe they've added value to a property which debatable) is over-leveraged, I think they have just over-borrowed.

It is important to recognise this distinction because it tells you "why property?". And the answer is this: housing is the only opportunity most private individuals ever get to make a leveraged investment. If I go to my bank and say I want to borrow 4 times my salary to buy APL, what do you think they'll say?


And when we die, we will die with our hands unbound. This is why we fight.
[ Parent ]

Being leveraged typically means (2.33 / 3) (#63)
by inah on Fri Oct 03, 2008 at 12:07:34 PM EST

the degree that an investor is using borrowed funds or credit in order to increase returns.  Typically, returns and losses can be greatly amplified, much like buying stock on margin.  If you hit the right stock, you make a killing.  Otherwise, your losses are greater since you used borrowed money.

You are absolutely correct; property is a big part of the problem.  It was the one thing which was supposed to have such strong, intrinsic value, it couldn't be a safer 'investment.'  Unfortunately, valuation was a bubble.

Many people have used lines of equity to 'reinvest' in their home.  They used their home's equity to get a line of credit -> used the extra credit to make improvements -> voila, incerased value of their home.  

As for credit cards, I see your point, but I see it as the same thing as leveraging.  The returns on using credit cards is certainly more dubious.  Hilariously, current fashion uses the word "investment" quite often to justify high ticket items.

[ Parent ]

I disagree (3.00 / 3) (#72)
by rusty on Fri Oct 03, 2008 at 04:46:12 PM EST

The returns on credit card purchases are generally nil. Most people's high CC debt was used for stuff like gas and groceries. The more prudent at least will have bought more durable goods, but I would bet that people who have bought stuff on credit cards that has any chance at all of increasing in value are few and far between.

It may be essentially the same action as leveraging, but if you look at it that way, it's leveraging into a guaranteed loss. Which is sort of not leveraging, in the same way that setting money on fire is not gambling.

____
Not the real rusty
[ Parent ]

Really? (3.00 / 2) (#77)
by inah on Fri Oct 03, 2008 at 05:24:35 PM EST

I'd consider gambling pretty much the same thing as setting your money on fire. :)

Returns are actually negative with interest rates, which is the hilarious part. I see your point, and I could go either way.

But there are those out there who are able to play the game to their advantage (cash back, points, mileage) even though these programs are getting highly devalued.

Seriously though, who gets 50k of credit card debt buying groceries and gas?

[ Parent ]

You'd be amazed (3.00 / 2) (#80)
by rusty on Fri Oct 03, 2008 at 09:04:38 PM EST

50k of credit card debt buying groceries and gas: millions of single mothers. The credit card debt situation is a disaster, and with CC debt-backed securities out there, we can assume those'll blow up just like mortgages.

At least with gambling there's some chance of an increased return. Ok, tiny and only if you gamble once, win, and walk away. But still. I don't think anyone's ever burned a pile of money and found they ended with more than they started with.

And yeah, interest rates too, so the return has to also beat the highest consumer-loan rates there are. Even with frequest flyer miles and so forth, I doubt anyone does better than breaking even.

____
Not the real rusty
[ Parent ]

I agree on part (3.00 / 4) (#84)
by Delirium on Sat Oct 04, 2008 at 03:22:18 AM EST

CC debt isn't really on investments—it's on consumption. However, I think there are probably quite few cases where it's really hardship, with people living frugal lives and resorting to CCs after all other options have been exhausted, to buy the necessities of life. Rather, there's a lot of buying premium cable, big-screen TVs, restaurant meals, new clothes, etc., etc. on credit cards.

You can see this pretty easily if you compare what an average American considers a "necessity" to what even an almost-first-world resident considers necessities. My relatives in Greece were somewhat appalled at the mass consumption in the US on one of their visits, and Greece isn't even a particularly poor country.

