My brother asked if I was going to post about the whole $700 billion bailout thing. Truth was, I didn’t completely understand. So I started reading more carefully. I think I’ve got the picture now. Tell me what I’m missing.
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Investors around the world were looking for a safe, profitable place to put their money, because those were becoming harder to find. (The US flooding the world money supply with its half-trillion-dollar war didn’t help.)
They turned to real estate, because everyone thought home prices would go up and up. Made sense.
To meet the demand for those investments, lenders needed to create more mortgages. So they started loaning money to people who had no business borrowing it. (The “sub-prime” borrowers.) They then sold those loans to all sorts of investors on Wall Street.
But the people who took out those loans couldn’t pay them. They began to default, and banks had to foreclose. Normally this isn’t a big deal, because the bank ends up with an object (the house) worth as much as the loan. But housing prices were dropping.
Suddenly investors didn’t own nearly as much “stuff” (mortgages or the homes themselves) as they thought. They needed to get rid of those low-value paper (mortgages and deeds).
So they took those bad loans, mixed them with good ones, got the rating agencies to rate them AAA or whatever, and sold them to, well, suckers. Suckers in other financial firms.
It wasn’t long before those suckers realized what they had, as housing prices continued to fall. Financial institutions suddenly realized that they didn’t have as much money as they thought.
Now, if you wake up to find that the value of your stock portfolio is a lot less than it was, it’s bad news, but you still go to work and get a salary. But for banks and other investment firms, they need to have a nice, fat balance sheet in order to make money. (After all, that’s how they earn a living — by borrowing and loaning money.)
But other banks didn’t want to lend them money anymore — after all, they didn’t have collateral. So the credit market “tightened” as institutions decided to play it extra, extra safe with their investments. For consumers, that means it became harder to get a loan without kick-ass credit. For banks, it became a nightmare.
Big bank to smaller bank: What kind of collateral do you have?
Small bank to big bank: Well, I have these mortgages….
Big bank to smaller bank: Buzz off.
As people realized this, they came to a conclusion: My bank may not have enough assets to back up my deposits. I’d better get my money out.
Can you say “IndyMac”?
And then it hit on a larger scale. Wall Street firms were saddled with billions in losses — in other words, they were finding out they were poor and being shunned by other firms. No one was lending money, and depositors wanted to cash out.
Firms began to fail because, without the ability to borrow money, they couldn’t meet their obligations.
And that’s where we are. The $700 billion bailout is the government saying, “We’ll buy a lot of those bad loans that you’re holding (mortgages, deeds, etc.), so your balance sheets will look better and your friends will lend you money again.”
Hopefully, the government thinks, those loans will turn out not to be so bad. When the economy recovers, it might be left holding deeds to homes that are actually worth plenty. If not, well, it’s just another bill for the taxpayers.
So most of what you’ll see going on, legislatively, are efforts to get financial institutions to start lending again. Today the Fed lowered the prime rate, for example. That’s the goal: Get lenders to start lending so the economy can start moving again.
The Fray
gnomic says:
Not exactly. Its a bit more complex and a bit simpler that this.
1. In the pursuit of banking profits, several rules and regulations changed to increase financial institutions ability to “leverage” their assets. This means that rather than holding $1 for every $5 lent, they held $1 for every $12 to 40 spent. This allows profits to rise dramatically, but also increases the downside risk should the value of these assets go down. Essentially, this is gambling with other people’s money. See http://bigpicture.typepad.com/comments/2008/10/sec-deregulatio.html
2. In pursue of keeping the economy running while running up tons of debt from 2 wars, increased spending, and simultaneous massive tax cuts, the US borrows like a junkie on heroin. The Feb keeps the cost of money so cheap that you borrow and spent today since inflation will cause tomorrow’s money to be worth less. This creates a bubble that will burst as oversupply drives prices down, ala the housing market. (Prediction: Look for debt costs to jump to mid-1980’s levels when a good home loan cost 12%)
3. The housing market was not the cause, but a leading indicator of the troubles to come. But as housing values drop, most houses are collateralized to support other debts, both by home owners and banks. Again, houses are highly leveraged, so a drop in value takes that 12-to-40 leverage value and pushes in the opposite direction, turning profits into losses overnight.
