The Fighting 44s

17 Responses

#1

SamuraiJack

9:57 pm | Sep 29, 2008

A trillion dollars was lost in the market today alone. $700 billion doesn’t look so big anymore.

It’s also ridiculous that they’re thinking of postponing negotiations because of the Jewish holidays - would they have delayed it if it were the Chinese New Year?

#2

nskripchun

10:47 pm | Sep 29, 2008

I hope folks don’t have their entire life savings in stocks.

#3

nightshade

12:44 am | Sep 30, 2008

I thought I was stupid when I liquidated my 401k earlier this year. I was getting a really bad feeling because I’d lost about $800–and I figured, you know, I think I’d rather have the money and spend it on travelling. Now I feel a lot less stupid. Though I suppose I really didn’t need that new handbag.

#4

jaehwan

1:13 am | Sep 30, 2008

Today basically sucked. If I had more energy, I’d go into the house.gov to see who voted which way and why. But man, we all get so tired and worked up when things like this take place, so I think I’ll have a beer instead.

#5

THX1138

4:38 am | Sep 30, 2008

This economic implosion is like watching the sinking of the Titanic and the Hindenburg disaster all rolled into one. It’s epochal. And the effects won’t be limited to the USA, as the shockwaves will reverberate around the world.

Someday, people might tell their kids that they witnessed history in the form of maybe one of the greatest economic collapses ever–if they get through it. The “Perfect Storm” that some analysts were predicting has finally hit.

The question is how will these things impact politics in the USA (and Asian Americans)?

I’m afraid the answer likely won’t be pretty.

“Army deploys combat unit in US for possible civil unrest”
http://www.wsws.org/articles/2008/sep2008/mili-s25.shtml

#6

Xian

7:28 am | Sep 30, 2008

First of all, my condolences to those who lost a ton of money yesterday.

Otherwise, I know this will have a massive reverberating effect far beyond the stock market, but can someone with better economic knowledge explain exactly how this will affect the vast majority of Americans who own little or no stock?

Thanks!

#7

jaehwan

12:23 pm | Sep 30, 2008

Xian,

If you own little stock and don’t own your own home, you may be in a better situation than most people. Because you teach, you get paid by the government, and the government never runs out of money for workers–if it runs out, it just borrows more (and passes the bill on to our kids, unless some efforts are made to pay down the federal debt later). So financially, you’ll probably be fine.

So let’s talk about how this crisis started. Banks were making bad loans to irresponsible people who had no business buying houses and condos. Making these bad loans made houses more affordable to people who ordinarily would never qualify, and so there was a housing boom where there were not enough houses to go around for all the new prospective buyers. You’d buy a house for $200k, and the following month you could sell it for $220k. Some localities had house prices double in a span of only a year. Builders, real estate salespeople, mortgage bankers, escrow officers, contractors, and hardware stores were going crazy because business was great.

The problem was the fundamentals. Many of these homebuyers should never have qualified in the first place, and when they defaulted (because they should never have owned a home to begin with), they defaulted on a mass scale. Banks had to step in and foreclose–which they generally don’t want to do because they don’t know how to sell houses to recoup their losses. If you buy your house at $300k, and your neighbor gets foreclosed on and the bank sells it for $150k, it hurts your home value, hurts the guy who got foreclosed on, and hurts the bank. It makes you want to sell, and it makes fewer other people want to buy (because they don’t want to lose value). All of a sudden, you have tons of houses, new and existing, that no one wants to buy. Builders, real estate salespeople, mortgage bankers, escrow officers, contractors, and hardware stores suddenly have no work to do. Massive layoffs take place. More people have to sell their homes because they no longer make enough money to afford to stay in them.

Meanwhile, on Wall Street, large banks lose billions of dollars because they made bad loans that never paid off. Think about it–you make a $200k loan on a house that get foreclosed and sells for $100k, and you’ve lost $100k…on one customer. Multiply that times tens or hundreds of thousands, and you’ll see how it can add up. All of a sudden, the banks no longer want to lend money. They no longer have much money to lend.

So here’s how this could affect people. Let’s talk about three things: assets, jobs, and credit, though they might not necessarily fall in that order.

