« Thoughts on the Bailout | Main | Maryland: Land of Compassion »

September 25, 2008

A Good Question

Homefront Six asks a good question:

If the government were NOT to step in and the "disaster of monumental proportions" were to actually occur, what would that mean for MY LIFE?

How would this collapse affect me and my family? Keep in mind we do not own (we rent but the house is owned outright by the homeowner) our own home and MacGyver's job is relatively secure. We have some consumer debt but nothing that we couldn't pay off in a year (sooner if we HAD to).

I'm going to attempt a short answer and a long answer, but before I do, a brief comment.

I'm obviously not an economist.

You all have seen me attempt to comment on legal issues. I have done so as a layperson. I try to stay with broad policy issues and comment only with the understanding and hope that readers will chime in with alternative points of view. The purpose of VC is to foster discussion and hopefully ensmarten us all a bit.

In economics, as with law, there are different schools of thought on various policy issues so you are getting the views this author has, after a fair amount of reading, found most persuasive. In that vein, I offer the following short scenario in response to the President's speech last night. It should help you imagine how the average American's life might be affected by a failure to swiftly enact some form of the proposed bailout package.

A more detailed response will follow shortly.

Yesterday's thoughts on the bailout were really just a very high level summary of a fairly complex situation. I didn't talk about the subject of credit default swaps, loan ratings, or the failure of Congress to regulate the trading of derivatives.

Simply put, what is the President worried about, and more importantly, why couldn't he make a plain and simple case for the bailout?

I'll give you my opinion.

The worst case scenario - the doomsday one - is a meltdown of the financial sector resembling what happened just before the Depression. This is what I described yesterday, when investors panic and begin dumping what is called 'commercial paper' (that is stocks 30 day to 2 year notes issued by businesses to finance day to day operations, correction courtesy of Levi from Queens - thanks so much!). The scary thing here is that perfectly solvent investment funds with no ties to the mortgage crisis can be driven under, simply by virtue of the fact that thousands of individual investors are selling at once.

This lowers the value of each share, since everyone is selling and no one is buying. If your retirement fund or your life savings just happens to be in one of these funds, you are now officially shit out of luck. Why couldn't the President talk about this last night? Well, as I mentioned yesterday on my Thoughts on the Bailout post, we've already seen how panicky investors can be. The President of the United States can't very well stand up before the nation and say, "Dang! I sure hope y'all don't pull all your money out of the market before it goes bust, because you know your fellow investors could cause any of these funds to go under at at any moment!".

So he can't make the best argument for urgent action, lest he precipitate the very crisis he's trying to head off.

Let's say you have no money whatsoever in the market, or even in banks. Let's say you don't own a home and you keep all your money sewn up in your mattress. Why should you care about a run on the banks?

Well, there are what are called second order effects of massive bank failures, or simply of a massive loss of confidence in the financial system. If you ever took an economics class, you have probably heard of the Multiplier Effect, or what is referred to as money creation.

This is the idea that increases in spending lead to greater than proportional increases in output/income. This is generally thought of as a good thing. The Federal Reserve uses changes in the money supply to stimulate or restrain the economy. The problem with allowing massive bank failures is this:

All of a sudden, investors desert traditional investments and flee to "safe" investments like Treasury bonds. In fact, everyone starts doing the "safe" thing. They stop spending.

They stop making loans.

Because there are fewer funds available for borrowing, the price of borrowing money (the interest rate) goes way up.

Some people say, "Hey! Let the market adjust! It's capitalism!" Well, most businesses don't have an enormous profit margin to begin with. If you increase the cost of capital (the funds they need to do business - you don't think they use their own money, do you?) you increase the cost of doing business. This means they will back out of contracts and lay off workers.

This means laid off workers and businesses with fewer contracts, in turn, won't spend as much money in the economy. What you have now is what I'd call a 'reverse multiplier effect'. We saw something very like this after 9/11 when a loss of confidence caused corporations to hoard capital and slash travel budgets to the bone years after the attack. It's not so much that they weren't profitable. It was that uncertainty caused them to hold onto their money rather than spending it. There was a ripple effect that spread outwards from the hotel and airline industry into other sectors of the economy.

There was a lot of ignorant and ill informed criticism of President Bush for his tax cuts and his supposed "failure to ask Americans to sacrifice" in the wake of 9/11, as though acceding to al Qaeda's avowed desire to deep six the U.S. economy would have helped the military prosecute the war. What Bush did was the best possible thing for this country - we needed to shore up consumer confidence and continue to spend money so that American companies didn't lay off more workers.

I truly believe that if we don't act promptly here, we will be facing some pretty dire consequences. People don't react soberly to financial crises; they protect themselves first.

The best line in the President's speech was the one about the government being the only entity with the "patience" to buy up what is essentially a good investment, because most American homeowners will NOT default on their loans unless we allow this to devolve into an even bigger mess than it already is. What the government is proposing is to buy low and sell higher, though the valuation of the proposed assets remains a risk.

Previous bailouts have actually broken even or even made money.

And the creation of the Federal Reserve itself was the response to a financial panic. Anyway, that's my uninformed two cents. As I have said, I don't claim to be an expert, and you are welcome to take potshots at me in the comments section.

That's why I'm here.

Posted by Cassandra at September 25, 2008 06:41 AM

Trackback Pings

TrackBack URL for this entry:
http://www.villainouscompany.com/mt/mt-tb.cgi/2412

Comments

There is an often used phrase used with respect to tax cuts for the wealthiest Americans, called 'the trickle down effect'.

This will be more of a tidal wave effect.

Everyone who uses credit to move their business will be affected, negatively.

1) Food will be more expensive, as farmers and all the middle-men will need to make more money to cover their credit costs.

2) Gasoline, electricity, natural gas for heating, etc., will be all more expensive as it will cost more to develop, produce and get to market. The value of the dollar will drop, so the cost of imported oil will also go up. $5/gallon gas next summer for sure.

3) Un-employment will go up as many marginal jobs will disappear, due to the increase in 'the cost of doing business', that is, higher interest rates.