[ Parent ]

Not much of an investment (none / 1) (#93)
by wildclaw on Sat Oct 11, 2008 at 10:41:30 AM EST

"And the answer is this: housing is the only opportunity most private individuals ever get to make a leveraged investment."

The problem is that housing isn't an investment beyond the fact that you get a place to live. As such, buying an expensive house is more of consumption than investment, just like buying an SUV is consumption except for the rare few that actually need one.

Counting on someone else to later on buy the house you are living in at a higher price or even same price is pure speculation, and that is what a lot of people has been doing.

Houses should be treated like cars. They deprecate in value over time, just over a longer time span than most other productivity increasing investments.

Sure, a value of the land a house is built on can increase over time if an area becomes more attractive to live in, but betting on that is speculation.

[ Parent ]

Having a place to live (none / 1) (#99)
by maniac1860 on Sun Oct 12, 2008 at 08:19:16 AM EST

has a pretty high value. If the sum of that value over the ownership time is greater than any deprecation then buying the house is pretty clearly an investment.

Just think about buying a house to rent it. No one would argue that doing that is not an investment. Now just rent it to yourself.

[ Parent ]

I was thinking (none / 0) (#130)
by TDS on Tue Oct 21, 2008 at 05:16:11 PM EST

mainly of Buy-to-let investors and flippers. Although yes, it does apply to people speculating on the value of their primary residence. And to be fair, back when there was the appearance of something called a "housing ladder" a generation of people did manage to come out on top, although in the cases I know of (e.g., my parents) this had a lot to do with with a highly inflationary 1970s.

And when we die, we will die with our hands unbound. This is why we fight.
[ Parent ]
Best reason not to bail out the financial system: (1.60 / 5) (#59)
by Enlarged to Show Texture on Fri Oct 03, 2008 at 10:26:40 AM EST

It's unconstitutional


"Those people who think they know everything are a great annoyance to those of us who do." -- Isaac Asimov
not to mention... (none / 0) (#119)
by viza on Thu Oct 16, 2008 at 01:21:11 PM EST

... un-American

[ Parent ]
Mortgage holders don't get more than the loan back (3.00 / 2) (#60)
by boomi on Fri Oct 03, 2008 at 10:31:51 AM EST

There's a serious error in your description of foreclosure:

  "If the original loan was $100K and the house sells at $150K, the banks won't complain too loudly because they'll make a profit."

No, the bank just gets its money back. The remaining 50k in your example would cover legal costs and other (maybe sub-prime) loans, and, if there's money left, it is returned to the initial owner. At no point during foreclosure is the property owned by the bank, unless they end up buying it themselves.

while it is a simplification (3.00 / 2) (#62)
by Liar on Fri Oct 03, 2008 at 11:49:08 AM EST

it is accurate. Assuming that the borrower made at least one payment which included interest, the banks do better than break even when the home price goes up.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
true, though it was historically the case (3.00 / 2) (#83)
by Delirium on Sat Oct 04, 2008 at 03:14:47 AM EST

Mortgages used to be basically collateralized loans, so if the mortgage holder failed to pay back the loan, the remedy was that the lender could seize the collateral ("strict foreclosure"). If the collateral happened to be worth more than the outstanding loan value, they kept the difference—if the homeowner wished to avoid that result, they could sell the house themselves, paying off the mortgage with the proceeds and keeping the excess.

However most U.S. states have eliminated this process entirely, and the few that leave it intact have safeguards that more or less only let it be exercised if the value of the house is less than the outstanding mortgage value.

[ Parent ]

No mention of predatory lending? (3.00 / 3) (#68)
by peace on Fri Oct 03, 2008 at 03:25:42 PM EST

You blame the CRA for forcing subprime loans on the market but lenders would issue subprime loans to people who would normally qualify for prime loans. Getting a loan is no simple task and many people fell victim to predatory lending.

Then the bank gets to pump their CRA numbers while keeping their actual risks low.