1. There are two major assets in this crisis that are being affected on a large scale: stocks and real estate. Not everyone owns stocks, but most people live in a place that they either rent or own. If the housing selloff continues, people who own will lose lots of money when they sell their house for much less than they bought it for. People who rent could be forced to move if their owners default on the mortgage or try to sell their investment properties before housing collapses.

2. Jobs: In the beginning, the job fallout took place among those who were involved with real estate: mortgage lenders, realtors, construction people, interior decorators, hardware stores, builders, contractors, escrow agents, insurance salespeople, appraisers, inspectors, painters, etc. Now it’s affecting people in banks–these consolidations (Wachovia/Citi;Merrill/BofA) will result in layoffs. Fewer jobs mean fewer purchases which means that the slump could extend to other industries…Circuit City, for example, which sells electronics, just posted a big loss today. This could result in a slowdown in consumer electronics. Fewer jobs mean more people will be leaving the middle class, which could have influences on violent crime rates, illegal activities, etc.

3. Credit: If the banks want to hold on to their cash, it’ll be harder for people to get loans–for homebuying, college, automobiles, and starting new businesses, which means that we might all have to apply for work at Google or Microsoft.

So this is just some of what could happen. It’s not comprehensive, and it’s possible that things could change, but much of this has already started.

#8

awong

1:28 pm | Sep 30, 2008

and yet I still wonder why the fools in the county commission in my area still like to approve housing development after development and now all there are, are empty lots, etc instead of fullfilling county needs such as new schools.

#9

nottyboy

4:23 pm | Sep 30, 2008

From a link on the Rainbow Tribe on Delphiforums, Michael Moore’s 2 cents:

“Everyone said the bill would pass. The masters of the universe were already making celebratory dinner reservations at Manhattan’s finest restaurants. Personal shoppers in Dallas and Atlanta were dispatched to do the early Christmas gifting. Mad Men of Chicago and Miami were popping corks and toasting each other long before the morning latte run.

But what they didn’t know was that hundreds of thousands of Americans woke up yesterday morning and decided it was time for revolt. The politicians never saw it coming. Millions of phone calls and emails hit Congress so hard it was as if Marshall Dillon, Elliot Ness and Dog the Bounty Hunter had descended on D.C. to stop the looting and arrest the thieves.

The Corporate Crime of the Century was halted by a vote of 228 to 205. It was rare and historic; no one could remember a time when a bill supported by the president and the leadership of both parties went down in defeat. That just never happens.

A lot of people are wondering why the right wing of the Republican Party joined with the left wing of the Democratic Party in voting down the thievery. Forty percent of Democrats and two-thirds of Republicans voted against the bill.

Here’s what happened: http://www.michaelmoore.com/words/message/index.php?id=236“

#10

Dialectic

2:38 am | Oct 01, 2008

Nice summary, Jaehwan.

To say a little more on his 3rd point, Xian, the main reason everyone is scared and using words like “economic collapse” is due to the lack of credit. World markets, particularly well-developed Western ones, run on credit: you build buildings, invest in companies, purchase inventory, buy houses and cars, go to school, even lend money, all on borrowed money. Without credit, many economic processes just stop.

As Jaehwan says, no one wants to lend money now because everyone is taking massive losses: it turns out that a lot of promises to pay, which is what debt is, and which you count as an asset, are being broken, and everyone is a lot poorer than they thought.

Also, a brief note on why this happened in the first place. Companies can sell debt like assets: you loan a guy money, he gives you a promise to pay (with interest), and you can now sell that debt, or a piece of it, to someone else (for a fee), who will then receive the debtor’s re-payments and interest instead. A principle of investing in anything is diversification: you want to have a lot of different assets so as not to put all your eggs in one basket, and you therefore “diversify” your risk away. This, too, applies to debt: you want to buy lots of different debts, and maybe “package” them with other assets to minimize and control your risk.

So there’s a big market for debt; there are a few reasons a lot of bad debts, or basically shitty loans, got into the system:

1. The U.S. is the least regulated of the Western economies. You guys are like cowboys on the frontier, and your banks have the least restrictions with regard to their lending practices. This is why the U.S. has been hit worse than Canada or Europe.

2. Banks make fees by selling debt, and big insurance companies (like Fannie, Freddie, and AIG) insure that debt in case of default, giving banks a massive incentive to create and re-package as much debt as possible. (This is why insurance companies are being wiped out along with banks.)