4) The federal government deficit will go up, as tax revenues drop; lower corporate profits, fewer people working, etc. This will mean an austerity budget for the government at all levels.

And that's only the first tier of effects that may shortly be manifest if there is not some resolution this problem.
I have no clue as to the right course.

Posted by: Don Brouhaha at September 25, 2008 10:12 AM

No potshots but I do have a question. How is Paulson going to decide how much to pay for the assets he buys? I see references in some articles to a reverse auction but I can't figure out if that approach is now officially decided on or just what some people think would be a good idea.

I've been trying to figure out why the Paulson plan worries me so much and I finally realized it reminds me of Reagan's illegal immigration plan back in the 1980s. The deal was that we would give citizenship to the illegal immigrants in the country then we would change the laws and beef up enforcement so we would never have the problem again.

I realize that pretty much everyone believes the consequences of doing nothing about these toxic assets would be disastrous but I don't see any reason to believe we're not going to be looking at exactly the same kind of disaster five years down the road.

Posted by: Elise at September 25, 2008 10:24 AM

The thing that is so scary about this is, if we do nothing, we risk bringing on a severe recession.

If we do too much, on the other hand, we palliate the symptoms that caused this in the first place. If you want to solve the problem, you have to let people experience some real pain as a result of making bad choices.

This isn't far different from allowing the insurgency to grow bad in Iraq: eventually it united the Iraqis against al Qaeda - but only after things got really, really unpleasant.

The question is, how much "unpleasant" are we willing to put up with in order to get real banking reform? All the folks who are shouting for no bailout, I suspect, are not really willing to live with the consequences of their chosen course of action. As usual, they are not being realistic.

They refuse to look at the choices on the table and then if they get what they wanted, they'll scream that the government failed to act.

Posted by: Cass at September 25, 2008 10:26 AM

Oh - The choices are crystal clear.

Either choose a bone-crushing 1930's style depression; a depression where everyone suffers but at least the miscreants that caused this whole mess do not get rewarded...

Or a runaway hyperinflation; a hyperinflation where our Dollar goes at par with the Zimbabwean Dollar - a hyperinflation where the creators of this giant ponzy-scheme get away with murdering our economy and our future.

I dunno what's worse: selling pencils by the souplines, or paying $5,000.00 for my next gallon of milk.

Posted by: Boquisucio-Da-Chump at September 25, 2008 10:29 AM

My formula to avoid a crisis is simple.

Reduce, reuse, take alternative forms of transportation, and wear less clothing.

Posted by: man riding unicycle naked at September 25, 2008 10:29 AM

How is Paulson going to decide how much to pay for the assets he buys?

He hasn't spelled that out, and he is wise not to.

I see no reason for him to tie his own hands in advance.

This is going to be tricky. He may have to change his strategy several times midstream, and people will scream "no fair!". What frosts me hear, once more, is that the very purpose of the executive is to allow swift action. Yes, we need oversight.

But for Pete's sake, we don't need the minute details in advance. Get a rough working plan in place along with provisions for oversight and get the heck out of the man's way and let him do his job :p At some point, people really do need to assume these people are going to do a decent job, then watch over them to see that they do.

That's our task. But not in advance.

Posted by: Cass at September 25, 2008 10:29 AM

err...."here".

Engrish is my first language :p

Posted by: Cass at September 25, 2008 10:30 AM

Cass,

Not everyone that wants to avoid a bailout is "unrealistic." They are staying true to sound principles, even if in this case they might not give us the best outcome.

It isn't unreasonble or unrealistic to suggest that government action facilitated and helped get us to this crisis. The govt has its hands ALL OVER the financial markets. Now the govt must act to prevent, in part, its handywork from being worse.

Then, fairly soon, the govt will act to prevent it from happening again. Then things will change, and eventually, not in 5 years but maybe 20 or 30 (when was the S&L crisis that was supposed to end all crises?) we find ourselves in a similar situation. And yet we will never know what would have happened had the market been a little more free, a little less regulated, and a little less poltical AT THE OUTSET.

At the very least, we should expect the government to do as little AS NECESSARY to prevent the really bad scenarios. But we know how restrained govt usually is when it does act, don't we.

Now if you'll excuse me, I need to load my weapons and guard my mattress.

Posted by: KJ at September 25, 2008 10:38 AM

How is Paulson going to decide how much to pay for the assets he buys?

Oh Cass - Paulson under grilling by the Banking Committee stated something to the effect, that under his plan the Treasury is to pay banks above market value for their illiquid assets.

This is no "bailout". He is to force us taxpayers into buying the banks' garbage at prices above their worth. If that's robbery I dunno what else is

Posted by: Boquisucio-Da-Chump at September 25, 2008 10:41 AM

Ooops - Belay That.

It wasn't Paulson who said that... It was BERNANKE of course.

Posted by: Boquisucio-Da-Chump at September 25, 2008 10:49 AM

I see your point about Paulson not tying his hands in deciding what to pay. I do wonder, though, if this is part of why Bush did not push the "we'll probably get our money back" idea harder. I suspect we'll end up paying more for the toxic assets than a bottom-feeder would (which I guess means a reverse auction is out).

I simply can't bring myself to think this bailout is a good idea. And even if I thought it was okay right now the idea of that much power in the hands of a government where the Presidency (and therefore the Treasury) and the Congress belong to the same party gives me the cauld grue.

I predict some variant of the Paulson plan will pass; it will ease the credit crunch; the lack of clearly defined rules for implementation will increase resentment between the helped and the ignored at all levels; no useful reform will follow; and five years from now we'll be looking at the same question: government bailout or bite the bullet big-time? And, since no one will have had to learn anything from this crisis, the source of the problem may well be mortgages once again.

Posted by: Elise at September 25, 2008 10:53 AM

When I say unrealistic, I say that for a reason, KJ. I know you grew up without much. I know a lot of other people have never had to do without.

I have listened to people for years who shudder at the idea of buying used baby furniture or clothes, for Pete's sake. These are the kind of conservatives who are shouting, "no bailout!" Yeah, right. These are people who don't let their kids go to school without the latest and greatest of everything, though they could. So forgive me if I doubt their willingness to carry through with their professed intentions.