Thanks for the article (none / 1) (#85)
by Cambria on Sat Oct 04, 2008 at 07:54:54 PM EST

I had no idea what was happening, just that lots of people were stressing about it and it was affecting the markets over here.

CRA? (3.00 / 3) (#88)
by stencilv on Mon Oct 06, 2008 at 09:03:50 PM EST

Maybe this has been rebutted elsewhere. But despite the author's attempt to downplay his "blame" of the CRA, he nevertheless writes:

So, in no way can we excuse Bear Stearns because of obligations they were fulfilling in the Community Reinvestment Act, but it's important to recognize that the nature of the act was to encourage riskier investments.

That act was passed 30 years ago. And while it was revised -- and saw a lot of activity -- in the 90s, most of the resulting activity was finished by 01. In 04, the law was significantly weakened, and nevertheless subprime lending intensified.

Moreover, independent mortgage companies, which are not covered by CRA, made high-priced loans at more than twice the rate of the banks and thrifts.

For a more thorough rebuttal of the "blame the CRA" meme, see Robert Gordon's article at prospect.org from which I now quote:


It's telling that, amid all the recent recriminations, even lenders have not fingered CRA. That's because CRA didn't bring about the reckless lending at the heart of the crisis. Just as sub-prime lending was exploding, CRA was losing force and relevance. And the worst offenders, the independent mortgage companies, were never subject to CRA -- or any federal regulator. Law didn't make them lend. The profit motive did.

And that is not political correctness. It is correctness.



Actually, I was defending it (3.00 / 2) (#91)
by Liar on Tue Oct 07, 2008 at 02:03:58 PM EST

Mind you, a liberal website defending liberal legislation is not exactly the ironclad defense you think it is.

Subprimes exploded after there was a secondary market for them and that was created by those lenders who needed to prove they were abiding by the CRA. Any lender not engaged in either the primary or secondary market would have been missing the boat and would have faced financial hardship because they wouldn't have been as competitive. If a customer doesn't know if he qualifies for a prime or a subprime, they're going to approach the banks with the widest standards, so even qualified borrowers would avoid those lenders who didn't engage in riskier investments.

And if the CRA didn't encourage subprime lending, what did? Greed has always been around so they should have been engaging in this long before the CRA and without any motivation. Banks have historically been risk averse and something caused that to change.

The CRA isn't bad legislation, but it was a disruptive technology that changed how lenders looked at themselves and so they put only enough safeguards into place to protect themselves but not the market in general. That's my only criticism of the CRA and it's why I see the government as having some responsibility.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
greed? not exactly (none / 1) (#97)
by stencilv on Sat Oct 11, 2008 at 10:16:37 PM EST

This is a bit like shooting ducks in a barrel.

"Lair" writes:


And if the CRA didn't encourage subprime lending, what did? Greed has always been around...

This seems obvious. How about an essentially theological devotion to free markets and deregulation, resulting in no regulation of new financial instruments.


That's my only criticism of the CRA and it's why I see the government as having some responsibility.

Well, I agree that the government has the main responsibility for the mess; there should have been much more regulatory oversight.

You can tell me -- probably correctly -- that repubs and dems both had a hand in technical aspects of this mess.

But I think the following is undeniable. Sometime in the '80s, the notion that "those pinheaded meddling regulators mess everything up"  became dominant. So I can't see how anyone can dispute with a straight face the following assertion:

Conservative ideas own this mess.

[ Parent ]

one more remark (none / 1) (#100)
by stencilv on Sun Oct 12, 2008 at 08:49:16 AM EST

Liar:


Actually, I was defending it

I should have started by saying that I thought your article was useful in its articulation of various issues.

But in my view the movement-conservative  "blame the CRA" meme - which I'll admit is not exactly what you were doing - is a dangerous one: it fails to point to a solution to curb future bad behaviour, and it undercuts the argument that deregulation was (by far) the greatest component of the problem.

That is why I spouted off...


