Saturday, February 28, 2009

The real reason we're in such trouble

Everyone mostly blames the downfall of real estate for the economic crisis we face these days. And while that surely has contributed to the problems banks face today, it would not be nearly as bad if the derivatives market had been regulated at all. But it wasn't. And AIG was/is at the center of the whole mess.

AIG is about to post an even bigger loss than before and come to the troth for government funds again. And there is little reason to think the government will not help out still more. Why? Because the government knows that letting AIG fail is basicly spreading banruptcy to probably every major bank in the world, let alone other countries as well.

I am re-printing this article by Joe Nocera of the New York Times because posting a link may require you to join . I feel this is a mandatory read for anybody trying to understand the heart of the problems we face.

*************************************************************

Next week, perhaps as early as Monday, the American International Group is going to report the largest quarterly loss in history. Rumors suggest it will be around $60 billion, which will affirm, yet again, A.I.G.’s sorry status as the most crippled of all the nation’s wounded financial institutions. The recent quarterly losses suffered by Merrill Lynch and Citigroup — “only” $15.4 billion and $8.3 billion, respectively — pale by comparison.

At the same time A.I.G. reveals its loss, the federal government is also likely to announce — yet again! — a new plan to save A.I.G., the third since September. So far the government has thrown $150 billion at the company, in loans, investments and equity injections, to keep it afloat. It has softened the terms it set for the original $85 billion loan it made back in September. To ease the pressure even more, the Federal Reserve actually runs a facility that buys toxic assets that A.I.G. had insured. A.I.G. effectively has been nationalized, with the government owning a hair under 80 percent of the stock. Not that it’s worth very much; A.I.G. shares closed Friday at 42 cents.

Donn Vickrey, who runs the independent research firm Gradient Analytics, predicts that A.I.G. is going to cost taxpayers at least $100 billion more before it finally stabilizes, by which time the company will almost surely have been broken into pieces, with the government owning large chunks of it. A quarter of a trillion dollars, if it comes to that, is an astounding amount of money to hand over to one company to prevent it from going bust. Yet the government feels it has no choice: because of A.I.G.’s dubious business practices during the housing bubble it pretty much has the world’s financial system by the throat.

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

I don’t doubt this bit of conventional wisdom; after the calamity that followed the fall of Lehman Brothers, which was far less enmeshed in the global financial system than A.I.G., who would dare allow the world’s biggest insurer to fail? Who would want to take that risk? But that doesn’t mean we should feel resigned about what is happening at A.I.G. In fact, we should be furious. More than even Citi or Merrill, A.I.G. is ground zero for the practices that led the financial system to ruin.

“They were the worst of them all,” said Frank Partnoy, a law professor at the University of San Diego and a derivatives expert. Mr. Vickrey of Gradient Analytics said, “It was extreme hubris, fueled by greed.” Other firms used many of the same shady techniques as A.I.G., but none did them on such a broad scale and with such utter recklessness. And yet — and this is the part that should make your blood boil — the company is being kept alive precisely because it behaved so badly.


When you start asking around about how A.I.G. made money during the housing bubble, you hear the same two phrases again and again: “regulatory arbitrage” and “ratings arbitrage.” The word “arbitrage” usually means taking advantage of a price differential between two securities — a bond and stock of the same company, for instance — that are related in some way. When the word is used to describe A.I.G.’s actions, however, it means something entirely different. It means taking advantage of a loophole in the rules. A less polite but perhaps more accurate term would be “scam.”

As a huge multinational insurance company, with a storied history and a reputation for being extremely well run, A.I.G. had one of the most precious prizes in all of business: an AAA rating, held by no more than a dozen or so companies in the United States. That meant ratings agencies believed its chance of defaulting was just about zero. It also meant it could borrow more cheaply than other companies with lower ratings.

