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Let's start in the mid-90s. "Redlining" was a big deal. It was made easier, and desirable, to issue more subprime mortgages; note that banks were resistant to such loans because, well, they liked to make money and the only way to make money on risky loans was to charge high interest rates--which turned out to have a race-based distribution (mostly attributable to non-racist motives, but at the time correlation was all that was needed to prove causation). This increase hit a wall when banks, stuck with such loans, weren't lending more to risky clients.
The solution was to securitize the loans. I doubt this was the primary goal of mixing investment houses and banking firms, but certainly had it as one consequence: You could take the risky mortgages and get them off your books. This meant you could make more loans, and sell them. The mortgages were bundled into securities and sliced into pieces, with the top-of-the-line "slices" guaranteed first payout of dividends and capital if the mortages went south. The lowest slices were only guaranteed a payout if all the higher slices got paid, but these were, in turn, bundled into CDOs, which were similarly sliced into pieces, some of which were higher priority in getting their money.
Without these two factors, there'd be no crisis.
As long as housing prices increased, people had trouble with foreclosures: They could sell their houses, usually not losing money and sometimes making money. Banks saw little downside in the risky mortgages, mortgage holders saw little downside in risky mortgages.
Housing market goes soft. Risky mortgages = more frequent defaults. Without the bubble, there'd also be no crisis since the reselling of risky mortgages would have been self-limiting. But, as it is, the mortgage-based securities are also of questionable worth. They were good as gold last month, and your sin is being the one caught with them when the market went soft. Had you sold them a few months ago, you'd be off scott-free. But now your question is a serious one: What are the securities based on slices of bundled mortgages worth?
Answer: You have no idea. Neither does anybody else. A single security might include bits of a thousand mortgages, some of which are good and some of which bad. This makes their "fair market value"--in some objective sense, their bedrock, lowest bound, value--nearly impossible to determine. They're toxic, i.e., nobody wants them, because nobody can evaluate the risk. Even if a security is actually still good, there's no way to determine this--meaning that the risk is necessarily overstated in a cautious market. Since return on investment is determined by perceived risk, and the amount of the return isn't going to increase, the percentage payback increases--that means the prices of the securities decline until the return for the perceived rate of return/risk is "worth it" to a buyer. At some point, however, the return isn't worth it at all. "Perceived" is the key word here, because the securities might still be worth a fair amount.
It works the same in various other kinds of markets. You have a van Gogh, you paid $100k for it last year, knowing that you can turn around and sell it for that much next month, if not more. Then there's a scandal, and a guy who sold to *your* antiques store is found to have mass produced 200 van Goghs in the last 3 years. The van Gogh market freezes. Your van Gogh might be genuine, but until you can prove it is, it's possibly a fake and can't be sold. In other words, until confidence is restored in the market, everybody's caught holding expensive crap.
Now, because these securities were usually short-term, they were put down as "marked to market". This means that they were carried on the balance sheet at what their current market worth was. You see your mortgage based securities sell for $1 when you paid $10, you suddenly have a 90% loss to those assets on your balance sheet, even though you're not selling them. These are carried as collateral; if you need to have $100 in collateral, and had $100 of these, you now have $10 in collateral. Once down as marked to market, you can't decide to "unmark" them to market. Without marked to market accounting, a practice that is neither inherently good nor bad (just very useful in some circumstances), we probably wouldn't have the crisis.
Moreover, we seemed to applaud when Fannie and Freddie had *their* stocks devalued. The same problem happened as with the mortgage-based securities, *and it was pointed out at the time* that the federal action with Fannie and Freddie could send brokerage houses into default--Lehmann was actually pointed out by name. Why? Because when those stocks and bonds lost value, places like Lehmann, with lots of holdings in Freddie/Fannie stock, *lost* much of the value of their collateral. Notice that there was noting improvident in what Lehmann did, except in hindsight. They held stocks that were considered trustworthy, as did many insurance companies, banks, and pension funds.
Now, let's assume that you're Big Bank A, and your brother is Big Insurance Company B. Where do you put the money from those putting money in your bank or paying insurance premiums? Well, you pay out more than you take in--in interest, if you're a bank, or for claims if you're in insurance. You need to make money on their money. So you invest it. In stocks and bonds. Let's assume that you invested in mortgage securities, Fannie Mae, and stocks for Big Bank B and Large Manufacturer B. When the stocks and bonds you've invested in suddenly lose value--Fannie Mae and mortgage securities, to be precise--at least you still have Big Bank B stocks. You look at your assets, find that you were minimally invested in the securities that lost money, so you and your brother can still stay in business. But then you find that Big Bank B was invested in Fannie Mae and mortgage stocks, and was just taken over--and its stocks are now essentially worthless. You've taken a hit, even though you and your brother were good guys and cautious. But you still have Large Manufacturer B stocks. Whew!
Problem is, Large Manufacturer B has a large line of credit with Big Bank B that allows them to easily do business because their cash flow waxes and wanes, and that's now gone. In fact, because of a chill in the banking industry, until banks can sort out what their assets are worth they can't afford to lend cash because they simply don't know how liquid they are--they're possibly close to being in default on collateral requirements and couldn't raise cash if their jobs depended on it (and they do), so Big Manufacturer B can't afford to stay in business. It has to cut back, and it might do worse. Its stock tanks, and the feds talk about a "bailout".