[ Parent ]

Nader on the bailout bill (none / 1) (#95)
by nostalgiphile on Sat Oct 11, 2008 at 12:45:35 PM EST

here. excellent article, btw.

"Depending on your perspective you are an optimist or a pessimist[,] and a hopeless one too." --trhurler
Question for passing Kurons... (none / 0) (#101)
by TDS on Mon Oct 13, 2008 at 05:32:39 PM EST

Do you prefer the Paulson bailout or the Brown bailout?

Brown, and most of Europe, are going with the Swedish model (fnar fnar, who wouldn't go with a Swedish model given the chance) where they buy stock directly in the banks.

The idea of owning equity is to attractive to me in so far as there is a clear mechanism for getting tax payer's money back and maybe a bit of jam on top; and also that it provides a degree of control. I should also add I agree with Robert Peston's recent article "banks should be boring". If nationalisation makes them less 'dynamic', good, they should be run as glorified utility companies at best. However, I read in the papers that American politicians generally consider that idea too communist and it is better to buy bad paper instead.

Yet more Pingu Full of Eastern Promise

Paulson seems to be doing some of that too (none / 0) (#126)
by Delirium on Sat Oct 18, 2008 at 09:49:13 PM EST

he's indicated he plans to also purchase equity with his $700b fund

[ Parent ]
Inflation? (none / 1) (#103)
by sllort on Tue Oct 14, 2008 at 12:00:49 PM EST

Your 'arguments against' do not list inflation, the primary problem most Americans have with printing the exact cost of the Iraq war in new money and handing it over to failed investment bankers. Keep in mind that only 7% of Americans support the bailout. This is because they understand how inflation works. Your failure to list it shows that you do not. Your failure to even use the word inflation in an article recommending a massive cash infusion into the banking system remains one of the greatest published absurdities ever witnessed on this shithole. Economics Fail. 1 2
--
Warning: On Lawn is a documented liar.
You shouldn't trust understanding about inflation (none / 0) (#105)
by Liar on Tue Oct 14, 2008 at 02:16:57 PM EST

Thank God the average person isn't an economist, then because they'd be wrong.

C'mon, this is basic U.S. government economy. How does the U.S. government raise money? One way is to raise taxes. In order to raise $700 billion in taxes, it would have to order the Fed to lower interest rates enough to inject about 8 times that amount into the economy and then wait until April 15th.

Alternatively, it can issue treasury bills which other people who already have money buy and no new cash gets injected into the global economy.

One of the counter-intuitive side effects of the bailout is that we'll face reduced inflation. Here's the relevant quote from that article:
    When a government borrows money, it uses up part of the national supply of cash. Thin refers to this as "mopping up liquidity."

    When money is scarce, it costs more -- just as a scarcity of gasoline, say, would lead to higher prices at the pump. One measure of the price of money is the interest rate, what it costs to get money. If the government borrows $700 billion, American consumers could expect interest rates at their local banks to rise.

    The silver lining is that if money costs more, it's worth more. That means inflation falls.
And that's what we'll do. Borrow it from other countries. This market is very robust and America is still among the best places to buy these types of investments. If anything, it's a way of getting other nations to print money for our bailout. Also, from the same article quoted above:
    The U.S. continues to look like a good bet for investors. The increased debt would still represent less than half of America's gross domestic product. For Germany, that figure is around 60 percent, Thin says, and Japan has a ratio of almost 1 to 1.

