The Financial Mess

[vakkotaur]

First the simple stuff that you hopefully already know. Stocks are sold by companies to raise capital. The investor gets a share of the company in return and if things work out, dividends from a profitable company. If an investor doesn't care for the company any more or just wants to convert his holding to cash he can sell the stock to someone else. The stock is paper (or used to be, anyway) but the company is real. Land, buildings, equipment - stuff you can see. If stocks are overvalued, then they're worth more than the stuff backing them up. This is the bubble (non-real perceived value) that bursts (people catch on to the perceived value not being real, want to turn their bit real before it goes *poof*) in a correction (the perceived value drops back to the real value). This, roughly, is what happened in the late 1990s when many shaky internet startups were seen for what they really were.

That's not what is going on now. This is more complicated and I'm not at all sure I really understand it. It's a combination of things, of course. Underregulated or incorrectly regulated financial institutions, shaky mortgages, speculation, and maybe even an accounting rule that is having a more painful effect than expected.

It's easy to blame just about everyone in Congress. I've seen folks saying this started with the deregulation of the 1980s and claiming the Republicans are to blame. Fairly recently there was a vote in 2005 about giving a regulator that would oversee Fannie Mae and Freddie Mac real power to put a stop to bad practice and every Republican voted for it, and every Democrat against it - that includes the Dodd, Frank, and Reid fellows who have been asking how did this lack of oversight happen. They really ought to know. However, there is plenty of blame to go around. That's just the recent history. If you really want to, you can probably chase a few threads of this to at least the Carter administration if not earlier.

For the last couple decades the money supply has been fairly closely regulated and the balance of inflation and interest rates, along with other factors, has worked out. A few years ago former Chairman of the Federal Reserve Paul Volker was asked how he'd handle today's (that was the today of a few years ago, mind you) problems and pretty much laughed as the "bad" numbers of that today would have been miraculous when he had the job, and certainly when he started. The result has been fairly low inflation, astonishingly low interest rates, and fairly low unemployment even if that number doesn't indicate what it seems to. There's nothing truly bad, by itself, there.

The low interest rates encouraged borrowing, which is what they were supposed to do. The problem is that not all of the borrowing (and therefore not all of the lending) was sound. A lot of people took on a lot of debt that they couldn't service (make the payments on) when the economy so much as hiccoughed. Some wasn't even that good and was based on the hope of being able to make it work later. That plenty bad, Kemosabe, but it get worse.

The big mortgage institutions of Fannie Mae and Freddie Mac didn't have proper oversight. Whether this is from simple lack of any oversight or from too many overseers to answer to with each assuming the others were taking care of things can be argued, but the result is the same: they did a lot of shaky lending. The 2005 vote mentioned earlier came and went and a deal was struck - they'd see what they could do to provide even more low income housing. It felt good, sure, but the end result was not more sound but even less sound lending. While Fannie & Freddie may be technically private corporations, they are governmental anyway. Just like the post office (work for the post office, you get a federal paycheck... after taking an oath to uphold and defend the Constitution) is a private business that's not really separate. That shakier lending was worse, but we're far from done.

With the two whales of mortgage lending making those loans, the smaller fry followed suit in order to be competitive. Maybe not every fish in the sea, but enough. They also made shaky loans, since if nothing else they could probably pass the loans along to Fannie & Freddie. Now that's even worse still, but we're still not close to being done.

A lender can take out what is basically an insurance policy on the loan. It's a sort of bet that the loan will fail and if it does, they get paid off. This is good for the lender, but a loss for the insurer. The insurer deals with the risk by spreading it out. After all, what are the chances of everything going to pot all at once? You can see the problem here, and yes it's happened or is happening but even that isn't the whole story. Because, so far, the property is still real. The land is still there and any property on it is still there, and the mortgage lenders loss is limited. Values can go down, but real estate isn't known for dropping through zero value. "Buy land. They're not making any more of it."

