World financial meltdown

[Bill Peckham]

It has been a historic week (that's what people I believe tell me) but I am not sure what happened. As near as I can tell the financial tools - especially how mortgage loans get broken into their constituent pieces (revenue, risk) repackaged and resold - got to the point where really no one knows what they are worth. Yet all these financial instruments could be used as collateral, were recognized as assets.

Everything in the credit market revolves around the value of assets. Now with the value of these financial instruments in doubt all asset values are suffering. I think fundamentally asset prices effect one another but in this case the value of many investment funds was directly tied to the value of these financial instruments. After yesterday's meeting between in DC between the Legislative and Executive branches and the federally chartered Federal Reserve Board it seems the fear is that without action money market accounts could be at risk of loosing principal value.

Money market accounts are considered (by investors) as very safe and conservative investments. You get a low return but you feel like there is no chance you will loose what you put in. That was the cliff we were headed over - they call it "breaking the buck" going below what people put in. That would have had huge economic costs. If you're money market account dollar was now worth 95, 85, 75 cents it would be a huge problem.

To avoid this the US government is talking about 500 Billion dollar fixes. Now in theory if the US government buys all these troubled financial instruments they could turn out to have value - even their supposed value. If somehow people could pay their mortgages next year and stay in their homes it would be very helpful but that is looking less and less likely, at least to me. I think baring some miracle this is going to end up being a trillion dollar expense.

On the bright side, we (all US taxpayers) now have a soccer team. We are the principal sponsors of Manchester United because we bought AIG and they've been ManU's primary corporate sponsor. http://www.manutd.com/

UPDATE
The price tag is now reckoned to be $700 billion http://www.cbc.ca/world/story/2008/09/20/bailout.html
This is on top of the $600 already pledged in the last year for the other assorted bailouts e.g. AIG, Fanny, Freddy.

[Zach]

Are you Rapture Ready?
 

[monrein]

Call me crazy, but lack of regulation combined with human greed can never lead to good things.  I can't remember who said this but it struck me as rather wise, "Self-regulation is to regulation what self-importance is to importance."

Money market accounts breaking the buck is frightening indeed because no one, but no one, ever considered them "risky" investments.   

The sub-prime fiasco from my Canadian vantage point seems like the predictable result of the greedy (financial institutions and/or mortgage brokers) hoodwinking the naive, foolhardy or just plain dumb into buying property they simply could not afford. 

[Joe Paul]

Are you Rapture Ready?
 

There is no "Rapture" but that is another conversation 

[Bill Peckham]

Call me crazy, but lack of regulation combined with human greed can never lead to good things.  I can't remember who said this but it struck me as rather wise, "Self-regulation is to regulation what self-importance is to importance."

Money market accounts breaking the buck is frightening indeed because no one, but no one, ever considered them "risky" investments.   

The sub-prime fiasco from my Canadian vantage point seems like the predictable result of the greedy (financial institutions and/or mortgage brokers) hoodwinking the naive, foolhardy or just plain dumb into buying property they simply could not afford. 

Most of these financial instruments have their uses and people are free to loose their money but in this case these "too big to fail" companies lost track of what they owned. Now the too big to fail US has to be accommodated by world markets.

I wonder if the size of the market and/or the size of the company should be the determining factor in who gets regulated. If "X" grows so big and successful that the US economy can't let it fail then "X" should be subjected to higher levels of regulation. If the US government is going to back money market fund accounts (which seems like a good idea - the Certificate of Deposits are already federally insured) then they need to be regulated more along the lines of banks (which seem to be in better shape).

More regulation means that every last economic efficiency isn't captured. But I think there needs to be broad categories of investment markets that are safer even if it means being less efficient. Housing is one of those markets. The housing market is simply too big and too important to be left in the care market forces. Short selling has its place but the housing and mutual fund markets need to be much more conservatively run/regulated.

And to the extent that we - the US economy - is too big to fail then we have an obligation to make sure that we are transparently run according to conservative accounting standards. We have not been doing this. It would require more regulation, a sacrifice of some economic efficiency, but it would be the right way to run things.

[Ang]

Call me crazy, but lack of regulation combined with human greed can never lead to good things.  I can't remember who said this but it struck me as rather wise, "Self-regulation is to regulation what self-importance is to importance."