Anyone who is truly prepared to sit out a serious and/or prolonged recession is hereby excused from my 'unrealistic' epithet. That may mean that you are unemployed. What's more, it may mean you have to watch your *kids* be unemployed. We have been a complacent nation so long that I'm really not sure too many people realize what is involved.

During the Depression, for instance, professional people like my Grandfather ended up mucking out farm stalls for a living. That was the only way they could put food on the table.

From past performance, what I've seen is that few people, when push really comes to shove, are prepared to suit the action to the rhetoric. They really have no idea what it means to let things play out. If they are really willing to do so, my hat is off to them and I will eat my words.

Posted by: Cass at September 25, 2008 10:53 AM

If I seem reluctant to wade into the trough, it's because I've worked my a** off for 25 years NOT to be poor. My husband and I and our two sons are just now happy and prosperous.

I'll be goddamned if I want to see us all forced into the poorhouse now just because people who (IMO) don't see the danger think it would be intellectually satisfying to see CEOs punished. I could care less about economic justice.

I have real doubts about the ability of kids just entering the job market to survive a prolonged economic downturn. As a parent, this scares the crap out of me, and I don't want to be dragged down with them because I'm not going to watch my sons and their wives go hungry.

Posted by: Cass at September 25, 2008 10:58 AM

I don't have your concerns, Cassandra, and I'm sure that colors our differing perceptions of the situation. My house and car are paid for, I don't have a job to lose, I have (insured) money in the bank, the money I have in stocks I don't need right now, and I don't have children just starting to make their own financial way in life.

All the same, I'm not interested in economic justice or in punishing CEOs. I'm interested in how we as a financial system make sure we don't get ourselves into this mess again. I know that people who are not me would be badly hurt if the plan doesn't pass and the consequences are as severe as predicted. But I fear that if the plan does pass the reliance on government bailouts will increase so more bad decisions will be made, and we will eventually wind up in a crisis that is so big even the government cannot get us out of it. Then everyone suffers more.

That's the source of my concern over how much Paulson is going to pay for the toxic assets. The question is not "Will the companies holding these assets be punished?" but "Will the companies holding these assets be hurt badly enough so they won't see government intervention as a desirable thing in the future?"

And it's not just companies that need to not do dumb things again if we're going to avoid a repeat crisis. If I were going to attach conditions to the Paulson plan I wouldn't worry about capping CEO compensation or setting up a strange oversight board. I'd attach a condition that requires 20% down and a reasonable income to payment ratio for all new mortgages.

Posted by: Elise at September 25, 2008 11:53 AM

Well, I agree with you there. But you would never get Democratic buy-in then.

Affordable housing is like the holy grail to the opposition. I'd be more worried about getting some regulation of trading of mortgage backed securities.

Ironically, I think one of the virtues of making the bailout REALLY BIG is that it WILL be painful. We *want* this to hurt so that we *aren't* tempted to do it every single time. If we do a halfway bill, then we WILL be tempted to do it again, and yet it may not work b/c it won't be fully funded.

Posted by: Cass at September 25, 2008 12:00 PM

I want people to be angry about this.

I want them to recognize that it is obscene.

And I see the bailout itself as a mechanism for inflicting pain less severe than a recession or decapitation but worse than half-measures that will only tempt us to go down this path again.

Posted by: Cass at September 25, 2008 12:03 PM

I've been reading up on this somewhat, and it seems to me that the Credit Default Swaps are one of the two key issues. (The other was the way in which the true risks of a given loan were masked by the assigning of AAA and other high ratings when the mortgages were converted to bundled securities).

So: if we have to buy that paper, we can use eminent domain to do it at 'a fair market rate.' Is that rate their face value, or what we estimate they would be worth if we didn't take action and the economy crashes?

They would surely regard that as a reason to avoid government intervention in the future, and it would reduce the size of the necessary bailout to something far smaller than the $700B+ we're looking at now.

Thoughts? This is an area where I'm very much trying to learn what I need to know.

Posted by: Grim at September 25, 2008 12:32 PM

What is really bothering me about this is what I see as the tendency to allow the perfect to become the enemy of the good.

There is a very good reason we have not been able to get reform of the mortgage lending market: we cannot summon the bipartisan votes. That has not changed.

There is a very good reason that we haven't been able to do a lot of things. Again, the conditions have not changed.

The question is, what do we want to do about it?

We can choose to kick the ball down the road again, in which case we have decided to leave ourselves at the mercy of market forces we've already seen are extremely destructive. I cannot believe that is a good course.

Or we can strike the best deal we can now, recognizing the competing interests with which we have to deal, in order to avoid a worse wound down the road.

That is the choice with which we are faced.

Posted by: Cass at September 25, 2008 12:35 PM

The problem, Grim, is that no one really knows exactly how much this stuff is "worth". The lawsuits could go on forever about what "fair market value" is.

I really don't think it is a productive use of the Treasury Department's time or effort to get caught up in that mare's nest. There is such a thing as false economy.

The default assumption here seems to be that Treasury is going to do something incredibly stupid. My guess is that they will buy up these assets at a rate over what they'd fetch on the open market but not something that completely soaks the taxpayer. The bottom line is, if it accomplishes the desired end (i.e., it shores up confidence and the government is able to sell them back later at a profit) then I am not sure the price of trying to maximize government profit is really "worth" it.

Posted by: Cass at September 25, 2008 12:40 PM

What I resent the most is to have our President - a President that I've ardently supported all these years, come and invade the privacy of my home last night and threaten me to put-up and pay-up or else.

I am beside my self.

Posted by: Boquisucio-Da-Chump at September 25, 2008 12:54 PM

The lawsuits could go on forever about what "fair market value" is.

I had taken that as the point of the bailout's provision limiting judicial review of the decisions it makes.

My issue here is that the CDS seem like genuinely bad practice -- people who understood how the mortgages were being converted into AAA bonds knew that the odds of failure were very different from what the market was presented. They used that knowledge to place huge bets on the market's failure, being willing to risk the collapse of the economy to see those profits.