Those mortgage insurance policies? The ones that were a sort of bet that things would fail? They're not regulated. At all. Which means it wasn't just the lenders making the bets to cover their own risks. It was speculators who figured they could get paid when things failed. A lot of speculators or at least a lot of speculation. Now, there is nothing backing this bet. The shaky loans have started failing in enough number to get noticed and the insurers can't pay off everyone because they simply can't cover every bet made - all the same way. This is the Big Problem. And now we're being asked to bail out... not just the mortgage borrowers (which would get some objection - they ought to have known better - but not all that much).. not just the mortgage lenders (more objection, they really ought to have known better) but the incompetent bookies (no pity for them) and the gamblers trying to collect (less than no pity for them) from the bozotic bookies. The gotcha is that this affects the money supply, and thus the whole economy, whether we want it to or not and whether it should or not.

There is an accounting rule that has come up, FAS 157 the "Mark to Market" rule. This rule says that in trading the insurance policies (bets) that they can only be exchanged at the value they could be sold for. "It's only worth what you can get for it right now." It makes sense, and not too long ago it was embraced as it let companies mark the value up. Now they have to mark it down. Far down. No one want to buy the things. So the system is wedged as they can't sell them, can't afford to sell them, and can't afford not to sell them, and they claim they have to sell them. Or at least that this why the losses are so big. Some claim that the real losses might be only 15% but the perceived losses run to 50% and that that's a big part of the problem - undervaluation. They say that removing or suspending FAS 157 would get things moving again... though I'm not sure how. If there's no perceived value, putting a higher price tag on the thing won't make it sell any faster. Some have called not using FAS 157 allowing "Mark to Make Believe." Is it worth a try? I don't know. I've seen someone claim that doing that would cost $40 billion, which ain't chicken feed but it beats a $700 billion cost... if it works.

"Too Big To Fail"

We've all heard this a few times and it's tempting to disallow anything from getting so big that the country can't afford its failure. The problem is that there are many, many things that size and most are doing at least reasonably well. There is the matter of how to judge when something is too big to fail. Chances are that by the time anyone notices, it's already been that size for a considerable time. Also, who would get to decide that and just what would be done about it?

I'm not saying don't investigate or oversee things. AIG (and a bunch of others) ought to be investigated - but if the only alleged "wrongdoing" is stuff that Congress left be legal, then let's not do anything stupid but just fix the real problem and just be done with it. If there was real, illegal wrongdoing then throw the book at them, certainly. The politics of jealousy and vengeance will not help anyone and are almost certain to make things worse.

The AIG loan (which isn't the $700 billion thing) is structured rather like the Chrysler bailout of the 1980s. The Chrysler bailout was a loan and an astonishing governmental involvement in private industry in the Reagan years. Here's the other surprise for many: it worked, and the federal government came out ahead on the whole thing. That's not a guarantee that AIG will work out that well, but it does mean that it isn't just "Here, have a bag of money."

$700,000,000,000 of... what? Or "Here, have a bag of money."

What do we get for that $700 billion? For the average citizen: nothing but tax burden and more national debt. For the federal government, assuming that the bailout gets them the actual mortgages and not just the bad bets, there is a potential for things to pay off. By one estimate, the payoff could be as high as 2 Trillion (yes, with a T) dollars. Sounds good, right? Double the money and use it to well, pay off the original $700 billion debt and pay off more debt besides. Except for one thing: When was the last time the federal government got money and didn't rush to madly spend it? Heck, I'm trying to recall a time when it didn't spend even the rumor of money - which means that by the time any profit is realized, it'll have been long spent. Not only that, but nationalizing a chunk of the markets is if not socialism, close enough to be worrisome. Creeping Socialism is bad enough, we shouldn't help it up so it can march. If you're not sure of that, think about why this line means what it does: I'm from the governement and I'm here to help. The silly "no oversight, review, etc. of anything" bit is also just plain scary. Lack of proper oversight is what caused the mess. Regulations should be no greater than absolutely necessary, but not nonexistant.

One suggestion was to then give the citizens of the country -- the taxpayers, the people who are really paying the $700 billion -- shares of the companies that the money bails out. This is another tempting but wrong thing. This is a redistribution of wealth on a massive scale - another bit of socialism. There might be a way to do this, but it's not to force people to do it. Forcing is bad; Allowing is good.