    With any given product, including debt like bonds and Treasury bills, economists look for what's called the market-clearing price. When you reach the figure at which sellers will sell and buyers will buy, you've "cleared the market." Thin says the new U.S. debt may cost a little more because investors find it riskier, but those bonds and Treasury bills will still sell. "At the right price, absolutely," Thin says. "Interest rates will rise enough to clear the market. I don't think it would be a problem selling it."
We won't make the same mistake of Weimar, Germany. We're Americans. We'll come up with new and different ways to screw things up.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
Good username (none / 0) (#106)
by sllort on Tue Oct 14, 2008 at 02:27:54 PM EST

I'm going to keep an eye on this dial:
http://finance.yahoo.com/currency/convert?from=EUR&to=USD&amt=1&t=5y
and watch you proved wrong.
Hedge fund transparency and full criminal prosecution of the UBS 20,000 is only a beginning of the real solution.

http://rawstory.com/news/afp/FBI_to_probe_Swiss_bank_UBS_in_tax__06222008.html
--
Warning: On Lawn is a documented liar.
[ Parent ]

And what is that supposed to show? (none / 0) (#107)
by Liar on Tue Oct 14, 2008 at 03:45:08 PM EST

Inflation doesn't reflect in foreign currency trade since there's too much other information that's included in figuring the exchange rate.

No, you want to watch the Consumer Price Index since it measures the price of actual goods and not just imports/exports. That's how you measure inflation.

Like I said, thank God the average person isn't considered an economist.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
wheee (none / 1) (#108)
by sllort on Tue Oct 14, 2008 at 04:27:30 PM EST

http://www.cnn.com/2008/POLITICS/10/14/miron.banks/index.html

highly effective troll article, btw, 10/10
--
Warning: On Lawn is a documented liar.
[ Parent ]

That's your response? (none / 0) (#109)
by Liar on Tue Oct 14, 2008 at 06:07:30 PM EST

Jeez, I can quote authorities too. People who's names you know, like the current Nobel laureate.

The guy you linked to sounds like Andrew Mellon and the liquidationists. You should see how tremendously successful their policies were.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
yes that is my response (none / 1) (#112)
by sllort on Wed Oct 15, 2008 at 01:07:39 PM EST

166 academic economists disagree with random internet dude troll.

you sir are a worthy adversary.
--
Warning: On Lawn is a documented liar.
[ Parent ]

166 random economists (none / 0) (#115)
by Liar on Wed Oct 15, 2008 at 10:45:07 PM EST

and yet no one anyone has heard of. No prize winneres. No former fed chairmen. No former fed bankers at all. No former treasury secretaries. No heads of state from anywhere around he world. Just 166 random nonconsequential Ron Paul enthusiasts who are still saying that gold is the best investment.


I admit I'm a Liar. That's why you can trust me.
[ Parent ]
correct (none / 1) (#117)
by sllort on Thu Oct 16, 2008 at 10:23:33 AM EST

support for the bailout is proportional in a linear way to the subject's proximity to power. when was the last time you saw newt gingrich and michael moore stand side by side on an issue? only the marginalized have the freedom to speak; the things you own end up owning you.
--
Warning: On Lawn is a documented liar.
[ Parent ]
Bailout Commentary (none / 0) (#128)
by Jizzbug on Mon Oct 20, 2008 at 03:33:43 PM EST

Bailout Commentary from Kansas City

I say unto you: one must still have chaos in oneself to be able to give birth to a dancing star. I say unto you: you still have chaos in yourselves.
 -- Friedrich Nietzsche, Thus Spoke Zarathustra: A Book for All and None

"Full faith and credit..." etc. (none / 1) (#131)
by DevonMcC on Wed Oct 22, 2008 at 12:30:22 PM EST

This was a reasonably good explanation with a few exceptions.  First is a quibble: the "full faith and credit of the U.S. government" language specifically does not apply to FNMA and FHMLC - only to GNMA.  However, as we've seen, there was always assumed to be some kind of implicit government support of the other agencies - support that has now been made explicit.

Also, there was little mention of the abandonment of lending standards, real-estate speculation because of rapidly rising housing prices, and the federal government's excessive promotion of home ownership via the massive tax-breaks on mortgage interest.  All of these contributed to the current problems.

As someone who works at one of the briefly mentioned ratings agencies, I suspect that the problems with ratings have much more to do with "liar loans" and the consequent recent changes in default rates compared to their historical norms than with the conflict of interest engendered by payment for ratings.