We normally forbid so-called "insider trading," just as we forbid manipulating bets on sporting events by arranging for a team to throw the game. This looks like that kind of thing to me. Why is it anything else?

Posted by: Grim at September 25, 2008 12:55 PM

I think the very first thing to do is put Jamie Gorelick in shackles on a straight-backed metal chair, and put her on a sodium pentothal drip and ask her questions with a recorder on. Seems like every time our country faces serious $#!+ (THE WALL preventing FBI from knowing about the terrorist plot brewing under their noses, Countrywide loans for her with preferred conditions) Jamie Gorelick surfaces. Whaddup wid that chick?

I want serious action on this problem, but I don't want to pump money willy-nilly into it. I wonder if there is a partial free-market solution. I'm busy patching holes in the roof and taking down wet wallboard and insulation, so I haven't had time to do a comprehensive study of the problem, but I understand that there are real, actual assets available here, i.e., foreclosed houses.

I wonder whether part of this bailout could be to sell or assign these properties to 10 or 12 mutual fund companies like Fidelity, open high-risk, high-yield funds which hold these properties and turn them as market conditions improve. People who have time to gamble with their money (those not looking at retirement in 5 years, for example, or people who are wealthy enough to take a risk) invest in high-risk funds all the time. This would be a way for investors to pump money into the market, with the knowledge that they are looking at short-term risk, long-term payback. Investors who can take that risk might just flock to such funds. And then, truly, Americans would get their money back, in a few years.

I lived in Houston in 1984-86 when the oil bubble had burst and people were unable to sell their houses. Houses which had been listed for 2-1/2 years had never had a single person even walk through. I worked with people who had lost one job in a two-income family, were unable to afford their house payment on one income and could not sell. Atlanta and Tulsa were hot at that time, and several people in my acquaintance finally put their house keys in an envelope, mailed them to their mortgage company, and moved to Atlanta or Tulsa to begin again. We moved from Houston to San Antonio to find hundreds of foreclosed houses on the market, and decided to rent for our stay there. We moved to Anchorage to find a thick insert listing HUD foreclosures all over the state in every Sunday paper . The house we finally bought was a HUD foreclosure, on a street with 16 HUD foreclosures out of 18 houses. Our house had holes in the wall, broken sinks, and the owner had urinated all over with the apparent belief that if he couldn't enjoy his house, no one else should, either. I learned my drywall patching and texturing techniques and how to install a sink in that house. My point is that I have lived in three cities very hard hit by similar circumstances, and no one bailed out anyone. People lost out, moved on, rebuilt, or like us, gambled on a beat-up piece of HUD Repo. We paid $67K for that house that had sold new for $150K. We sold it when we moved overseas two years later for $88K. A few years later Houston, San Antonio and Anchorage had all recovered and diversified their economies a bit and had good housing markets again.

I understand that this problem is more systemic, so just letting it all work out might be result in breadlines. So we may have to do a bailout. But...if individual investors could buy into a mutual fund of these properties and wait out the rough weather like they did in Houston, San Antonio, and Anchorage, this problem might be sorted out with a partially market-based solution. And I say prosecute the jerks that got us here, and let them rot in prison.

Bueller? Bueller? Anyone?

Posted by: MathMom at September 25, 2008 01:18 PM

I'm not betting on anything making it into the package until they're done tinkering with it.

Despite all the technical terms being thrown around here, economics deals with how human beings make choices. I don't think all that nonsense changes it much.

I don't think anyone wanted to see the market fail, Grim. I think people are just incredibly shortsighted. They knew it was a gamble but so long as there were profits to be taken they convinced themselves that the reckoning could be deferred indefinitely. I don't think anyone believed these companies would fail (the 'too big to fail' fallacy) or that the government would allow the market to collapse. They would tell you they were helping to spread risk, not creating it.

As I've been writing in an unfinished post, the great fallacy with free market economists is that they fail to account from just this type of behavior - it's just another form of 'free riderism'. But they'll tell you that somehow it will all sort itself out, just like if we took all the locks off our doors, no one would steal from us.

*rolling eyes*

There is some natural degree of regulation that needs to be in place, and it is arguable that the more complex the system, the more regulation we need.

Posted by: Cass at September 25, 2008 01:19 PM

Oh Cass - [Bernake] under grilling by the Banking Committee stated something to the effect, that under his plan the Treasury is to pay banks above market value for their illiquid assets.

Would that be above market value today or above market value X years from now?

You see, if you have an item that is normally worth $100, but because of the current crisis, you could only sell at $70 today and I buy it at $75. The question is not have I overpaid. It's can I afford to sit on it until it's worth $80?

Most investors can't afford a 2,3, or 4 year turnaround. The .gov, due to it's massive size however, can sit on it for 10-15 years quite easily.

That is what is meant by saying the .gov has the 'patience' for the investment.

Posted by: Yu-Ain Gonnano at September 25, 2008 01:29 PM

MM,

The scenario's you've described are similar in-kind, but vastly different in degree.

As you said, in those cities where the markets collapsed some people mailed in their keys and moved out while out-of-town investors bought cheap and moved-in. With a nationwide collapse, there's not really anywhere to move *to* and no real 'out-of-town investor' to buy cheap and move in.

Not anyone you'd want us selling to, anyway.

Posted by: Yu-Ain Gonnano at September 25, 2008 01:40 PM

I think people are just incredibly shortsighted. They knew it was a gamble but so long as there were profits to be taken they convinced themselves that the reckoning could be deferred indefinitely.

The problem with that is that these CDS were precisely bets that would only become profitable in case of failure. And that's where most of the money is: the actual value of the homes, the value of the defaulted loans, it's in the $250B range as I understand it. The rest of this huge money pit -- the majority of it, and maybe the vast majority -- is coming from leveraged bets on failure.

Now, the people who were letting subprime mortgages get converted into AAA bonds, they may be guilty of shortsightedness of the type you describe. (They may also be guilty of fraud in some cases, but that's another debate.) I can see that perspective.