In fact, Big Banks C and D are now sweating. They loaned lots of money, and have to have cash in reserve for FDIC/federal requirements. They were counting on easily dumping liquid assets like stocks and bonds if a lot of money was taken out of their banks, but they know they can't. There's the connection between toxic assets and bank failures--if you have close to the cash margin needed to keep your bank open, and there's a run on your bank, you just might not be able to raise the cash. If word leaks out you heavily invested in what are now toxic assets, it even makes a bank run all the more likely. So why can't you just sell the assets or even properly value them?
Because nobody knows what the securities and stocks are worth. Two paragraphs back, Big Manufacturer B just had problems not because of a problem in its business, but because the liquidity environment changed, because its bank and other banks had problems. How many other companies are like Big Manufacturer B, about to have problems with their business, and therefore with their stocks? Moreover, if Big Bank B had problems, and Big Bank C knows *it's* getting close to not having the required cash on hand, it's not going to trust Big Bank D when it needs to borrow money, and vice-versa. In fact, they won't trust your stock, either, Big Bank A, and probably not Big Insurance Company A's stock, either. And when they ask you for money, Big Bank A, you're going to look at your assets and question what they're worth and if you could liquidate them. Can *you* afford to lend them money? Might that not mean you'll wind up with not enough money when the question inevitably arises, How trustworthy is *your* bank?
This won't affect, until very late in the game, small-potatoes lending for easily liquidated real assets. The "man in the street" will judge what the entire system is like based upon one of the last things to go sour. His data sample is harshly biased, and any class consciousness will only reinforce that bias. But back to the main topic.
The result of the banking problems is that liquidity takes a nose dive.
Now, how do you fix the problem? Keep in mind, when liquidity gets too tight, companies that rely on loans will have problems getting loans, as will new businesses that aren't obviously solid gold, and then the finance-based economy (Wall Street) hits the *real* economy, businesses.
So what's the fix? The first problem is to restore proper confidence in the mortgage-based securities. So the question is, What are the mortgage-based securities worth? Or, the alternative, How do we restore ever-increasing house prices? Either would fix the problem, but the second restores the bubble and plays kick the can--and you *still* have a problem with determining what the mortgage-based securities are worth, and have to deal with that question. So let's deal with it. In other words, we dispose of the toxic securities' toxicity. How do you do that? By saying what they're worth. How do you do that? You hire teams of people to look deep into the guts of those securities, people with the authority and connections to pull together all that information. You have a security that's the topmost slice of a CDO that bundled together 100 of the bottommost slices from securities, each of which bundled together 2000 mortgages, and you get to determine the status of as many as 200,000 mortgages, find out how many are in default and their disposition, and the likelihood of the mortgages in a given CDO going bad. Then you know what those CDOs are worth at that moment and something about the risk. You find that the asset carried on your books as $1 is worth $0.01. But when you do it for the topmost slices of the mortage-based securities, you find that while you carry them at $1.00, they're worth $150. The upside is much bigger than the downside.
If you're the feds, you have an easier time getting all the info. If you're Big Bank A, you don't have the pull or the resources to do it. Once the confidence in the various mortgage-based securities is worked out, much of the liquidity problem just might go away.
Note that you don't actually need to do the scut-work for *every* security. You do it for 100, and you can start doing stats based on how the mortgages were securitized. After you do a half dozen securities based on randomly assembled New Jersey mortgages, most other securities based on randomly assembled New Jersey mortgages will probably turn out essentially the same. The risk determination won't be precise, but will be close and statistically determined. This is leveraging the research in an interesting way.
But if the feds buy these securities, they have to pay a price for them, right? What price? Buying them at their current price won't help anybody much--it'll provide some liquidity, but just swap out cash for assets. Those banks who are close to being belly up will continue to be close to being belly up. So somebody has to determine a "fair price", as opposed to the "market price". This is risky: Ideally, you'd like Paulson to be able to buy $100 billion of these toxic assets, do the work to properly value them, and sell them for maybe $101 billion (in order to recoup the expenses involved in valuing them properly). By guessing as to what the "fair price" is, it means that the $100 billion might buy stuff worth $100 million or $150 billion when all is said and done.
Why do I care? Because I have money in my kid's education fund, which crucially depends on stocks and bonds. Because my mother receives a pension--my mother was, after all, in a union--and pensions are crucially invested on stocks and bonds. Because my father, not in a union, got a lump-sum retirement, which is invested in various securities. Because my wife's pension is also invested in stocks and bonds. Because large corporations, banks, etc., pay a significant portion of taxes--the mess with a few brokerage houses and banks will likely cause the NY State and City tax revenue streams to suffer some real hits (mostly because their tax structures are "progressive", and those suffering most in this will be at the upper income levels) ... and this will push down NY property values, making more failed mortgages likely. Because I often see a doctor, and they have malpractice insurance, and because I have health and renters and car insurance, and high rates of return on stocks and bonds keep insurance premium increases down while insurance company losses make for higher insurance premiums.
But also because I recall something called a "multiplier" from my one macroeconomics class, and I'd expect a liquidity crisis to decrease the multiplier. The multiplier is, crudely put (which is how I ever understood it) the number of times a single dollar changes hands. It's not just the # of dollars in circulation, it's what they purchase. Decreases the multiplier and you can trigger severe deflation--and then you get things like the Great Depression; increase it, and even if the money supply stays constant, you get inflation.
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