3. Financial markets (and derivatives products, which are products which “derive” their value from some other asset, like an option to buy a stock at a certain price) are really, really complex, and almost nobody had much of an idea of who was actually assuming the risk which everyone was creating, re-packaging, and selling. This is why people were referring to financial “clouds” for a time, because nobody knew where the fuck the risk went. (A few people did see this coming 2-3 years ago, because as Jaehwan said, it comes down to fundamentals, and banks were making shitty, shitty loans. But the American spirit is composed of an unbridled optimism and the faith that you can always make more from less - which is what profit is - and that there will always be more. Also, having Bush’s very ideological Republicans in charge for 2 terms didn’t help.)

#11

Xian

8:02 am | Oct 01, 2008

I guess my question is:
The size of our economy was just illusionary, so wouldn’t any measure to preserve the status quo merely be attempting to prop up that smoke and those mirrors?

The biggest problem I’ve seen for the last couple of decades is that as we’ve fabricated fake money, costs have gone way up for human rights commodities–higher education, food, transportation, housing.

Why not just put the money into making sure people don’t starve to death during this rough patch, pass regulations and reforms so we don’t do this again, and just weather the economic contraction?

#12

minbo

11:53 am | Oct 01, 2008

I do have significant (to me at least, though a pittance to many) “savings” in mutual funds via my 401k and I also own my own place so take this for what you will…

I for one am not totally behind the “bailout”. I do realize that without some government intervention the US is headed for very very hard times financially. Even so, I do not know enough about the bailout plan to decide if the short term harm of a financial collapse will be greater or lesser than the long term harm of the bailout - it all depends on how it is negotiated and structured.

As to the root cause, I have a slightly different summary than Jaehwan.

Initial infection:
Economists always plan their theoretical models with the assumption that participants in the economy are “rational actors”. Starting in the Clinton presidency, and continued in the Bush presidency, there has been a push for greater deregulation. This deregulation created an environment where greed had the opportunity to override rationality. The regulatory opportunity however was not sufficient to create this mess.

The additional ingredient needed for our current financial crisis was the massive redistribution of wealth and reduced tax burden on the wealthy. The redistribution of wealth from the larger population into a much smaller population created a situation where the wealthy few looked to invest their money to make more money, and the easy way to do so is via loans. This over supply of money seeking to be loaned is why “sub prime” mortgages blossomed - the mortgage companies would never have expanded their products into that market if they did not have the easy access to money to do so.

In the era of easy loans, the mortgage companies did three bad bad things.

1) They provided “sub prime” loans. These were mortgages given to people who by the mortgage company’s own standards were not truly credit worthy. Sometimes, they gave mortgages to people who overstated their income to be able to buy more expensive homes. Other times they gave loans to people who were speculating and buying many properties, but did not have the income to really sustain the 10 mortgages without selling a house a month.

2) They relaxed due diligence in evaluating the value of homes. Mortgage brokers and real estate agents work on a commission based upon size of mortgage. Sellers want to value their homes as high as possible. Buyers want a valuable property. Without due diligence by the mortgage companies, houses were “valued” and given mortgages greater than their “real value”.

3) Even with the expansion of the mortgage market above, mortgage companies still had excess money to throw around. The next field they pursued was to convince people to refinance their mortgages. They convinced people who were in good standing to re-finance their mortgages by convincing them to go into greater debt - to take out larger mortgages to “realize” some of the gains in value to their house and have cash in hand for whatever. To allow people to afford their new mortgage, they convinced them that they should take adjustable rate mortgages, which were initially low. They sometimes also violated HUD guidelines by not fully explaining what the potential payments could be should the interest rates grow, such as to the poor retirees who were not having a problem for the past 20 years of their life with their old mortgage.

The incubation period:
Now you may ask, how did these companies run this by their finance people and have everyone say how wonderful and smart they were for finding new markets to expand into? Well they took all these “bad loans” and bundled them up. If you have one thousand sub prime mortgages for houses which makes payments of $3,000 a month, the projected cash flow would be $3,000,000. Of course since they were sub-prime, there has to be some consideration of people who miss a payment or people who default on their loans. But project that number to be something like 5% over the life of the security, it seems to be a manageable risk, besides, that is why as a pool they get a higher interest rate, so the 5% loss is covered by everyone else in the pool that does not default. All of a sudden, instead of a pile of bad loans, you have a credible “Mortgage backed security”. What is the value of this security? Simply whatever someone is willing to pay for it. that’s right, there is no “intrinsic value” that the security can be redeemed against. This is not to say that mortgage backed securities are bad, they have been used in the US for over 30 years. The difference between the old mortgage backed securities and the new ones is that the old ones were made with more rigorous standards, and the default or delinquency rates were well understood, something like 3% if I recall. This is what Fannie Mae and Freddie Mac were chartered to do.