But what makes this a disaster of unprecedented size is the fact that some people saw the problem clearly, and used that knowledge not to fix it, but to set themselves up for vast profits in expectation of the coming failure. That's not shortsightedness or a belief that the reckoning can be put off. It's a recognition that the reckoning can't be put off, and making it worse for everyone -- worldwide! Severe economic trouble in America means starvation and death in Africa and elsewhere -- in order to profit vastly yourself.

Normally when someone uses special inside knowledge to hurt others and help themselves, we call it a crime -- and on this scale, we call it evil.

So let's do what we have to do to protect the economy and keep it stable and flowing: but let's also treat the wickedness as wickedness deserves.

Posted by: Grim at September 25, 2008 01:49 PM

With a nationwide collapse, there's not really anywhere to move *to* and no real 'out-of-town investor' to buy cheap and move in.

It's the latter scenario I am worried about.

You see, if you have an item that is normally worth $100, but because of the current crisis, you could only sell at $70 today and I buy it at $75. The question is not have I overpaid. It's can I afford to sit on it until it's worth $80? ...Most investors can't afford a 2,3, or 4 year turnaround. The .gov, due to it's massive size however, can sit on it for 10-15 years quite easily.

Yu-Ain, you explained that far, far better than I could have.

I thought that was an incredibly important point, but I certainly didn't explain it very well. Thank you for making it so clear.

Posted by: Cass at September 25, 2008 01:53 PM

It all comes back to psychology. How much is something worth. Well, it's worth what someone else is willing to pay for it. If you don't like what someone's asking price is, you don't buy... you go elsewhere. Can a business afford to sit on something for 10-15 years? Sure... if they've got enough cash flow elsewhere to keep the business running for those 10-15 years... AND if they're not publically traded.

I throw in the last, because the old saw in business is "if you're not growing, you're dying" is only true for public companies. Think about it. Mom and Pop Incorporated makes their widgets; and they're making enough profit to pay their workers, keep the factory running and pay themselves as well. They never have to expand, or develop their market globally, or buyout their competition. But Publically Traded Industries can't just cruise along meeting demand and paying the workers. They need to keep expanding. New factories, new markets, new products. Why? If they don't, their investors will leave. They're not making gains in their marketshare. Thus, the company, which can be turning consistant profits can actually go bankrupt if their public shares become worthless.

It's just psychology. Publically Traded Industries is just as profitable as Mom and Pop Incorporated, but because the shareholders see it as "stagnant" they take their investment dollars elsewhere and the company goes under. In our current situation, the banks were put under the gun and told to liquidate assets because their investors wanted out. Suddenly, the actual value of their holdings were called into question. And since something's only ever worth what someone else will give you for it, and no one wanted what they had... well... their holdings were essentially worthless (or worth less, more accurately).

The stock market can jump 100 points in a day or fall 400 bases on 'perception of the market' (i.e. "what folks think it's worth"). It's really a crappy way to run an economy. But it's the only thing we've got. Sure, you could go to a gold standard again... but gold's ultimately only worth what someone will give you for it. So even the gold standard is really just a psychological construct. You can't EAT gold, or run your car on it, so as a commodity, its value is ultimately subjective. Wheat or oil would make a better standard, but again... only worth what someone will give you for it.

Posted by: MikeD at September 25, 2008 01:54 PM

So: if we have to buy that paper, we can use eminent domain to do it at 'a fair market rate.' Is that rate their face value, or what we estimate they would be worth if we didn't take action and the economy crashes?

There is a school of thought that says none of the toxic assets - including the CDS - are truly illiquid. It's just that the institutions holding the assets will not sell them for the low price being offered by the bottom-feeders. So fair market value would be the price offered by the bottom-feeders (same price would be returned by a reverse auction). If Paulson was going to pay that, though, the institutions could just as well sell to the bottom-feeders and we could avoid the bail-out.

The justification for Paulson paying more than bottom-feeder type fair market value is that such a low price will not pump enough money into the firms to let them start doing business normally again. In other words, all the on-paper losses they've shown as they mark to market would become real losses if they actually sold at market.

My issue here is that the CDS seem like genuinely bad practice -- people who understood how the mortgages were being converted into AAA bonds knew that the odds of failure were very different from what the market was presented. They used that knowledge to place huge bets on the market's failure, being willing to risk the collapse of the economy to see those profits.

Now I'm really confused. I thought Credit Default Swaps were like insurance where someone who held a mortgage-backed asset essentially bought insurance from someone else. The asset holder paid premiums to the someone else (the "insurer") as long as the mortgage-based asset wasn't in default. If the MBA did do into default, the insurer was supposed to pay the asset holder whatever the asset holder had lost. The problem occurred because the insurers assumed the housing market would grow forever and when it didn't and he had to pay up he didn't have the money. From that it seems to me that the insurer was betting the economy would keep going and the asset holder was just hedging his bets - he made money whether the MBA stayed out of default or went into it.

So I'm not sure who was betting on the failure of the market.

Posted by: Elise at September 25, 2008 01:55 PM

Normally when someone uses special inside knowledge to hurt others and help themselves, we call it a crime -- and on this scale, we call it evil.

That's true, but normally we also require *specific* knowledge of when it will happen (the "insider" part of insider trading). In this case, the traders were assuming the risk of their gambles, so it's hard to make the argument for it being a crime, especially in the absence of ex post facto laws.

As far as moral culpability, I'm with you.

Posted by: Cass at September 25, 2008 01:56 PM

Now I'm really confused. I thought Credit Default Swaps were like insurance where someone who held a mortgage-backed asset essentially bought insurance from someone else. The asset holder paid premiums to the someone else (the "insurer") as long as the mortgage-based asset wasn't in default. If the MBA did do into default, the insurer was supposed to pay the asset holder whatever the asset holder had lost.

Hence my statement that they would tell you they were helping to mitigate risk.