Money market accounts breaking the buck is frightening indeed because no one, but no one, ever considered them "risky" investments.   

The sub-prime fiasco from my Canadian vantage point seems like the predictable result of the greedy (financial institutions and/or mortgage brokers) hoodwinking the naive, foolhardy or just plain dumb into buying property they simply could not afford. 

and  who  said  monrein  was  just  a  pretty  face 
could'nt  of  said  it  any  better,cause  i'm  not   that  intelligent

[jbeany]

Are you Rapture Ready?
 

More like "Are you Depression ready?"

Isn't my Depression-baby Grandma gonna gloat when we're all too broke to buy t-paper and the 50 years worth of catalogs she's hoarding in her basement suddenly become useful again. . . .

[Bill Peckham]

This morning on the news programs I saw US Treasury Secretary Paulson talking about homeowners ... I felt contempt for his discription of what has happened. This commenter to TPM said what I was thinking when Paulson was talking about people taking out mortgages that were higher than they could afford and about them needing to live up to their obligations. http://www.talkingpointsmemo.com/

I find it incredible that he would use language like that while asking taxpayers to send a trillion dollars to Wall Street because investment banks made irresponsible investments and aren't able to live up to their obligations.

In any loan transaction there are at least two parties. If I give my unemployed and uneducated brother-in-law a half a million dollar loan wouldn't I be just as irresponsible giving it as he is taking it? Moreover, a large majority of borrowers did not have financial training to be able to understand complex mortgage terms and risks of the underlying investments. Investment banks have armies of Ph Ds working for them that helps them analyze market risks and credit exposure. They got it wrong too! It strikes me as strange that unsophisticated borrowers are being held to much higher standard than ultra-sophisticated bankers.

It is despicable to try and pin this on the people who got lured into this, while giving the architects of this mess, people like Phil Graham, a free pass. This also from TPM:

The New York Times reports this evening that "foreign banks, which were initially excluded from the [Wall Street bailout] plan, lobbied successfully over the weekend to be able to sell the toxic American mortgage debt owned by their American units to the Treasury, getting the same treatment as United States banks."

The Times further reports that two of the biggest foreign banks in need of such relief are Barclays and UBS. In fact, my understanding is that UBS is more on the line here than any other foreign bank.

Let's add this up.

John McCain's top economics advisor, who is widely believed to be his choice for Treasury Secretary, should he win in November, is former Sen. Phil Gramm. (Indeed, just last night his spokesman refused to say Gramm wouldn't be McCain's choice for Treasury Secretary.)

Gramm is both vice chairman of UBS's US division and a lobbyist for UBS.

If UBS successfully lobbied over the weekend to get in on the bailout, what was Gramm's role in the lobbying?

If we're going to do this we should be buying the companies instead of just buying their lousy "assets".

[monrein]

Bill, I don't disagree with you on the inequity of who is left holding the bag on this, and the mess isn't going to go away any time soon.  Even though the stock market has rallied (temporarily at least) the underlying credit collapse remains very significant and the pinch will be felt by us all.  Not just in the US.

It does appear that the "architects" are getting a free pass and I think I'd be wanting some rather large fines on some of the financial executives who were in key positions and involved in the duping. 

I would however also like to see better financial education in schools, aimed at the average person about how finances, mortgages, credit and so on actually works.  I am continually amazed at the lack of understanding of these issues (interest structure in an amortized mortgage is but one example) on the part of folks who are unable to understand the financial agreements that they enter.  Most people have no ability to understand the basics so the bamboozling is all too easy.

If I am unable to understand how something really works, I am not going to sign on for it.  Period.  Having said that, dumb is one thing, irresponsible, greedy and misleading is another and the penalty for each ought to be quite different.

[Zach]

I would however also like to see better financial education in schools, aimed at the average person about how finances, mortgages, credit and so on actually works.  I am continually amazed at the lack of understanding of these issues (interest structure in an amortized mortgage is but one example) on the part of folks who are unable to understand the financial agreements that they enter.  Most people have no ability to understand the basics so the bamboozling is all too easy.

Very good point.