To be sure, most of A.I.G. operated the way it always had, like a normal, regulated insurance company. (Its insurance divisions remain profitable today.) But one division, its “financial practices” unit in London, was filled with go-go financial wizards who devised new and clever ways of taking advantage of Wall Street’s insatiable appetite for mortgage-backed securities. Unlike many of the Wall Street investment banks, A.I.G. didn’t specialize in pooling subprime mortgages into securities. Instead, it sold credit-default swaps.

These exotic instruments acted as a form of insurance for the securities. In effect, A.I.G. was saying if, by some remote chance (ha!) those mortgage-backed securities suffered losses, the company would be on the hook for the losses. And because A.I.G. had that AAA rating, when it sprinkled its holy water over those mortgage-backed securities, suddenly they had AAA ratings too. That was the ratings arbitrage. “It was a way to exploit the triple A rating,” said Robert J. Arvanitis, a former A.I.G. executive who has since become a leading A.I.G. critic.

Why would Wall Street and the banks go for this? Because it shifted the risk of default from themselves to A.I.G., and the AAA rating made the securities much easier to market. What was in it for A.I.G.? Lucrative fees, naturally. But it also saw the fees as risk-free money; surely it would never have to actually pay up. Like everyone else on Wall Street, A.I.G. operated on the belief that the underlying assets — housing — could only go up in price.

That foolhardy belief, in turn, led A.I.G. to commit several other stupid mistakes. When a company insures against, say, floods or earthquakes, it has to put money in reserve in case a flood happens. That’s why, as a rule, insurance companies are usually overcapitalized, with low debt ratios. But because credit-default swaps were not regulated, and were not even categorized as a traditional insurance product, A.I.G. didn’t have to put anything aside for losses. And it didn’t. Its leverage was more akin to an investment bank than an insurance company. So when housing prices started falling, and losses started piling up, it had no way to pay them off. Not understanding the real risk, the company grievously mispriced it.

Second, in many of its derivative contracts, A.I.G. included a provision that has since come back to haunt it. It agreed to something called “collateral triggers,” meaning that if certain events took place, like a ratings downgrade for either A.I.G. or the securities it was insuring, it would have to put up collateral against those securities. Again, the reasons it agreed to the collateral triggers was pure greed: it could get higher fees by including them. And again, it assumed that the triggers would never actually kick in and the provisions were therefore meaningless. Those collateral triggers have since cost A.I.G. many, many billions of dollars. Or, rather, they’ve cost American taxpayers billions.

The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.


At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labeled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.
There’s more, believe it or not. A.I.G. sold something called 2a-7 puts, which allowed money market funds to invest in risky bonds even though they are supposed to be holding only the safest commercial paper. How could they do this? A.I.G. agreed to buy back the bonds if they went bad. (Incredibly, the Securities and Exchange Commission went along with this.) A.I.G. had a securities lending program, in which it would lend securities to investors, like short-sellers, in return for cash collateral. What did it do with the money it received? Incredibly, it bought mortgage-backed securities. When the firms wanted their collateral back, it had sunk in value, thanks to A.I.G.’s foolish investment strategy. The practice has cost A.I.G. — oops, I mean American taxpayers — billions.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

I asked Mr. Arvanitis, the former A.I.G. executive, if the company viewed what it had done during the bubble as a form of gaming the system. “Oh no,” he said, “they never thought of it as abuse. They thought of themselves as satisfying their customers.”
That’s either a remarkable example of the power of rationalization, or they were lying to themselves, figuring that when the house of cards finally fell, somebody else would have to clean it up.

That would be us, the taxpayers.

Monday, February 23, 2009

The "Fight Club" Solution

One of my favorite bloggers is Rolfe Winkler over at Option Armageddon. He hits the nail on the head time and time again and I appreciate it. Among the many financial blogs I read when I can, his is the one that is the most educational and honest and forthright. This past weekend he mentioned the "Fight Club" Solution. One of my favorite movies, in which two guys plan to blow upthe buildings of all the credit card companies. Actually that is just a side plot, but it is amazingly funny how it relates to the situation we are in today. As Rolfe points out:

Few appear to recognize the depth of the crisis we face. Most still aren’t
prepared to ask the hard, fundamental questions about our economic system.
Anyone who mentions the gold standard, for instance, is treated as a
novelty. Nevermind that fractional reserve banking—or perhaps our central
bankers’ management of it—is the most important contributing factor to the
crisis.