Posted by: Cass at September 25, 2008 01:58 PM

However, I would be the first to tell you I don't fully understand that whole thing and furthermore don't care to :p

Posted by: Cass at September 25, 2008 01:59 PM

One small mistake in the post above -- commercial paper is not stock but rather 30 day to 2 year noted issued by business to finance day to day operations. If it freezes, essentially all freezes. If stock prices go down, sobeit.

Posted by: levi from queens at September 25, 2008 02:03 PM

Oh! Thanks so much, Levi - I was in a hurry. I'll correct and credit you :)

Appreciate the correction!

Posted by: Cass at September 25, 2008 02:05 PM

My understanding of CDS is that they work not to limit risk, but to increase it. The intent may be otherwise, but the function is to create a system where a default means that I lose my investment plus some additional sum; whereas you now have a new risk, in that you will have to pay if I don't lose.

That looks like leveraging the initial investment, not "insurance." I'm adding to my risk in the expectation of even-greater rewards (which, believing that I own a AAA bond, is not unreasonable); you're taking on a new risk in the hope that my debtor will fail.

If it both increases my risk and also creates new risk, it's not spreading the risk. It's expanding the amount of risk in the system as a whole.

And it seems to be doing this without reference to the concept of "whatever the asset holder had lost." If that were the case, the failure couldn't cost more than the total value of all the homes that the various mortgages were based on.

Yet the actual bailout is close to three times what I have understood the value of the homes to be; and the losses in the system may exceed a trillion dollars, which is more yet.

Posted by: Grim at September 25, 2008 02:17 PM

... the function is to create a system where a default means that I lose my investment plus some additional sum; whereas you now have a new risk, in that you will have to pay if I don't lose.

That is not my understanding of how they work at all. There are various forms of credit default swaps and I'm not an expert on them.

In hedging, it's my understand that in the event of a default, you stop paying and get the amount of your investment back. That is the purpose of the CDS. What you pay if there is no default is the "premium": some percentage of the value of your investment. This reduces the profit from your investment, but insures you against the risk of losing it all.

As to the other, why do I get the feeling we're about the delve into the dubious joys of fractional reserve banking?

[shuddering]

Posted by: Cass at September 25, 2008 03:12 PM

I'm at the top of the thread. This is a general thought about the idea of the question "it doesn't affect me, so who cares?". "... what would that mean for MY LIFE?"

For starters, is that all some people think about: Me, Me, Me?

Now that I've cooled down a little and looked over the thread, I think it's safe to say that you and the commenters have answered the question - if not the "me first" philosophy that brought it up in the first place.

I don't suppose it helps any to point out that the Republicans in Congress (Senate?) tried to put through a bill, co-cponsored by McCain, that would have put some regulation on entities like FNMA. It was soundly defeated by the Democrats. (I think that what happened was that Cox simply tabled it - put it aside, never to be seen again.)

On another tack, there's the old saying that goes, "if somebody owes you $10,000, he's a debtor. If someone owes you $10 billion, he's a partner".

Posted by: ZZMike at September 25, 2008 03:28 PM

Yu-ain,

Thanks for the reply. I know that since the problem is nationwide, you can't expect everyone to shift locations. That's the idea of the mutual fund that gives people who have funds a chance to buy into a thing of value, but not great value right now. The money comes from the taxpayer, but not at the point of a gun - it's a conscious decision to invest and wait out the bad market with a large pool of other investors. It would not be just me, wishing for a buyer, and finally sending in my keys and moving to Easter Island. The houses would be bought by private investors who don't mind the risk or uncertainty in the short term, and expect rewards in the form of increased share price after a few years when the market has been able to absorb the properties.

And, BTW, there were many half-completed buildings in Houston, San Antonio and Anchorage for several years - it was not a little ripple, it was a locally devastating problem. But because the market was allowed to work, at great pain to many individuals, all three cities came back stronger, more resilient, and more diversified.

I just want less money confiscated from us for this, and a creative way to have it willingly given with the hope of reward.

Posted by: MathMom at September 25, 2008 03:31 PM

Howdy, podners!

We is all a goin' to the big hole togethah!

@ Grim:
I think you have got the gist of this, as I sorta understand it, too. It is similar to playing futures markets on commodities. A lot of futures investors take BOTH sides of the market as a way to hedge their bets (or to launder money, heh).

Reminds me of the wife of the former governor of Arkansas, who made $100K on the cattle futures market. Who da thunk that could happen?

Posted by: Don Brouhaha at September 25, 2008 03:35 PM

Maybe I'm not making myself clear here. Sorry, I'm kind of busy.

Sure, some people are betting on failure. But my specific point was unless they have precise knowledge of when a institution will fail and use that to profit, (or worse, they are causing runs on banks in order to profit, if this is what you are alleging) I don't understand how you can say what they're doing is criminal. As long as they take some risk of loss (b/c of uncertainty) they are 'paying their own way'.

If they are smart enough to hedge their bets by betting on both sides, good on them.

If you're arguing we shouldn't allow unregulated trading that can potentially bring our entire financial system to the brink of disaster...

Well :)

I think that's an excellent point. But then I kind of said that earlier. That's a structural problem. I don't have the knowledge to get into that, but that's a long term problem Congress needs to address.

Posted by: Cass at September 25, 2008 03:50 PM

The Marine!Goth says that re-upping is looking better by the day LOL.

Posted by: karla (threadbndr) at September 25, 2008 04:04 PM

MM,

The problem is whether the investors have the stomach to ride out the short term turmoil until conditions improve. Most can't/won't.

It takes a stout hearted investor to (to use my previous example) to buy @$70 to get $80 when he believes that it'll hit $40 first. Most will wait for the $40, which will essentially cause that to happen faster, but the faster the price falls, the more reluctant the investors are to buy and you start a downward spiral.

Yes, a few handful of investors will get rich as the now $10 stock rebounds back to $100, meanwhile, the rest of us peons get bent over as financial institutions layoff employees for their direct salvation as well as all the other business layoff employees as they no longer have access to cash (as Cass mentioned, they aren't running their business on their own money).

BTW,
I'm simply presenting the opposing viewpoint. Not necessarily endorsing it.