[Joe Paul]

I would however also like to see better financial education in schools, aimed at the average person about how finances, mortgages, credit and so on actually works.  I am continually amazed at the lack of understanding of these issues (interest structure in an amortized mortgage is but one example) on the part of folks who are unable to understand the financial agreements that they enter.  Most people have no ability to understand the basics so the bamboozling is all too easy.

If I am unable to understand how something really works, I am not going to sign on for it.  Period.  Having said that, dumb is one thing, irresponsible, greedy and misleading is another and the penalty for each ought to be quite different.

Monrein, have you ever considered that most people aren't rich here in the USA? When they finally are able to build up a credit line, having never really had money, it turns into a spending spree, and the credit companys just keep sending credit cards, on and on. I am not condemning the Rich, its just that they, having been born with a silver spoon, never had to worry much about what they bought, or how much things cost. 

[dkerr]

My boss said that even though Fannie Mae and Freddie Mac were in trouble - the guys in charge got million++ bonuses this year anyway.

[Bill Peckham]

This is as understandable an explanation of the situation as I have read (I would like to read any others that people find).

BTW I think this is exactly right

My boss said that even though Fannie Mae and Freddie Mac were in trouble - the guys in charge got million++ bonuses this year anyway.

As this article says whatever fix that is settled on it must assure:
"...that prior investors in these financial institutions and their executives bear very large financial penalties. Irresponsible homeowners should as well."

If it were up to me the executives would literally be bankrupt at the end of this - I would not care a wit if it was fair or not - tough beans.

>>>>>>>>>>>>>>>>----------------------------<<<<<<<<<<<<<<<<<<

It’s helpful to think of how to address the current financial crisis (and I don’t use that word casually) in terms of the end-state we want to achieve, and the transition plan to get there.

The problem we face is often described as mind-bendingly complex, but in its essentials, it is simple.

It is well known, in retrospect, that we had a classic speculative bubble in home prices. As is typical in a bubble, its later stages were characterized by reckless investment, excess debt and shady-tending-to-illegal business practices. As cheap credit pushed up the market price of houses, homeowners began to incur lots of debt (i.e., promises to pay other people on Tuesday for a hamburger today), which they were comfortable doing because they believed that they had sufficient equity value in their homes to make good on the debt if required. Some of this debt was mortgage debt. Many people who previously would not have received credit for a mortgage got them. Simultaneously, many homeowners were offered and accepted mortgages that approached all-debt at floating interest rates, rather than the traditional 20% down 30-year fixed rate mortgage. In the worst instances, these mortgages had payments that were all-but-certain to rise in the future. These homeowners were betting that they would get raises, inherit money, or, more likely, would be bailed out by an increasing home price that would allow them to roll over the debt. Other debt was incurred by existing homeowners for the purpose of consumer expenditures, which had the net effect of hollowing out the equity they had in their homes. All these effects are just examples of greater levels of debt secured against the market prices of homes.

Here’s the problem with having lots and lots of debt and no savings, whether in the form of passbook savings or equity in your house: Sooner or later Tuesday comes around when you happen to have had a bad week, and the guy who sold you your hamburger wants his money, but you don’t have it. Once home prices began to decline (or for the most over-leveraged homeowners, simply stopped rising fast enough), therefore, it was a big problem when Tuesday started to come around and lenders and vendors started to ask to get paid for the hamburgers.

Normally this would have been bad for both the homeowner and the guy who wanted to get paid for his hamburger, which might very well be the mortgage lender, but not really a big deal for you or me. (If enough of this occurred, of course, it could lead to a general slowdown and hurt pretty much everybody.) But this impact was magnified by the fact that most of the mortgage lenders sold the right to the payments under the mortgage to third parties. These third parties broke up the rights to the payments from the mortgages into lots of little pieces, combined these pieces with the rights to payments for little pieces of lots of other mortgages, repacked these in “creative” ways, and re-sold them to fourth, fifth and sixth parties. Four, five and six then used these promises as their own equity in order to raise further debt of their own. This would be like you using an IOU from your neighbor as your down payment for a mortgage. So when lots of these over-leveraged homeowners started to miss mortgage payments, parties four, five and six had less money than they expected, and they had problems making their own debt payments if they themselves had taken out enough debt. Oh yeah, many of these debt contracts are in fact between parties four, five and six.