The problem, I think, is that so many of our leaders are tied immovably
to legacy ways of doing business. A man will make himself believe most
anything if his salary depends on it. Lots of salaries are at risk, so
lots of heels are digging themselves in.

Anyway, as I’ve argued for awhile, the only way to “solve” the crisis is to let asset prices fall. And that means the balance sheets on which those assets currently reside need to recognize substantial losses. Call it the “Fight Club” solution*—everyonegoes back to $0. This would be highly painful for ALL Americans. But it would be most painful for those with the most to lose…


The good news is that this will eventually happen. In a way it already has started. Our major world banks are insolvent and it is only a matter of time before our governments are forced to recognize this fact and close them down in their present form. How do I know this and the government doesn't? Good question. I listen to what the markets tell me, and when Citi is under $2 and Bank of America is under $3, that tells me the market is only waiting for certain events to happen (nationalization among them) before dowgrading to zero. But nationalizing the banks, which even some Republicans are beginning to endorse, will not fix the problem. Because then the government would become the bank that won't write down these assets. Which will put the government in trouble instad of the banks. Not good. (Unless you are short the US dollar).

Restoring confidence in the financial system can only be acheived when the financial companies themselves become honest about their activites. Which means admitting their assets can't cover their equity/liabilities. Why why why won't/can't the government and the banks see what we americans can easily see? I used to ask this question every day, but I found my answer even though I secretly (from myself) already knew it: "it would be most painful for those with the most to lose."

The banks and the politicians are the ones with the most to lose.


Friday, February 20, 2009

Weekend of Doom?

The Dow gapped down 200 points on heavy volume this morning and is weakening every minute. Citibank is under $2. The banks are taking a pounding. Is this the reckoning? Are we looking at S&P 500 at 500 by Monday? Is Nationalization upon us? This just feels big.

Funny how all americans seem to know the banks are insolvent, but the markets still value them at even $1. Betcha that won't be the case anymore come Monday...I wonder how many banks will be gone...Citi, BofA, both under $4. That's two Dow components for goodness sake. Wells Fargo under $10. Who am I missing here?

Tuesday, February 17, 2009

Can't get Worse, you say?

YIKES! This from Marketwatch:

"A sixth quarter of negative growth (in the S&P) ties the prior record
set when Harry Truman was president, running from the first quarter of 1951 to
the second quarter of 1952.
“‘Next quarter, we’re expecting a new record of seven quarters of negative growth,’ said an analyst.
“As of the close of business Thursday, [he] calculates S&P earnings per share, on a reported basis, at a loss of $10.44 for the quarter. If financials were taken out of the equation, that deficit would drop to $2.35 a share."


So we are about to witness the first ever amalgamated LOSS for the S&P, according to estimates. Of course 80% of the red ink comes from the Financials. Have I mentioned I am short S&P Financials by way of owning SKF (ProShares Ultra Short S&P Financials)?

And I still see pundits on NBC and Fox (yes I watch both) talk about finding the bottom! The bottom of what? The toilet? I had told friends to look for the S&P to test 600 in this quarter (which hasn't come true yet). But a smarter trader I know has reset his target to 450 based on technical analysis of many charts, and I'd have to say that the Fundamentals now seem to agree with him.

Friday, February 13, 2009

Stimulus and Bank Bailout Won't Work

Spend Spend Spend. These days republicans and Democrats may disagree on the nature of the stimulus, Democrats want jobs and social spending and Republicans want tax cuts, but they both agree that something has to be done now. Even waiting to examine the plan for mistakes is too big a mistake in itself. Obama tells us we need stimulus to avoid disaster. Bush told us the same thing last year. This is an emergency. Nevermind that the first stimulus and the first bailout didn't work. We need action! And Fast! It doesn't matter what caused our problems, spending has always worked in past recessions, so spending is the answer to this recession. Hurry!