Set up a corporation (I don't relish the idea of another pseudo-private corporation of the federal government, but it seems a less bad plan than the ones I've been hearing) whose job it is to do the bailout and sell shares in it - those wanting shares of it can buy them. It's a voluntary free-market solution. And if doesn't raise enough? Maybe it's because the market is smart. The thing to watch is: are billionaires interested? If they want in on that deal, there's a probably a good reason for it. If they stay as far away as they can get, there's a reason for that, too. This is not next quarter type investment. This is buy-and-hold stuff as it will take at least a few years to pay off at all. Oh and ideally, add a sunset provision (this will be hard to get right enough that it can't be fudged) so that the new entity goes away when no longer needed - and it doesn't get to create or redefine the need.

Is that the solution? I have no idea. I don't even know if it's even a solution. I expect that I have some details wrong, at the very least, but this is what has happened as I have come to understand it so far.

Comments

[jmthane.livejournal.com]

When was the last time the federal government got money and didn't rush to madly spend it?

That would be the end of the Clinton era, when there was a budget surplus for at least two years.

Interesting analysis - I like it.

[nefaria.livejournal.com]

We had a Democratic president who wanted to spend the money on things that the Republican Congress didn't want, and vice-versa, so we ended up with a stalemate and a surplus. I think both sides have fixed that problem by deciding to let each other spend as much money as they want, so there won't be any more surpluses.

[jmthane.livejournal.com]

Actually, what we have are Democrats who roll over showing belly to the Republicans. The GOP have set a record in number of filibusters in this term of Congress, blocking just about anything they don't want to go through. And Bush finally used his veto pen during this Congressional session.

[rillaspins.livejournal.com]

Do you read Kassrants? http://kass-rants.livejournal.com/150744.html?thread=3349976#t3349976

[vakkotaur.livejournal.com]

I don't, but he does make a point that seems to echo 1929 even if it isn't Wall Street. In the 1920s you could easily buy "on margin" using a loan to buy stocks and use the stocks themselves as collateral on the loan.. if the loan defaulted, the lender gets the stocks and still isn't hurt so long as the market keeps going up. The same thing has happened again, only with the real estate market rather than the stock market. One thing to note is that the people who didn't sell off in the panic(s) but held on to the stocks for the long haul were the one who came out the best. Buy and Hold is a good idea. Bailing out OF things right now is probably a Bad Idea.

[rillaspins.livejournal.com]

I can see both sides of bailing out the industry. To tell you the truth, I don't understand Wall Street all that much.

Mark has consistantly said that holding stock for the long haul is the way to go. I don't think he's trading out. I'll have to ask.

[vakkotaur.livejournal.com]

The non-financial institution stocks should be unaffected (they will be affected, belief is a contagious thing, but not in real value). Most of even the financial institution stocks will likely not be too bad in the long run. Right now many are bailing out driving the price down, so it might even be a good time to buy some of the better ones if you can figure out which those are. Panic-selling is where real losses happen. Those who "let it ride" will likely ride thing out. The real innocents who are apt to be hurt are those drawing retirement pensions from the devalued investments. They have to sell to get cash, and selling undervalued items means they take a hit. Those folks, however, are still probably doing better than to rely on just Social Security. That's whole 'nother mess.

[thecanuckguy.livejournal.com]

A good analysis! Vakkotaur for President! I'd vote for ya! (If it wasn't for the whole citizen-of-another-country thing ... )

Paragraph 5 seems to hit the nail on the head in terms of the absolute root cause of the problem: John Q. American. His irresponsibly "taking on more debt than he can afford", simply so that he can have enough toys to "live the American Dream" and/or "keep up with the Joneses" is the root cause and now it's come to bit him in the ass, big time. And there's far too many of them doing it (as I inferred, it's part of the American psyche to sidle huge debts). Sure, the government ought to do something when the problem has become as large as it has been, simply because it's affecting the country, which the government is responsible for, but it really comes down to "should the government legislate common sense?" This is the government, not our mother. A part of me *really* wants to say that if people are taking out loans that they have no hope in hell of paying off then they deserve the consequences.

(And, not, I'm not simply "ragging on the Americans", at least not this time. John's cousin, Harvey R. Canadian, does the same thing (I know I've racked up the debt to a point that I've wondered "what the hell am I doing?", especially when my wife was out of work), but being Canadian we're a bit more prudent about it. My debt isn't anywhere near what I hear my southern neighbours have.)