Systemic invasion:

So, what do you do with a stack of newly varnished “mortgage backed securities”? Well, you get them off of your books and sell them to other investors. Like large trading companies or banks. After all, with a known value these can be considered assets. Assets with which to take loans out on. Some companies, like Bear Sterns, can say “I have 300 billion in mortgage backed securities. I’ll put them up for collateral if you will loan me 3 trillion dollars that I will repay tomorrow or next week”. Then those companies take the 3 trillion dollars and play on the stock market, in forex, etc, make a shitload of money, repay their loans and borrow some more money to repeat the next day/week. If all of a sudden, tomorrow the assets claimed was worth 3 billion to secure a loan of 3 trillion suddenly are worth 1 billion, then the lonee would need to come up with another 2 billion to secure the loan or repay the loan. Even if they are worth trillions of dollars, if they do not have the cash that instant, they are insolvent and would have to declare bankruptcy.

Retail banks also buy these securities. They keep them in their vaults and use them also as assets/collateral. But instead of taking loans on them, they use them to maintain a minimum level of assets to deposits. If all their retail customers (like you and I), have deposited one trillion dollars into their coffers, federal regulation says that they have to secure it with some percentage in assets, and have another percentage available in cash to cover withdrawals. If their mortgage backed securities decrease in value, they no longer have the minimum level of assets needed, and then either need to find a way to increase their assets, or they are taken over by the government.

However, when buying and selling these “mortgage backed securities”, since as was mentioned, there is no intrinsic value to the securities, some purchasers may not have been entirely convinced that the securities were worth what the sellers were saying that they were. The seller says that the mortgage backed security will pay 3 million dollars a month, the buyer might turn to a third party and buy a credit default swap, or a credit derivative. The buyer might agree to give the third party some rate equaling 2% of the value over the life of the contract, in return, the third party guarantees that if the seller of the security defaults and does not pay the monthly agreed amount, that the third party will pay out. This is what many companies do to “hedge” their risks. AIG was a big third party gaurrentor. Since these are “contracts” and not considered insurance (walk like a duck, quack like a duck….) they are completely unregulated. Nobody outside the people directly involved in any specific contract knows who has contracts nor does anyone know the total amount of outstanding contracts there are floating around in the world. If the third party fails, then all the assets that they “guaranteed” are suddenly at much greater risk of default, and thus suddenly plummet in value.

The crunch:
When the economy was humming along, everything was fine. Then all of a sudden, the FED had to raise interest rates to prevent inflation. The increase of rates slowed the housing market.This caused the land speculators who relied on buying and flipping properties to start defaulting because without selling properties regularly, they did not have the income to pay all their mortgages This also caused the adjustable rate morgages to skyrocket, which then caused caused a lot of people in category 3 to start defaulting. When the housing market slows, sometimes prices decreases also. combined with the downward pressure on the housing market from people defaulting and their houses going on the market, a lot of people in category 2 were now “underwater”. They owed more on their mortgage than their house was worth. If they did not care about a bankruptcy, then there was/is incredible financial incentive to “walk away” from the loan and let the mortgage default.

so, when the new markets systemically start to default at higher rates than expected, the mortgage backed securities start to fail. Mortgage backed securities become “toxic”. No one wants to buy it at 95 cents on the dollar, perhaps 30 cents on the dollar. People holding these mortgage backed securities now have lower assets and their collateral securing loans is no longer sufficient. The CDS third parties now have to start paying out.

#13

jaehwan

2:07 pm | Oct 01, 2008

Thanks, everyone! Lots of stuff to talk about.

I agree 100% with D calling us cowboys and saying we have little regulation. It’s scary because even after all this, McSame still supports deregulation. If you watch the debate, he was dancing around that question. With Palin, the deregulation question was actually the funniest part of her Couric interview. Check out the last few minutes of this video; I blogged about it on my personal blog here.