Posted by: Yu-Ain Gonnano at September 25, 2008 04:21 PM

With respect to what the learned banker Yu-ain Gonnano says, there is also the 'opportunity cost' of capital.
Investors may be able to buy at 80% of face value, and realize the 100% of face value SOME DAY, but if it takes too many years, few are willing to be that long term. They have to see a faster return on investment; hence the 'opportunity cost' of tying up capital waiting for real estate (or whatever the financial instrument is) to mature. Even more difficult if the said instrument or item is of unsure value in the interim ( which is where we all got on this train, I think).

Warren Buffett comes to mind as someone who has done this successfully. Coincidence? But Buffett invests in ways unlike almost anyone else, because of the large amount of money he can use at his own personal discretion and judgement.

The Federal Government and Federal Reserve banks CAN do this, as they are not exactly beholden to votes of stock holders (just voters!). Besides, the Federal Gov can print their own money; nice trick!
The Fed Gov has taken on almost $10 billion dollars in debt since 1941, and frankly hasn't retired any of the principal in that time. But they continue to pay the interest, so the Treasury bills are still a good investment.
For now.

Posted by: Don Brouhaha at September 25, 2008 04:36 PM

Uh, that's $10 Trillion dollars in debt since 1941, not $10 billion.

Good thing I'm not in banking or anything requiring a brain. :)

Posted by: Don Brouhaha at September 25, 2008 04:40 PM

That is the entire issue the govt. purchase is tryin to get around - the tendency of people to sell an investment in the short-term that doesn't look profitable to maximize their own profit/minimize their loss.

If they these securities were attractive to individual investors now, we wouldn't be talking about a bailout.

Posted by: Cass at September 25, 2008 04:43 PM

OMG! I think I understand Credit Default Swaps. The Econ 101 professor whose class I slept through would be so proud. Ahem.

From what I can tell CDS did start out as a form of insurance and it works as I described: an asset holder pays a premium to someone who in exchange promises to pay the asset holder if the asset defaults. Simple and very clean: both parties know what they're on the hook for - the asset holder's maximum cost is the premiums, the insurer's maximum cost is the total value of the asset. Fair enough and easy to account for.

As always seem to be the case, though, there was a snake in that Eden: someone figured out that you didn't actually have to own the asset to buy insurance on it. So let's say I own all of Securitized Mortgage Bundle 1 (SMB-1) and it's worth $100. I have entered into a CDS with Grim in which I pay him $5 a year to protect myself from default. Clean transaction, easy to account for.

In the meantime, Cassandra hears about my CDS and goes to MathMom and says, "I'll pay you $5 a year if you promise to pay me $100 if SMB-1 defaults" even though neither Cassandra nor MathMom have ever even been within spitting distance of SMB-1. MathMom says, "Yes", another CDS is born, and Bob's your uncle.

Never one to let a good deal slip through his fingers, MikeD goes to ZZMike and offers him the same deal Cassandra offered MathMom. ZZMike accepts and yet another CDS is born.

Now the $100 of SMB-1 is holding up $300 of risk: the insurance risk between me and Grim and the gambling risk between Cassandra and MathMom and between the two Mikes. That's how CDS can be "worth" $45 trillion which is like a gazillion times as much as all the mortgages in the US.

If we add another common permutation, then Grim may well have entered into a CDS with, say, MathMom in which he pays MathMom $4 a year in return for her promising to pay him $100 if SMB-1 defaults. Now that $100 of SMB-1 is holding up $400 of risk and you can decide for yourself if Grim's deal with MathMom is prudent risk management or gambling. (I'd say the former on his part, the latter on hers.)

This all worked fine as long as the housing market was growing and defaults were as scarce as hen's teeth. Once the growth slowed and defaults increased, though, SMB-1 actually defaulted. Now Grim owed me $100, MathMom owed Cassandra $100, ZZMike owed MikeD $100, and MathMom owed Grim $100. Unfortunately, MathMom and ZZMike had figured bubbles never burst so they don't have the cash on hand to pay off their gambling debts.

Rather than take the honorable way out - an apologetic note to the spouse and children, a quick brandy, and a pistol in the study after returning home at dawn from the stews - they turn to the federal government for help. That's fine with Grim, Cassandra, and MikeD because they know they'll never get their money anyhow. And if Grim can't cough up what he owes me with getting his money from MathMom, that's fine with me, too.

I'm so proud of myself.

Disclaimer: All characters appearing in this drama are fictitious. Any resemblance to names of real people is purely coincidental.

Posted by: Elise at September 25, 2008 05:13 PM

Now look here, toots :p

I may not be yer Uncle, but you sure are one smart cookie!

Posted by: Uncle Bob at September 25, 2008 05:26 PM

WAAAAAAAH!!!!!!! NOBODY EVER TOLD ME BUBBLES BURST!!!!!

I WANNA FEDERAL BAILOUT!!!!

Great explanation, Elise!

Posted by: MathMom at September 25, 2008 05:47 PM

Heh....

I am going to put her in charge of Official Explanations from now on :)

Elise!!! You have the con!

Posted by: Uncle Bob at September 25, 2008 05:49 PM

Seriously, between Elise and Grim and Bob (not Uncle Bob) and Yu-Ain and...

Oh I could go on and on...

Do I have the smartest commenters in the world or what?

Posted by: Uncle Bob at September 25, 2008 05:50 PM

The stock market can jump 100 points in a day or fall 400 based on 'perception of the market' (i.e. "what folks think it's worth"). It's really a crappy way to run an economy. But it's the only thing we've got. Sure, you could go to a gold standard again... but gold's ultimately only worth what someone will give you for it. So even the gold standard is really just a psychological construct. You can't EAT gold, or run your car on it, so as a commodity, its value is ultimately subjective.

Yep :)

Posted by: Uncle Bob at September 25, 2008 05:52 PM

All value is ultimately subjective. That's what value means: How much I care about it.

If you and I are standed on a desert island, you have all the gold and I have only enough survival gear for one, there is no amount of gold that I would sell my gear for. Your gold is worthless to me.