Unfortunately for you and me, parties five and six are the financial institutions where we have our life savings deposited.

The end state that we want to get to is pretty clear.

The price of the average home in America has fallen a lot, and is likely to fall further (although there will be huge regional differences). Some very over-leveraged homeowners are going to declare bankruptcy. Others are going to sell the boat and eat out less in order to avoid this. We need prices to mark to market (which they will eventually do anyway), as rapidly as possible consistent with not causing a depression caused by a collapse of consumer activity.

Many financial institutions have both profitable commercial businesses, and financial instruments that are wildly unprofitable, housed under one roof. We want the executives of these companies to lose their jobs, and the shareholders and bondholders in them to lose their money, while preserving the productive parts of the businesses and preventing a depression caused by a collapse of credit.

The trick, of course, is how we get these excesses purged from the system without tanking the economy worse than anything we have seen at least since the 1930s. What makes this especially tricky is that we don’t have a lot of visibility into how exposed each of parties four, five and six are to collapse.

This is what Paulson and Bernanke are trying to manage. They have done three big things in the past couple of days:

1. Proposed a huge RTC-like government “bad bank” that banks can dump all their bad loans into. (Apparently, though, unlike the case with the RTC, they will not need to declare bankruptcy to do it.)

2. Provided a federal guarantee on money-market accounts.

3. Promulgated a temporary ban on naked shortselling for about 800 financial stocks (in related news, the new recommended medical practice when you discover that you have a fever is to smash the thermometer against the wall, since this makes the problem go away).

All of these things are, in theory, bad. In practice, all will have very negative consequences over time. Here are some of the problems:

1. We’re getting pretty close to nationalizing (hopefully temporarily) a reasonably big piece of the U.S. housing finance market, as well as other financial sectors that are put at risk by it.

2. Time will tell, but likely medium-term implications include higher government interest payments, worse deficits and higher taxes. This certainly reduces the probability of making the Bush tax cuts permanent in a couple of years, no matter who is in the White House.

3. This is obviously unfair. It bails out irresponsible behavior, and by implication, punishes responsible behavior. Longer-term, unless there is a lot of pain felt by financial company executives – who, remember, don’t look like they have to go bankrupt to dump their bad loans on taxpayers – this creates a massive moral hazard problem. Further, if such a situation develops, it won’t be lost on voters, who will likely demand greater socialization of consequences of reasonably-foreseeable bad behavior by people who don’t make a million dollars per year. The ideological consequences of the last few weeks will take many years to play out, and conservatives are unlikely to happy about them.

4. It’s also unclear how much of the problem, and what problem, this really solves until home prices hit bottom. As the market price of the underlying assets keeps dropping, more and more debt instruments become “bad”, with cascading effects. Though not likely, it is a lot more plausible than it was five days ago that the federal government may become a buyer of the actual housing assets. In that case, welcome to the introduction of large-scale public housing for middle-class Americans.

These all sit on one side of the scale. Against all of this we have one huge consideration. If investors lose confidence in the safety of money market funds, mutual funds, demand deposit accounts and the other storehouses of value in the modern economy, we would have a problem that would make somewhat higher taxes and moral hazard seem like child’s play. Trust me – you do not want to experience a full-scale bank run in contemporary America. I’m not sure how many people realize how close we were to the wheels coming off at about noon yesterday, as major commercial-paper processing banks like State Street lost 30% – 60% of their value in about 2 hours. Want evidence: When was the last time you heard of the U.S. government identifying a problem, developing a multi-hundred-billion-dollar program and announcing it within about 48 hours?

It seems to me that these are prudent actions as temporary, emergency measures. What will be essential is that:

1. These are temporary, and these positions be unwound as rapidly as possible. This includes not just the actions of the past two days, but also getting the federal government out of the insurance business (AIG) and the home lending business (Freddie and Fannie) as rapidly as is consistent with orderly unwinding of these positions.

2. The ultimate resolution assures that prior investors in these financial institutions and their executives bear very large financial penalties. Irresponsible homeowners should as well. Expect big political battles over the definition of “irresponsible”.

If done in this way, we can (in the hopeful case) work through the problem with limited actual costs to the taxpayers as assets are sold off, while limiting moral hazard and long-run government control of financial assets. But there are many very bad downside cases.