Order vs. reform (none / 0) (#137)
by pavlos on Mon Oct 27, 2008 at 04:03:53 AM EST

Thank you for this explanation of events. To summarize it even further, the banking industry (depending on intent, which we cannot determine) achieved or degenerated into a situation where debt (as an asset) was being traded above its real value. The debt was mostly mortgage based. Here are some things we can say about this:

    It's normal to trade debt as an asset. It's no different from an industrial or IP asset. Like those, it is a license to take a cut from someone else's productive activity.

    It's in the interests of banks to sell the debt above its true value, since they are selling it. It's the same as if they were selling a tech stock.

    Its foolish to speculate on debt if the debt is going to be serviced, because then its value is capped. However if the debt is going to be defaulted the guarantee (the house) may be worth more than the debt.

    Real assets such as houses retain their long term value while their market value fluctuates wildly in a boom or crisis. Thus, a lot of wealth can be gathered by speculators in a crisis.

So, perhaps unsurprisingly the mortgage based debt ended up in a market bubble, it burst, and there was an investor run. This meant that debt traded below its real value, which can lead to two conditions:

    If the debt is very complex, its value will plummet below the real value of the collateral, because it's not practical to foreclose and sell the collateral. This is mostly what's happening. This is mainly a problem for investors and savings.

    If the debt is simple enough that someone is in a position to foreclose the collateral, they will aggressively do so either to dump it (and reduce their loss) or to speculate (keep it and sell when the housing market climbs). This is mostly a problem for the real economy (everyday life, jobs, etc).

It's worth pointing out also that somewhere in the system is a real economy crisis: People aren't able to pay of their mortgages. This crisis may be eased or worsened by what happens in the financial market of debt, but the real-economy crisis exists. This is like the situation where a manufacturing industry has real productivity issues, compounded by stock market instability. Faced with this situation, what can a government do? It has the following courses of action open:

    Do nothing. This will result in continued instability in the debt market. Speculators will flee the market, and long term traders (mostly banks) will have to pass on the loss to consumers by foreclosing or failing to pay out savings (going out of business in the process). This would create chaos in the monetary system and be very bad for the real economy. It may be good or bad for speculators depending on whether they have the means to ride out the crisis.

    Bail out the speculators. By buying out the debt at something close to its previous market value, the government is bailing out the speculators who hold an excess. It also restores business as usual for the banks who oversold it. This averts short-term risk, but it's hard to see how it imposes market discipline or how it does anything good for the real economy. The government will either demand that the debt be serviced, or it will sell it at a loss. The party who is eventually eligible will want to collect the debt or the collateral, making the impact on the real economy the same or worse.

    Bail out consumers. If instead of buying out the debt the government guaranteed consumer mortgages and loans it would have the following effects: Guaranteeing mortgages would relieve consumers of debt, amounting to a cash injection into the real economy rather than the financial one. The cash would trickle into the financial economy (since bad debt would be made good) and some sensible trading would resume. Guaranteeing deposits, which is what the government does in a real banking crisis, would maintain the integrity of the monetary system while allowing failed banks (those who suffer a run) to go out of business as they should.

So, it seems that what is happening is the government is doing something (which it must), but it's doing the wrong thing. It's bailing out the financial industry which amounts to maintaining the current order. Speculators and financial investors will be happy (which is also good for wealthy consumer's savings) and banks will continue their practice undisciplined. If instead the government bailed out the consumer credit relationships that were in trouble (mortgages and deposits) that would amount to a (very socialist) economic reform. It would hand the cash to (perhaps undisciplined) consumers and maintain the daily function of the real economy, while bringing harsh discipline to the financial and banking industry. I believe this would be the better course of action.

The Credit Crisis and the Bailout in Plain English | 137 comments (120 topical, 17 editorial, 0 hidden)
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