If you got clean water*, however, we'll talk.

*which only costs pennies/gallon at the kitchen sink.

Posted by: Yu-Ain Gonnano at September 25, 2008 06:40 PM

I'm at the top of the thread. This is a general thought about the idea of the question "it doesn't affect me, so who cares?". "... what would that mean for MY LIFE?"

For starters, is that all some people think about: Me, Me, Me?

I was the one that posed that question and yes, I do think about people other than myself. However, the way my brain functions, it is easier for me to grasp a concept such as the one we are discussing here if I can put it in personal terms.

My brain does microeconomics much more easily than macro.

That's all the question was - an attempt to understand a HUGE debacle on a more personal level so that I could wrap my brain around the question of WHY it is important for me to support this $700BILLION bailout. Not what you misconstrued it to be.

Posted by: HomefrontSix at September 25, 2008 07:28 PM

On the whole discussion of credit default swaps. I thought that in most cases of taking out insurance, you were required to have an insurable interest in it: you can't just take out a life insurance policy on anybody you want to; when you get car insurance, you pay a premium based on you driving your car, and any other drivers you want added, you have to pay for that added risk; when you get homeowners insurance, you have to actually own the home. Why should it be any different for insuring the risk of a mortgage borrower defaulting on their mortgage? The only person with what I would consider an "insurance interest" is the entity who loaned out the money...

Posted by: Miss Ladybug at September 25, 2008 09:21 PM

Dealbreaker has put together a spreadsheet with some rough estimates of how much money got paid in fees by the various parties to the current mess. The numbers are north of 2 trillion, though it is changing based on sourced input in the comments
ouch

Posted by: James at September 25, 2008 11:08 PM

Another bites the dust WaMu is now history. How many $Tens of Billions will this whack the FDIC with; and by extension, our taxpayers' pockets?

Oh and James, I am afraid that Dealbreaker hasn't factored-in all the outstanding Derivatives-based obligations out in the market. Estimates that I've heard run up-to $One Quadrillion. how quaint - only two measly trillions

Posted by: Easy-Mark-Boquisucio at September 26, 2008 01:32 AM

So... lemme see if I've got this straight.

(Keep in mind that every time something was bought, sold, insured, or bet upon, there is a non-refundable fee involved that goes to the seller of whatever is being sold or the guy taking the bet.)

Somebody bought a house for $100,000. He mortgaged the whole thing. Somebody else then bought this mortgage. That somebody packaged it with a whole bunch of other mortgages, some good, some bad and sold the packages minus the worst mortgages.

The worst mortgages in package 1 got upgraded to the best mortgages in package two. The worst of the worst in package two became the best in package three... ad infinitum? Surely there wasn't a package four!!

So then, the owner of packages one, two and three bought insurance on their packages. They did this because they didn't know whether their package was one, two, or three.

Then a gambler comes in and says I'll bet a #100 that package three defaults. Gambler #2 says OK, I'll take that bet. And the same happens for each of the other packages. Were there no limits on how many bettors could place or take bets? Whoa...

The amount of money to be lost is tremendous and I don't see where anybody but the fee takers are making anything solid.

So... am I on the right track or totally off base?

And how do I get to be a fee taker?

Posted by: Donna B. at September 26, 2008 04:33 AM

There is no requirement that the buyers of protection in a CDS have insurable interest. These people are gamblers (or speculators if you prefer) pure and simple and they are - as Grim said - betting a particular asset will default or that the market as a whole will crash. An April 11, 2008 (yes, more than 5 months ago) article said:

CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to speculate on market changes. In one blogger's example, a hedge fund wanting to increase its profits could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money - free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. And there's the catch: what if the hedge fund doesn't have the $100 million? The fund's corporate shell or limited partnership is put into bankruptcy, but that hardly helps the “protection buyers” who thought they were covered.

To the extent that CDS are being sold as “insurance,” they are looking more like insurance fraud...

However even people legitimately protecting an insurable interest could result in my measly $100 of assets supporting way more than $100 of risk. Here's one of the things I read that finally made the light bulb go on about CDS: How does a CDS work?. Specifically this paragraph:

The CDS contract references a specific bond (or bank loan). For example, the 5-year Alltel CDS references the AT 7% '12. In the event of a default, the seller will be buying some bond which is pari-passu with the reference bond. The buyer of protection doesn't have to actually own this bond. In fact, the buyer of Alltel protection might be a bank with which Alltel has a credit line. The bank knows that if Alltel gets into trouble that the credit line will be drawn down. But they also know that the CDS contract spread will widen substantially, and they will have a profit in the contract. If Alltel actually defaults, they can buy the bond in the secondary market at a steep discount, then sell it to the seller of protection at par and make a huge profit.

The buyer of protection does not hold the bond but they do have what could be reasonably be called an "insurable" interest. That is, they have exposure to Alltel. However, Alltel could have credit lines with 10 banks and they may all have entered into CDS to buy protection just as the actual asset holder may have done. If Alltel defaults, somebody (or more likely somebodies) owes all of those people money: 10 banks plus one asset holder equals $1100 owed for a $100 default.

For a brief (some rude language) overview of CDS and their horrible domino effect, you can take a look at this.

So, Miss Ladybug, I’m afraid you are just so twentieth-century with your insistence on insurable interest. And, Donna B, if you figure out how to be a fee taker, please let me know - I’ve got my eye on a little place in the Mediterranean islands.

Posted by: Elise at September 26, 2008 11:57 AM

My biggest concern is where this "bailout" money (the money the gov wants to use to buy the risky paper) comes from, and whether or not it will increase inflation. I know that I am not the only one concerned. I think that if they could guarantee somehow that inflation would not skyrocket based on this plan, they could get a lot more people behind it.

Posted by: Emily at September 26, 2008 12:25 PM

Post a comment

To reduce comment spam, comments on older posts are put into moderation 5 days after the last activity. Comments with more than one link also go into moderation. If you don't see your comment after posting it, try refreshing the screen. If you still don't see it, your comment is probably in the moderation queue.




Remember Me?

(you may use HTML tags for style)