And, btw, you've mentioned socialism a few times in your post as if it's a Bad Thing. So? Take a look about 500 miles to the north of ya, you'll hit a country that's way more socialist than the US is comfortable with and it's in pretty sound shape. I also consider myself a socialist (though I don't defend any of the "traditional" socialist regimes like Cuba, Vietnam, PR China, USSR, etc., at least not the parts that everyone knows is bad, because they're also dictatorships. A lot of people don't understand that socialism and dictatorships do not go hand in hand. Again, look at us.) I will agree that there is a mentality in the US (thank you Joseph McCarthy) that anything socialist has no place in the US of A (which is why our health care system will always be better than yours ;) ), but maybe you guys will let go of your stubbornness one day. ;)

[jmaynard.livejournal.com]

which is why our health care system will always be better than yours
Sorry, but I can't let this one slide. If the Canadian health care system is so much better than ours, why are Canadians constantly coming to the US for health care?

[thecanuckguy.livejournal.com]

Let's explain the differences between our health care systems, shall we? (Caveat: I've never actually had to use the American health care system, even while travelling in your fine country, so my understandings of your system are purely taken from observation):

American health care system is based on coverage - if you can't afford coverage, you're SOL. You have to pay through the nose to get medicines, if you can't afford the medicines, again, "don't come crying to us, we can't give you anything for it."

Canadian health care system has a basic level of coverage for everyone. If you can't afford private coverage (many people, on both sides of the border, can't), the government's got your back. If you can afford better care in the States, you're free to do so, no one's holding a gun to your head to use the Canadian system (and there's been some minor uproars when Canadian politicians are discovered having used the US system - the public expects them, the defenders of our system, to use it, while forgetting that if you have the money, like they do, they're free to do what they want with it). Myself, I could probably get treatment in the States for whatever I needed, but I can't afford to do that at all, so I use the Canadian system, and have no complaints about it. Because I know that if I was an American I wouldn't be able to afford some of the things I get now (especially with all the medical issues my son had in his first year of life, that definitely would have been too costly and my insurance didn't cover it - I work for an American-based company btw.)

Ergo, Canadian health care is better. Coverage for all.

[jmaynard.livejournal.com]

Your last statement assumes health care is a fundamental right. I cannot agree with that statement. The world owes me health care no more than it owes me food, shelter, or anything else that gets lumped into "a living". I can darned well work to earn it, or do without.

I know this sounds cruel and heartless. The alternative, however, is a system that's either hideously expensive, underfunded, lacking in the best available options for care, or some combination of the three. We can't afford it. Neither can Canada; the system there is underfunded (which is why folks come to the US instead of waiting years for elective procedures, or doing without entirely), and those who can afford to come to the US to get the superior care found here.

It's no accident that people come from all over the world to places like the Mayo Clinic or the Texas Heart Institute or the University of Texas MD Anderson Cancer Center for treatment. The best medical care in the world is found right here in the US.

[thecanuckguy.livejournal.com]

I could also answer your question with another question: If the American health care system is so much better than ours, why are Americans buying their prescription drugs in Canada?

[jmaynard.livejournal.com]

Because they're able to take advantage of Canadian drug subsidies by doing so.

[sideband.livejournal.com]

IAWTC

[ginafae.livejournal.com]

I pretty much agree with you! After all, even as socially liberal as I am, I am fairly fiscally conservative.

the point I wanted to make, though, is that I worked in the Real Estate business before staying home with the kids. I quit in October 2005. To be honest, before I left, there were and had been *terrible* loans. "No Doc." loans. Yea, those are ones where the lender cannot ask if the person has a job, no proof of income, just give out the money as fast as possible. Time and time again, I saw closings on loans where people were buying a house that was *clearly* more than they could afford, and then getting additional loans against that house to pay off credit cards. There were *so many* loans where we looked at eachother and knew that the loan officer had no business giving that loan out.

There were quite a few people in town who had sweet deals going... like a realtor who could always find someone who was *very* low income to buy a house. That his wife would then write the loan for.

