What in the hell is going on?
To most of us this whole Economic Crisis is still a very vague mystery. In an effort to help dispel the confusion in my own mind and in the minds of my friends and family I'd like to share what I know of the current Crisis.
The clear and Present Danger: Overnight Credit is Frozen
Currently company A is unwilling to lend to Company B large but short term loans. These loans are vital for companies to get product to market, purchase raw materials, make payroll and in general moderate the ebb and flow of hard cash that comes and goes in the short term business cycle.
There are two reasons these basic but vital transactions can fail to happen.
1. The Creditor does not believe the Debtor can pay back the loan.
2. The Creditor does not have the cash reserves to make the loan.
In the case of bank to bank loans #1 is the problem. In the case of Bank to Business loans #2 is the problem.
Bank to Bank loans: The Cause of the Problem
In the day to day world of consumer credit an individual seeking a loan say for a car or house a creditor would look at the individuals income, bills and assets (things that the individual can sell to raise money) to determine the ability of the individual to pay back the loan. This process is called risk assessment and usually determines the interest rate the creditor is willing to lend the money at. In this case, the assets in question (stock port folios, cars, real estate etc) have well defined and known values. With banks this is not the case.
A large majority of Banks Assets are now tied up in things called Mortgage Backed Securities. The how and why these things exist is a much more complicated discussion for another time. Suffice it to say that the real estate bubble has popped and the real market value (if the bank had to sell it today value) is anybodies guess. On top of that, much of these things are based on sub-prime mortgages. The rates on these mortgages are in the process of switching from the low monthly payments that enticed people to buy property to much higher payments that they can't afford. So not only is the real market value up in the air but the monthly cash revenue from people making house payments is evaporating as home owners default on loans. The banks have no idea what their assets are worth and no one is willing to buy them.
So Bank A asks bank B for a loan. Bank B looks at Bank A's assets to make sure bank A can sell stuff to pay back the loan in case there is a problem with repayment. Bank B sees all these mortgage backed securities in Bank A's Assets - which are quite possibly worth the paper they are printed on - and says hell no. In other words Bank B has no confidence that they will get their money back.
Bank to Business Loans: The effects that can screw us all.
Banking 101: Capital, Loans, Assets
So by federal law banks have a capital reserve requirement, this is the cold hard cash they have to keep on hand to do day to day business and its tied to the amount they can loan out. So if a bank has $1000 in cold hard cash, no outstanding loans, and the reserve requirement is 10% they can loan out a maximum of $900 and must keep a minimum of $100. In many cases banks might temporarily over extend themselves and need to barrow money from other banks to meet their reserve requirement. So for some reason our bank loans out $950 and calls up bank B and asks for a $50 loan to meet its $100 reserve requirement until we can get our customers to deposit more money in our accounts. Normally this isn't a problem but because Bank B has confidence in our Bank's assets.
Back to the real world.
So now all of our Banks find themselves worried that they don't have enough capital reserves (cold hard cash) or enough assets (things they can turn into cold hard cash) in order to meet their reserve requirements. Before this wasn't a worry because Banks could borrow the cash they needed to make ends meet.
This means banks are unwilling to extend credit to businesses. Not because they think businesses will default one the loans but because they are worried about their ability to get cold hard cash. So companies with large cash reserves will be ok for a little while because they don't need a loan to get things done. But businesses that don't have much in the way of cash reserves need loans to keep going until payday.
Questions of Doom:
So what happens when your company needs a loan to make payroll while your waiting on clients to pay their bills? What happens when manufacturers need a loan to ship their products to stores in order to make money? Everything grinds to a halt. Paychecks don't come, people don't buy products, Businesses Collapse, individuals withdraw savings, banks collapse, and the process repeats creating a downward spiral we desperately want to avoid.
The Infamous $700 Billion Bailout
Why we Need it:
The immediate problem here is the short term credit crunch. In order to fix this problem we need to do one of 2 things:
1. reassure the financial institutions that their Mortgage Backed Securities are actually worth what they think they are.