But what if this is not a recession? A friend of mine recently told me "nobody I've seen has started calling this a depression yet. things haven gotten THAT bad!" Well I fear that depends on who you ask. It has gotten that bad for more people than you think. And its going to get worse, because spending your way out of debt is non-sense and we all know it. Fundamentally, we all know this can't work.


Here's a chart showing the debt to income of the USA. This doesn't include "off the balance sheet" obligations like Social Security and MedicAid. It also doesn't include the stimulus bill that just passed (which will add another 30%) or the final cost of the actual bank bailout. Our GDP has grown at 3-5% per year, yet the growth in debt has been much faster. It is taking increasingly larger units of debt to fuel the same unit of growth in the economy.

And that is the biggest lie of all. GDP. It is not Gross Domestic Product any more. We are not producing anything, we are consuming it. It is really GDC, or Gross Domestic Consumption that our government is trying to grow. And we all know on a very fundamental level, that once you borrow enough, you have to stop spending, if only because you are forced to by your creditors, who stop extending credit.

What is happening to America today, is we are running into a wall, and the government is pushing us head-first into it by moves like the spending bill that just passed. Supposed to be about creating jobs, infrastructure and tax cuts, it instead has items like a $8 billion for high speed rail lines, $200 million in compensation for WW2 injuries, $2 billion in grants and loans for battery companies, money to build schools in towns who are losing population, an AMT rollback costing $70 billion, and much much more that simply doesn't relate to the task at hand, regardless weather or not they are good programs.

Honestly, instead of giving me $13 back per paycheck, Obama and Congress should be asking us for $26 and sinking it into a better healthcare plan for all the people who are losing their jobs.

Thursday, February 12, 2009

The Geithner/Paulsen plan

I have to admit it. I really hoped and even thought maybe Obama would and could change things. But the new plan to save the banks that Geithner presented on Tuesday is basically the same thing as Bush/Paulsen's plan. No details. Give the banks money. And one more thing, "Transparency." But it is basically just a government-backstopped credit call option available to private investors, that exposes taxpayers to even further losses presuming asset market prices are artificially high.

Why won't the government just let the market determine a value on its own? Yes we know it will not be pretty, but as long as government tries to claim that all these mortgage backed securities are worth what people paid for them, this sinkhole will just get bigger and bigger. Printing money only leads to inflation. And at the rate Geithner is accelerating matters (this plan will cost $2 Trillion after Paulsen's failed $700 billion plan), we are looking at some serious hyper-inflation.

The problem is nobody is sure who is solvent and who is not. Can GM survve? Starbucks? Citibank? Your neighbor? When the governmentjust props them all up and won't let any of them fail, then nobody is going to loan anybody any money. Which means no new buildings, no new business to pick up where things are falling. No new jobs to help those in need pay for their rent. And eventually no food on the shelves of the local grocery store. And not enough money to buy what is on the shelf.

I know it is hard to believe that is where we are headed. Take a trip to Best Buy and it all looks the same as two years ago. And inflation? I must be crazy. Have you seen the price of a car lately? Or gasoline? I know I know. Prices are going dOWNN. And for now they are. But believe me, our government's policies are taking us down a dangerous road. Much more dangerous than the also painful road of raising taxes, raising interest rates, and letting banks fail or even nationalizing them. No self respecting Republican or Democrat seems to agree with me (except Ron Paul)

Obama says we need bold moves, but is not delivering them.

