Economists: Please explain to us pedestrians . . .

Factual Questions
1

. . .

Anyone that pays the least bit of attention to the business/economic news sees some serious problems in the financial markets.

That being said, with all of the write-downs being reported from companies like Citibank, Morgan Stanley, Merrill Lynch, Countrywide, the various hedge funds, etc., etc. has all of this money simply disappeared or has it shifted from those companies to other entities?

If a balance sheet was done on the total finances in the USA would the bottom line numbers be lower today than a year ago? Did this money ever really exist or is a write-down just an adjustment to more reasonably reflect the assets of the companies? Are there a lot of people (those that owned stock in those companies) actually worth less as a result or have they just given their assets over to others that capitalized on the turmoil?

Does the money that the Fed is pumping into the financial markets really exist or is the government just printing it to cover up the problem. Where is the money coming from? It it being borrowed through bond sales or is it just being created to avert a crisis?

Factual answers please just to fight ignorance of what this financial crisis is all about.

2

Much of the credit problems stem from people being unable to repay their mortgages. So Bank X loans 300k to some dude, and that dude uses the money to buy the house. Now, let’s say the dude can’t pay back his mortgage. The bank forecloses on his house and gets 200k for it. That 100k, for all intents and purposes, is essentially gone. Poof in a cloud of smoke. That’s where the money all of the banks have lost has, more or less, gone to.

Going hand in hand with that is the devaluation of some outstanding loans based on the increased risk of non-payment. In other words, everyone is looking at all these people defaulting, and are concluding that more people will default. If you have a bunch of loans together you can calculate the value based on interest rates, and expected default rate, you can calculate the value of that group of loans. If the default rate goes up, those loans become less valuable.

Those are the two areas where the writedowns come from. Money they’ve lost from defaulted loans, and value they’ve lost due to higher expectations of defaults.

3

Hmm, one year of college economics does not make me an expert, but it’s 1am here and I can’t sleep, so I’ll take a shot at some of this.

To a large extent, the question of how much money there is gets determined by how much money people believe there is. By that I mean that things are worth whatever people are prepared to pay for them. This sort of applies to paper currency too: a dollar is simply an a designation. Thus a dollar bill will always be a dollar bill, but what it’s actually worth depends on what people are prepared to give me in exchange for it. That varies.

So you could assert that a lot of the money that has disappeared never existed in the first place, and if you think of money in terms of dollar bills, you’d be right. But it isn’t really a useful way to view a system as complex as the US economy. What has changed is the value of things. As such, the money lost hasn’t changed hands, it has effectively vanished in a puff of smoke.

Think of the house situation mentioned by treis. If your house is worth, in your estimation, $300,000, but you accept my offer of $290,000, there is a sense in which you could say that $10,000 has simply vanished into the ether. But did it? It existed because you believed it did, and is gone because I was able to persuade you that it didn’t.

In the current situation, we have to recall that loans are tradeable assets. And what they’re worth depends on how likely it is that they will be repaid, because an unpaid debt is worth nothing at all. Financial institutions sell loans to each other at a price that is broadly determined by the likelihood that a debtor will make good on the debt. If it seems probable that a debtor will not pay a debt, anyone wanting to sell the debt (that is, the right to collect the debt) will have to accept less money for it. Yet again, money has disappeared.

All of this makes more sense if we remember that debts are, in fact, assets to the creditor. If I have $1m in the bank, and someone owes me a further $1m, I could claim my net worth as $2m. But not if the guy who owes me that $1m doesn’t have a chance of actually paying it back.

Have I been vague enough here? :smiley:

4

I want to make sure I’m understanding this right, though. If the bank loans me $100K to buy a house, then that money goes into the hands of the seller. That money hasn’t gone anywhere. The money that has disappeared, however, is whatever the lender was hoping to make in profit. Right?

5

Sometimes, yes. More often it is value that disappears - if actual hard cash disappears then someone is probably stealing it :stuck_out_tongue:

But the example treis gave illustrates the point well. The bank lends you $100k, on the assumption that you will repay the money. For some reason, you can’t or won’t. So the bank forecloses, and sells the house to recoup their losses.