2. Take the Mortgage Backed Securities off their hands.
#1 one is not possible as the mortgage backed securities were created on speculation and the belief that property values would continue to rise indefinitely. They are simply not worth as much as Banks paid for them.
Since there are no buyers for these Mortgage Backed Securities in normal markets - the Federal Government has become the only possible buyer of these assets of unknown value.
Side note: one alternative might seem to be to simply set up a $700 billion line of credit. That will only buy us some more time. That credit line will be extended and we will find ourselves in the same predicament we are in now.
Whats Wrong with the Proposed Legislation
The problem with the original bill is that it is a very vague 3 page document that give one individual license to spend up to 700 Billion taxpayer dollars (that's about $2000 per American) to buy "mortgage related securities" on behalf of the federal government without any oversight.
Section 8 reads as follows:
Decisions by the Secretary pursuant to the authority of this Act
are non-reviewable and committed to agency discretion, and may not be
reviewed by any court of law or any administrative agency.
How this money is handled will have some pretty dire consequences on weather or not the American people will have effectively paid the economic ransom to wall street to keep our economy running. The core issue is that we have no idea what we are buying (how much its worth) and wont until after we buy it. We are very likely to pay way more for these mortgage backed securities than they are actually worth. In effect subsidizing the irresponsible economic behavior of the Financial Industry.
Minimizing the Impact to the Taxpayers
It is within the realm of possibility to use auctions to discover the real value of these assets, provided the assets are identical and there are a lot of sellers.
Economic Concept: Price Discovery
Imagine going to a market. You are the only buyer. There are hundreds of merchants trying to sell you the same very expensive widget. You've never seen this widget before and you have no idea what its worth. Fortunately for you the sellers know what its worth. So you put the sellers in competition with one another. You say sorry folks but I'm only going to buy one widget, so who's going to give me the lowest price? And after much yelling and anguish you finally find a seller willing to sell it to you at a fraction of the initial asking price. This is a good indicator of the widget's actual value. This process is called price discovery.
Now when there are only only three merchants they can get together and agree to only sell you the widget at the initial high asking price, this is called collusion.
On the other hand all the widgets might not be the same. Some might be different colors, some might be gizmos disguised as widgets, some might come with complimentary pink fuzzy dice, or some might come with Schrodinger's pregnant cat, who knows. Because the widgets are different there is no way to get the merchants to compete and reveal the real value of their widgets.
Back to the real world:
Mortgage Backed Securities are not a standardized product - there was no rules guiding how they were made, structured, or sold. There are some similarities if you break up the securities into small enough chunks but this increases the incentives for collusion between sellers. Essentially we are signing ourselves up to take the short end of the stick. If we minimise the cost to the taxpayer via good price discovery, we will pay pennies on the dollar for these assets and we will make our dollars go further. This will effectively remove lots of the doubt out of the financial system but it will be the only baseline for the remaining assets that are still in the market - effectively devaluating the remaining better mortgage backed assets that are actually worth something. If this devaluation exceeds the cash reserves of banks and the banks can't raise capital fast - the banks go bankrupt. This may not be the case, but we won't know until we get there. This leads us to our core problem.
Bank Insolvency: The painful truth we have to deal with eventually
This is the monster under your bed that will bite you - hard. Even after we get the credit market moving again we still aren't out of the woods yet. Of the banks that are left around the world we have no idea which ones of them will be solvent after Taxpayers establish a price for these securities. While its possible that insolvent banks have already been purged from the system, I seriously doubt it. Once we establish a baseline price for these mortgage backed securities more banks are going to go under. The Federal reserve can lower the reserve requirements and make short term loans to help banks to make ends meet temporarily but if consumers aren't willing to trust these banks with their money - there won't be any real long term hope of recovery for these financial institutions. Unfortunately there's no way around this next wave of bank failures and there is no way to tell how bad its going to be.
That's about it for this summary. I have some more thoughts on what this means for Americans in general but they are based on some more speculative ideas and not particularly pertinent to our original question - What in the Hell is going on?
Next Question: What in the Hell do we do about it?