[monrein]

I would however also like to see better financial education in schools, aimed at the average person about how finances, mortgages, credit and so on actually works.  I am continually amazed at the lack of understanding of these issues (interest structure in an amortized mortgage is but one example) on the part of folks who are unable to understand the financial agreements that they enter.  Most people have no ability to understand the basics so the bamboozling is all too easy.

If I am unable to understand how something really works, I am not going to sign on for it.  Period.  Having said that, dumb is one thing, irresponsible, greedy and misleading is another and the penalty for each ought to be quite different.

Monrein, have you ever considered that most people aren't rich here in the USA? When they finally are able to build up a credit line, having never really had money, it turns into a spending spree, and the credit companys just keep sending credit cards, on and on. I am not condemning the Rich, its just that they, having been born with a silver spoon, never had to worry much about what they bought, or how much things cost. 

JP, what makes you think I'm talking about the rich?  The truly wealthy will have money to fall back on if they make a financial mistake.  I worry precisely about the working poor, students, and others who get themselves into financial trouble, often at the urging of those who stand to make big profits in the form of interest off of these debtors..  Running up a credit card at 21, and having to pay credit card interest rates is foolish.  Everyone needs to understand this.  The first house we bought was not the one we liked, it was the one we could afford and we wanted to make sure that we had as good a down payment as possible because the bank owning too much of our house by lending us more money than our salaries could afford would not have been smart.  No matter who told us it would all be OK.  We also tried every year to pay off as much of a lump sum as we could on the anniversary date.  Our current home is 900 square feet with an equivalent basement.  We bought the smallest house in the best neighbourhood we could afford.  I have friends who bought large (huge in my opinion) homes in less desirable areas but with little or no down payment, the bank still has them by the short and curlies and they still owe money.  Their properties have not appreciated as well either and so the overall return on their outlay of money at the end of the day will be significantly less.  On the surface, they appear far wealthier than us but WE HAVE NO DEBT.  And that's a devil of a detail. 

It is important for everybody to understand that credit is NOT free money.  Credit is expensive money and long-term mortgages may look good because each payment seems nice and low but in the end you will have payed more in interest than you might even have borrowed in the first place.  Debt is absolutely necessary but the people making the money are the creditors. 

Just because I understand the temptation of anyone (particularly in our consumer-driven world where many measure status in terms of what people buy, and in which instant gratification often trumps a wiser, more measured approach to getting what one would like to have)  to just spend themselves into a corner, doesn't mean they don't need to know more about credit, debt and how to handle it. 
I got interested in financial matters very young because I immigrated to Canada at 15 and my parents gave me a cheque at the beginning of each year, to pay for my school fees and living expenses.  I had to be responsible about how it lasted.  I never once had to say I'd run out.  I paid far more attention to money, to saving, to spending wisely and to learning about finances when I had little or no money than when I was working and earning more of it. 

The point you made JP is of course accurate but people need to know that feel good spending can and will get them into trouble and that won't feel good at all.
The rich can write off their losses against their gains.  The rest of us may need to take a second job to dig ourselves out of a hole that others have encouraged us to crawl into.

[Joe Paul]

JP, what makes you think I'm talking about the rich? 

I'm sorry, I re read your post, and I don't know what I was thinking. Blaming that on this sinus infection, its playing with my head. In short though, I do agree with what you said.

[monrein]

Hope your sinus infection clears up JP.   

[Joe Paul]

Thanks much 

[Bill Peckham]

I would say my Personal Pucker Factor (PPF) is pinned in the red zone. It is looking like things are going to get pretty bad, pretty quick.

Apparently there are other "securitized" debt instruments out there - credit card debt is the big one waiting to go off that we haven't heard anything about - no one knows how big the problem is.

The Dollar is on the verge of crashing. Commodity prices will likely hit new highs this week.

I feel like I am in an airplane and the pilot is is on the overhead speakers "Brace. Brace. Brace." I'm thinking We're at full throttle. How much is that going to help?

[Wallyz]

I haven't seen anything in this package hat will do anything to alleviate the central issue, that is, the eventual collapse of the secondary mortgage loan market, and subsequent foreclosure waves.  All this is doing is putting it off, but no one is going to buy these instruments ever again (or until they forget what happened this time).