Here is Goldman Sachs' research department on the "new" Geithner plan:

KEY POINTS:
1. As expected, the Treasury's financial rescue plan will work within the constraints of existing TARP funding (of which about $350bn remains), attempting to catalyze private sector funds to purchase bad assets and restart the securitization process. However, the speech and accompanying fact sheet leave open many questions about the timing of these interventions and the terms of asset purchases and recapitalization. Much of the program clearly remains to be worked out over the coming weeks and months.
2. Bank stress test. A key feature of the program will be a "stress test" for all banks with assets >$100bn. This will be used to determine which banks need to be recapitalized, or shut down. However, details on the exact nature of the stress test are scant. The Treasury will make additional TARP funds available to purchase convertible preferred shares that will be converted to common "if needed to preserve lending in a worse-than-expected economic environment."
3. Public/private bad bank. Rather than a fully government-funded bad bank, the Treasury will attempt to catalyze private sector investment via a "public-private partnership." This will start at “up to” $500 bn in size, and potentially expand to $1 trn. It is clear from Geithner's remarks that this is a concept at this point, rather than a fully designed entity -- Geithner mentioned getting public comment on the potential structure. Supposedly, private sector investors will determine the prices (perhaps with the benefit of cheap financing or partial loss protection from the government).
4. TALF expansion. As leaked repeatedly prior to the speech, the Fed's Term Asset-Backed Securities Lending Facility will be scaled up by a factor of five to $1 trillion and expand to backing CMBS and possibly RMBS. The goal here is to restart securitizations and thereby expand the flow of new lending (this is not an approach to deal with bad assets). While potentially an innovative approach to restarting securitization, it remains to be seen how effective this program will be. The Treasury's commitment to this would be $100bn rather than the $20bn currently earmarked and would be drawn from the $350bn remaining in TARP.
5. Transparency and accountability provisions. Not many surprises here, though it bears emphasis that the provisions apply to new extensions of aid rather than to those already supplied. Institutions that accept new help will be required to pay only $0.01 per quarter in dividends, refrain from purchasing shares and from pursuing new acquisitions. Geithner also outlines a number of additional reporting requirements intended to keep the pressure on institutions to make new loans.

Monday, February 9, 2009

The Crux of the Matter

Reading about the possible solutions Tim Geithner is going to announce on Tuesday just drives me crazy. Why can't these educated economists see the truth like foolish little me? They are making the exact same choices that our leaders made in 1928-1936 which fueled our last Great Depression for more than twelve years.

Here is the rub. Take for example that 1200 sq ft Miami condo that sold for $1 million in 2005. Its owner could not pay the accelerated monthly payment that his/her ARM charged, and he could not sell it for even $500k. So now he/she has defaulted and walked away, leaving the bank with an "asset" which is worth $1 million on its books, but is really not worth half that. It may not even be worth 1/10th its original price. So if the bank has to write down that asset to 10 cents on the dollar, it would have to take a massive loss for which it doesn't have the equity to cover, thus ending in bankrupcy.

Of course in the case of BofA, Citi, Chase, Wells Fargo and others, we are not talking just $1 million, but hundreds of billions in write downs. Easily more money than they booked in "profits" the past 10 or so years combined! And leverage is the culprit. Not only are our banks leveraged to the abyss but so is our Federal Government.

So Geithner/Obama have been looking at ideas to keep the bad assets off the books of the banks and give them a free ride for taking failed risks. Thinking this will save the economy. We've already tried TARP, which originally was Paulsen's plan to flat out purchase the toxic assets with taxpayers money. Were they going to pay $1 million for that Miami condo? or $800k? or $600k? It doesn't matter because what they did is just hand them some of the money and purchase preferred shares in the banks (overpaying in the process) which did not help the value of those assets go up at all. So TARP 2 doesn't look like it will work to Geithner, so they have floated arount the idea of a bad bank, or using Taxpayer money again to buy up the assets (again at what price?) and put them in a bank created to hold these assets until the value returns. The only fair price for that condo in Miami is $100k, but that would force the banks to book that income at a 90% loss. Something their balance sheet can't handle. That would cause instant bankrupcy.

Then the idea was to "insure" the value of the assets. The banks would pay the government an insurance premium against the value of those assets falling further in value. But that would mean the USA would have to hand over a million dollars for that Miami condo when it finally does sell for $100k.