There were situations where the people buying the house would show up to close and say "Whoa... what? These aren't the terms that the loan officer told us?" Then we'd call the loan officer (they didn't have to be at the closings, right?) and they'd say, "oh... well things changed... they can't qualify for that really low rate we advertised."

There were people getting loans from companies who e-mailed them the documents at home. Then it was these people's responsibility to print out the docs, find a notary, sign them, and mail them back. All of this done over the 'net with no legal oversight, explanation or anything.

The thing is, from what I saw, people walked into these loan officer's offices thinking that this was the "old days". They thought that the loan officer was their advocate, who was working for them. Who was a go-between them and the company itself. That the loan officer wouldn't let them do anything stupid, and that the bank would protect itself by not giving out a loan that couldn't be paid back. What the average person didn't realize is that the scheme had changed. Now the deal was that the loan officer is a salesman, who will try to sell you the highest loan he possibly can. He'll encourage you to get a 95% loan. Why? Because then he can charge mortgagge insurance which is as much as your mortgage itself. He'll give you a 100% loan. Or a 103/110% loan (!). All you have to do is show up.

The loan officers were being encouraged to do this, because the investors were banking on this boom. They were *causing* the housing boom artificially by giving out more money than people's incomes could keep up with. They were, in short, creating money.

I am not a financial genius. I rarely follow the news, nonetheless the stock market. Macroeconomics has always been a mystery to me. But this, I knew, I saw, and could predict the "correction"

And those people who actually had equity in their house? They were encouraged to take out "home equity loans", get their money out, and drop it into the market. "Make it work for you" they were told. But let's be honest. Did most people do that? No. They bought cars, boats, vacations, weddings, and a myriad of other things that only depreciate. And it all furthered the boom, and made these investors and high-ups a ton of money.

I say, let them reap what they sow. We, the average American, was stupid enough to go along, and we're going to pay for it no matter what. Let's not have us pay for it on the back-end too.

[foolscap001.livejournal.com]

Since you were in the real estate business, I'd be very interested in hearing anything you might have to say about the Community Reinvestment Act in this context.

[ginafae.livejournal.com]

I assume you're wondering whether or not I think it's made this worse.

To be honest, I can't speak to that as I was in the Title side, which means that I dealt with Realtors, Attorneys and Loan Officers daily, but I don't have experience with their restrictions as they came down from above.

But I will tell you this: The worst offenders I saw in my town were, Countrywide, companies like Ditech (of the commercials and internet-based loans), and by far the worst, various Mortgage Brokers.

Countrywide would give anybody a loan, just jack up the fees for those less likely to be able to pay. It was a clear case of pay up front for loss on the back end. Mortgage Brokers were little tiny companies that you would go to in town that would *find* you a loan. These were people who would walk in with $45 k in credit card debt, sign a couple pieces of paper, and off they were. And the loans were coming from the weirdest companies you've never ever heard of. I worked in the business and would be like "Who the heck is THIS?" And we got a ton of those.

Ditech did the same stuff, but totally skipped having a closing (No Closing Costs!!!) so you couldn't possibly get an explanation on the paperwork you were signing. I know about them because my friends got fleeced. They refinanced their house for what I know to be *signifanctly* more than it was worth, to get quick $$$. Like idiots, they went for it. Now they owe more than it's worth. SIGNIFCANTLY MORE.

Anyways, did that legislation contribute? Let me tell you this: Nobody was holding these guy's arms behind their backs. They wanted to give these bad loans. Because all that mattered was how much money they were pushing a month. There were awards ceremonies for who sold the most loans that month, both number and money-wise.

Bad bad deal.

[vakkotaur.livejournal.com]

Thank you. Even though I'm still not sure I really understand what is going on or has gone on.

Go right ahead with the watching. Though you might want to read back a bit and see how dull things really are.

[bucktowntiger.livejournal.com]

Mark-to-market is designed to reflect the true worth of a business' assets and liabilities. It is intended to keep companies from taking excessive accounting profits that are not realizable. Getting rid of it may fix the current problem on paper, as it would make the banks look viable, but in reality, everything will still crumble--we just won't know when it does, and as such, we will get hit much harder.