The other issue that is causing me pause is the temporary freeze on shorts.  Why don't hey just re-institute the uptick rule?
It worked for 70 years, it stopped the process of Bear raids that we see have started up again after the revocation of he rule in 2007, and instead of investigating and fining people for naked shorts, they are stopping everyone form shorting only a narrow segment of the index.  What's to stop them from doing a bear run on GE? Or the Big three auto makers?  It feels like they either don't know what they are doing, or are at the beck and call of the larger banks,and my worst fear is that it is  a combination of the two.

[Wallyz]

The internet scam artists are already on this one.

DEAR AMERICAN:

I NEED TO ASK YOU TO SUPPORT AN URGENT SECRET BUSINESS RELATIONSHIP WITH A TRANSFER OF FUNDS OF GREAT MAGNITUDE.

I AM MINISTRY OF THE TREASURY OF THE REPUBLIC OF AMERICA. MY COUNTRY HAS HAD CRISIS THAT HAS CAUSED THE NEED FOR LARGE TRANSFER OF FUNDS OF 800 BILLION DOLLARS US. IF YOU WOULD ASSIST ME IN THIS TRANSFER, IT WOULD BE MOST PROFITABLE TO YOU.

I AM WORKING WITH MR. PHIL GRAM, LOBBYIST FOR UBS, WHO WILL BE MY REPLACEMENT AS MINISTRY OF THE TREASURY IN JANUARY. AS A SENATOR, YOU MAY KNOW HIM AS THE LEADER OF THE AMERICAN BANKING DEREGULATION MOVEMENT IN THE 1990S. THIS TRANSACTIN IS 100% SAFE.

THIS IS A MATTER OF GREAT URGENCY. WE NEED A BLANK CHECK. WE NEED THE FUNDS AS QUICKLY AS POSSIBLE. WE CANNOT DIRECTLY TRANSFER THESE FUNDS IN THE NAMES OF OUR CLOSE FRIENDS BECAUSE WE ARE CONSTANTLY UNDER SURVEILLANCE. MY FAMILY LAWYER ADVISED ME THAT I SHOULD LOOK FOR A RELIABLE AND TRUSTWORTHY PERSON WHO WILL ACT AS A NEXT OF KIN SO THE FUNDS CAN BE TRANSFERRED.

PLEASE REPLY WITH ALL OF YOUR BANK ACCOUNT, IRA AND COLLEGE FUND ACCOUNT NUMBERS AND THOSE OF YOUR CHILDREN AND GRANDCHILDREN TO WALLSTREETBAILOUT@TREASURY.GOV SO THAT WE MAY TRANSFER YOUR COMMISSION FOR THIS TRANSACTION. AFTER I RECEIVE THAT INFORMATION, I WILL RESPOND WITH DETAILED INFORMATION ABOUT SAFEGUARDS THAT WILL BE USED TO PROTECT THE FUNDS.

YOURS FAITHFULLY MINISTER OF TREASURY PAULSON

 

[dkerr]

Love it ......

[Zach]

Is that from West Africa or the West Wing?

[Bill Peckham]

The more you hear about this and after watching the President's address to the nation, it seems to me we don't have the political leadership to deal with this right now. I think all you need to read is:

In fact, some of the most basic details, including the $700 billion figure Treasury would use to buy up bad debt, are fuzzy.

"It's not based on any particular data point," a Treasury spokeswoman told Forbes.com Tuesday. "We just wanted to choose a really large number."

Okay then you should all be fired.

Secretary Paulson said he could only spend 50 billion a month - there is no way this could get going in the 39 days left before the election - so how about authorizing spending just 50 billion between now and the election and then let the new Administration guide legislation through the lame duck Congress.

They're pushing through a 25 billion dollar auto industry bailout this weekend. They could get a 50 billion dollar bailout through by Sunday.

Until there is an administration that is willing to take an unvarnished look at the nation's finances there really isn't any point in going forward. Last night the President didn't mention any other looming problems. Nothing about the credit card credit market which has many of the same features of the failed mortgage credit market. Nothing about the auto loan credit market which has many of the same features of the failed mortgage credit market. Until we hear the full story Congress shouldn't try to ram through the full legislation.

[okarol]

 

[okarol]