You see Geithner has to make up something so complicated as to fool the American people and congressmen into believing they are not on the hook for the whole risk taken on the asset to begin with. The crux of the matter is there is only one answer and those in power, weather you argue it is the politicians or Wall Street, are trying everything they can to avoid that answer. What is the answer? Tell the truth! Admit that the Miami condo is worth only $100k. Admit the assets on your balance sheet are worth a fraction of what you say they are worth! Go Bankrupt and wipe out sharehoder value completely and force your creditors to accept the loss of their risk too. Start over from scratch! It is the only answer.

Anything else only makes things much much much much worse.

So the question of the day is what price to pay? Almost any price over 10 cents on the dollar may be too much for that condo in Miami, yet that is what Geithner and Obama are going try to force taxpayers to do. Pay more than they are worth and take the bath for the bankers. Don't they realize that is a recipe for riots?

The numbers I am talking about are real, not because 90% of loans are bad. No it is true that most mortgages and car loans and such out there are pretty good. But when you consider that the most of the big banks' assets are in the form of mortgage backed securities, credit default swaps, and collateralized debt obligations, and that these instruments actually ratchet up the leverage tenfold because they are not regulated, these derivatives will be considered the thing that brought our economy (and way of life it will turn out) to its knees.

Thursday, February 5, 2009

Real Estate Bubble

As I contemplate the economic turmoil we are all only just beginning to experience, I always try to wrap my brain around how it happened. I want to figure it out. How could it get so bad that the pundits now talk about avoiding a depression (which means we are already in one)? I've written some about the mortgage business and about debt and money creation, so now I want to turn to the Real Estate bubble that so many news stories refer to.

I recall , over the years, driving through many towns or cities, including the one I live in, and marveling not just at how many new houses could continually get thrown up (pun intended), but also at how expensive they seemed. On a trip to Washington DC I saw 900 square foot townhomes for $400,000! Even 2500 square foot homes in Dallas asking for the same price seemed steep. I read about $1 million condos (900 sq ft again) in Miami. 40 year old homes in LA that cost $600,000. Of course all they sold. And sold. And sold. How could so may people afford all these expensive homes, I kept asking myself. Then I had to buy my own home and I found out how. I was offered loans that allowed me to pay only $400 per month (with fine print stating that could and would change of course). I opted for a more traditional fixed rate, but at least I knew how all these people could keep buying all these expensive houses. I also figured it wouldn't last forever.

And I also know why there are so many foreclosures today too. Those Option ARMs and alt-A loans are kicking in to higher payments and worse, at a time when many people are losing their jobs. So how did all this happen. Is it just chance you may ask (like I did)?

Here is how it happened.

All the demand for homes (and cars and TV's and stuff too) was created out of thin air by the banks and government who encouraged lending to a larger and larger spectrum of people, using tools like the ARMs and Alt-As and even credit cards to get the demand cranking. With everybody in on the action and buying and flipping homes left and right, demand kept sending prices and values up. And it seemed perpetual. Hairdressers became real estate speculators. Profits were made flipping houses. Additional loans were taken out on the increased equity and spent on other things like cars and TV's and additions to the house. Which paid salaries to people who took out still more loans on homes and it was just a big neverending party!

Of course, every party has to end. And clean up is never fun. But what if every time the party seemed to end we just bought more beer and turned the music up? What if every time we seemed to go into recession, the government just stepped in with more tax breaks and "stimulus" spending and borrowed to do it? Well the party would seem to go on because everybody loves beer and music and free money from the government, don't they? So everyone would continue to hang around and buy more TV's and houses and listen tothe music and drink more beer. Would the party ever end?

Of course it would. You can avoid a hangover can you? And you can't avoid a recession either. Just like a hangover, if you treat it with more beer and loud music it only gets worse and worse and worse. Until CRASH!