I agree for the most part with minbo up until the “crunch”. I think that there was irrational exuberance and economic fundamentals that would have created a slowdown regardless of whether the Fed raised rates. Think about Las Vegas for example–a house costs $200k one year and skyrockets to $400k the next. Not only did the ridiculous appreciation create doubt in the mind of some buyers, but a lot of people simply weren’t able to afford such houses anymore, even with 60% debt-to-income ratios. The slowdown had to happen. When investors see a slower rate of appreciation, they question the numbers. And when they get jittery, they pull out. And when they pull out, there’s no more money to lend.

And yes, the high default rates helped the implosion, but had housing prices continued to rise at the same rates, it’s quite possible that the defaults would not have hurt the investors quite as badly. The problem again is fundamentals–you can’t expect $300k houses to rise to $600k in a year’s time when everyone in the neighborhood only makes $50k.

One excellent point that Minbo brings up is the question of valuation: what is an asset worth? It’s a question that no one really knows the answer to. Having been through two economic crises, first the tech crash and then this housing crisis, I can attest to the fact that many people think the going is good when the economy is booming, whether the boom is based on fact or fiction. We all really thought Cisco stock was worth what it was at $300 or whatever it was at; we all really thought that housing would continue to rise. We were wrong because we didn’t pay attention to the fundamentals.

So to answer xian’s question about starving people, here is my opinion–and it’s only just an opinion, so like minbo, please take it for what it’s worth:

We live in a capitalist society, which means that the private sector is the engine of growth. Companies, in general, provide wages for people to eat, and companies provide employment. The main goal of the bailout right now needs to be to restore faith in this capitalist system, otherwise people will be out of work–in general, the American government doesn’t provide jobs or have the revenue necessary to feed people in the long term.

What this means is that the $700 billion or however much is necessary needs to be directed towards companies. As D mentions, our society is built on credit; credit for starting companies, credit for investing in infrastructure, etc. It also needs to help homeowners too since workers staff companies. I think the idea is correct, but we’re going to need a lot of really smart people working on real solutions to this mess.

#14

minbo

3:13 pm | Oct 01, 2008

Oh, sorry, the housing market was most certainly in a bubble, and the mortgage backed securities and credit derivatives were a precarious house of cards waiting to fall. It would have happened sooner or later for any number of reason, especially people realizing that it’s a ponzi scheme and deciding to get out.

The fact that I think that the nudge that toppled everything was something as banal and predictable as rising interest rates shows how I think that everyone involved with any knowledge of finance was incredibly financially delinquent.

#15

jaehwan

8:46 pm | Oct 01, 2008

Well nobody really knows exactly what happened or what needs to be done, which is why we’ve got all these smart people debating it. I’m curious as to what the people in Washington are going to come up with. I guess we’ll know more tonight!

#16

hyhy

10:57 pm | Oct 01, 2008

Hey, here is my short three paragraph take on what happened.

There are only really two ways to control risk in a mathematical sense: diversification and insurance. Wall St. for the past two decades engineered insurance products to hedge against high risk investments. Insurance has the effect of dramatically lowering risk for any individual who participates, but it also makes participants more dependent on one another. So any individual firm’s risk function also dependens on others and on the system as a whole. However, the total systemic risk doesn’t go down. Risk is just spread around.

When more people participate in the insurance fund, the individual risk goes down further (ex. universal healthcare). The system got a lot people to participate in 401Ks and IRAs, and got foreign entities to particpate as well (Fannie and Freddie). This diluted the risk on the individual level even further. Wall St, being a bunch of alpha dogs, tried to out-alpha one another by taking more risk. More individual risk = more individual reward.

However, this led to a dramatic run up in systemic risk and the system couldn’t take it anymore. This is similar to the Prisoner’s Dilemma, where micro, individual incentives can turn into marco, collectivist dis-incentives.

#17

jaehwan

12:31 pm | Oct 02, 2008

hyhy:

You can also control risk by not taking so much. A 65% debt-to-income ratio makes little sense, as does creating products that expect a 20% default rate. (and I know for a fact that these existed from people I knew who worked for a subprime company.)

Just saw this: it’s already affecting small businesses, in areas as diverse as medical supplies. It’s affecting colleges too.