4. Innovations in securitization, a process that allows debt to be sold and get it off an institution’s balance sheet and free up working capital, created derivatives, instruments so complex that they could not be risk-rated. Investors were buying junk that was rated as low risk investments. So investments were much more risky than anyone realized, so when things stated going bad, financial companies thought they were safe and they were not. This caused everyone “in the know” to panic, and rightly so. See http://www.newsweek.com/id/161936
5. Since no one really knows where they stand, all the banks are all hoarding money to survive. The “run on the bank” is not by consumers, but by other banks.
6. Since no one is really working with their own money (except Warren Buffet), but operating with cheap borrowed money to pay the day-today bills, we are all “highly leveraged.” So if you can’t borrow money, it doesn’t impact you tomorrow, it impacts you today.
7. The entire banking system “freezes” so companies can’t get the money to run. Economy tanks.
What should you do? Stock up on food, hoard some cash, downsize your life, keep you job and consider getting a second one. Seriously, this is going to last 2-5 years at least. Expect MASSIVE inflation and supply shortages.
What should the government do? Invest heavily in building infrastructure to generate jobs, stop the wars, invest heavily in innovation, specifically energy independence, and rewrite policies to drive down food and transportation costs. Also, consider executing executives.
Expect partial nationalization of banking before this is over. And as odious as this option is, it is the only option that has ever solved a crisis of this type.
Seriously, hold executives and boards of public companies accountable by requiring an audit of any failing company to assign accountability and if any executive or board member is found responsible, they should be banned from serving in an executive or board role at any public company. Prison time is optional.
Best source of info on this crisis: http://bigpicture.typepad.com
Want the scary version of the future: http://www.riskmetrics.com/webcasts/2008credit_crisis_mess
gnomic says:
And the GOP is now blaming the poor for the crisis. http://www.newsweek.com/id/162789
How absurd!
Marie says:
Andrew, your explanation ties in with what I’ve tried to learn so far. One question has been nagging at me, though: Why shouldn’t the ones who sold the securities to the suckers put up the money for the bailout? Who are they? Where are they? Are they being held responsible? Well, I guess that was more than one question.
gnomic says:
The problem is how do you hold the banks accountable? Fine them? Jail them? Whatever action you take against the banks hurts the consumers as well. And some banks have been punished by the market – they’ve gone out of business.
And if you start punishing executives and board retroactively, everyone gets punished. They all jumped on this bandwagon. Except of course those banks like suntrust and capital one and others that aren’t in the news because they acted responsibly.
A better question might be how do we reward these banks?
gnomic says:
More good info
Taking Hard New Look at a Greenspan Legacy
http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html
5 Myths of the Greenspan Era
http://www.thestreet.com/markets/economics/10265345.html
Randy says:
The best guide to how we got in to this subprime mortgage crisis I’ve found.
http://bigpicture.typepad.com/comments/2008/02/how-subprime-re.html
Randy says:
Found another great write-up of just WTF happened here. Little note in the article says mentions Warren Buffett calling out a warning of sorts in 2003. Apparently, almost no one listened.
http://www.theweek.com/article/index/89404/3/3/Briefing_Wall_Streets_hidden_time_bombs
Vince says:
Andrew I think this is a good breakdown.
I think the biggest problem is people are pulling their money out of these troubled banks. If you keep the money in there, as long as its backed by the FDIC (and its less than $100K) you can still get it. If everybody kept their money in the banks, we would be in bad shape (because the banks would still have the bad mortgages, deeds, etc), but we wouldn’t be as bad.
That’s my two cents.