Tuesday, February 3, 2009

How money works today

Our economy is based on fractional reserve banking. Long before fractional reserve banking, savers, looking for a safe place to keep their money, deposited it with a goldsmith or other businessman and would receive a note for the deposit. Eventually these notes became a medium of exchange or as money (i.e. they were used to purchase items instead of using the actual gold on deposit). Also, these notes were never redeemed all at once, so the businessmen started to loan the deposits out to other people, collecting interest as profit. Further, they would loan the deposit out many times over. If one in ten loans defaulted, they could cover that loss with the interest collected from the other nine loans given out. All the while, they still only had one deposit to cover the ten loans given out. Eventually these businessmen became known as bankers. And fractional reserve banking was born.



This is one way money is actually created in our society. Your $100,000 deposited at the bank is lent out to multitudes of people. All those people suddenly have (and spend) money that didn't exist before your deposit. And the businesses that receive this lent out money in exchange for goods and services, book it as actual money. The number of $100,000 loans the bank hands out based on your deposit is called leverage. And today many of our banks are "officially" (on the balance sheet) leveraged 30 to 50 time over. Unofficially, or off the balance sheet, they are leveraged 100+ times over. At lease Chase, BofA and Citi are.



Now all of this has worked wonderfully for so long because of the math. If I am a bank and I loan out $2 million based on your $100,000 deposit (20 to 1 leverage) in ten year terms at 7% annual compounded interest, I will make $1.4 million in profit. If three of my 20 loans default, that will only cost me $300,000. Add to that the original deposit and I still profit by $1 million. In fact I could cover the default of 13 of the 20 loans without suffering the loss of the original deposit. And even if I did have 13 defaults, I would still own the property purchased with that loaned out money. Which (as long as there are buyers of land) will still net me a profit. Really wonderful since historically, even the riskiest loans (made to people with a questionable credit history) have not defaulted at even close to a 65% rate. Of course the riskier the loan, the more you charge in interest to mitigate the amount of profit with the expected loan default rate.



Naturally it costs more than nothing to run my bank over ten years, so to cover the salaried employees, the building costs, etc. I would need to have a lower default rate, charge more interest, increase my leverage, or some combination of the three. And if I pay myself handomely today with all that profit I expect to earn tomorrow, but that profit doesn't materialize, I could be in trouble and may have to ask the government for assistance.



Now this is a simplified explanation of how it all works, but I don't think the complicated explanation is even necessary to help understand the trouble we find ourselves in today.



Our banks today book those loans as assets and value them at the amount loaned out plus the interest they will collect. (of course they "write down" the value as the defaults increast, too)Then they resell those loans to other banks and brokerages who then package them into collateralized debt obligations (CDO's) and in turn re-sell them to retirement funds, pension funds, 401k funds, municipalities, state treasuries, and anybody who is willing to buy them. And of course these "investments" are rated by credit rating agencies so the investor can know how safe or risky the investment is compared to other investments. So essentially everybody is loaning money from their savings (weather deposited at a bank or invested in a debt fund) to everybody to buy homes and cars and TV's. And as long as there are buyers for all this stuff, everyone is happy because the value of the loans is equal to or less than the value of the assets they represent.



Our banks and investment houses today have also been buying (and selling for that matter) "insurance" against massive default of these loans by purchasing credit default swaps (CDS's) from other companies. They will pay a fee to a company, who will in turn pay down the debt obligation if the default rate exceeds a certain threshold. But these companies who sell the swaps (including both insurance companies like AIG and investment banks like Bear Stearns) don't want them to be called insurance because insurance is a regulated (by the government) industry. Being regulated would mean they would have to hold x dollars in reserve to pay out claims. Which would mean less mean less money available for houses boats and TV's. So these tools were called "swaps" to get around this issue. And our government has been inclined to de-regulate financial markets the past twenty or more years anyway. So the companies who sold "swaps" were not keeping really any money in reserve in case of massive default rates on these debt obligations.



Which leads us to where we are now. There is alot more to why our economy has no hope of recovery. And much of it has to do with the steps the government is taking to avert "recession." But that is for another day. More to come.