But oops! The house will, today, only fetch $50k. So the bank is out half the money that they lent you. And you don’t have that $50k either, having lost your house. So here’s the situation: Original seller has $100k, you have nothing, and the bank is down $50k. The bank gave the money to the seller on the understanding that you would repay them (kind of - in reality the bank gave it to you to give to the seller, but from this POV it’s the same difference) so the seller now has their cash.

The missing money is not merely what the lender expected to make in profit - it’s the difference between the money the lender gave to the borrower and the money the lender actually was able to recover. The reason why the money is missing? The value of the asset (house) provided as security for the loan decreased. It decreased because people decided that the house was worth less.

And who has the missing $50k? No-one. The person who bought the house for $50k in the foreclosure sale has an asset that is worth 50k.

6

Um, I missed this point: the anticipated profit in such a transaction is the difference between the amount loaned and the amount the lender expects to be repaid. That difference is the interest charged on the loan.

Of course, interest is only a consideration if the debtor actually repays the debt.

7

Actually, in this case, the original house owner has it. They sold a house now worth $50K but got $100K for it. Good for them.
The bank paid $100K for a house now only worth $50K. Sucks for them.
The defaulter loses his good credit history.
The last buyer got a $50K house for $50K, and is square.

8

Hmm. Well, at the time the original transaction took place, the seller got $100k for a $100k house, and so is square. They would only be up $50k if the value of everything had halved.

9

It’s only a $100k house in terms of what it sold for. Perhaps it was a new house, and cost the builder $90k for land and construction, so $10k went to the builder as profit. Perhaps it was an old house, bought for $50k five years ago, so $50 went to the previous owner as a capital gain.

10

This is all true, but I’m not sure it’s directly relevant to the question asked, which I read as “Where did the money go?”

As such I took it to be referring to money at any given instant in time. I’d say that a 50% drop in the value of a house does indeed cause that 50% to vanish. At that instant, of course. The odds are that the missing value will return in time.

But in the end, I think it agrees with my basic point, which is that value exists while people believe that it does, and disappears when they stop believing.

11

I guess it depends on what the question means. Overall, the economy is not a zero-sum game, because wealth can be created and can be destroyed. However, in some of the transactions here, there were people walking off with gains, if they were part of a transaction at the right point in the market, while others were losing as a result of those transactions.

12

That’s true of stocks and art also, of course.

But to answer more clearly, the money went to the seller. What has disappeared is the expectation the bank has of being repaid, which is kept on its books. When it writes down the money, it doesn’t actually pay anyone anything, but removes 50% of the value of the loan from its list of assets.

13

I’ve always had trouble with this aspect of economics. Say I buy $5 worth of lumber and make it into a nice table that I can sell for $100. Somebody (or something) somewhere has to make the decision “We had a bazillion dollars in assets in this <neighborhood> <city> <county> <state> <country>, now we got a bazillion plus 95.” I suppose the same thing happens in reverse if the house of the guy who bought the table catches fire and burns to the ground.

In a similar vein we keep seeing headlines like Market Has Biggest Drop in Five Years. Thousands of stocks are suddenly worth billions less – where did it all go? Three days later it’s Market Rebounds to Former Levels Now its all back – where did it come from? The assets of the companies involved certainly did not fluctuate that much over those three days.

I swear economics is like a big fantasy sometimes where thing are so because it’s commonly accepted that they are so with no tie to reality – whatever that is.

14

Thanks! This goes back to the OP. Does the money actually appear and disappear like an illusion or does it shift from one owner to another? Is the money real or is it only an accounting entry that can be written off as though it never existed?

15

This is really what I was trying, clumsily, to address. Value (and ultimately, money) exists because people believe that it does.

Suppose I own shares in your company, and I think you’re a shit-hot boss, your business plan is wonderful and the product you produce is something that everyone will buy. I’d pay a lot for shares in such a company.

But oh dear. News has just come out that you have been hit with a lawsuit because your product seems to turn children’s faces an unfortunate shade of mauve. Parents are furious. Suddenly my shares look more of a liability than an asset, so I want to sell them to the next available sucker.

Unfortunately, everyone else has heard the same news, and reached the same conclusion. Simple rules of supply and demand will cause the value of my shares to plummet, since everyone is trying to sell something that no-one wants to buy. On my balance sheet, I had listed them as being worth $100 yesterday, but today they’re only worth $5. My net worth has decreased.

A week later, it is revealed that the mauve children allegation was being maliciously spread by a competitor, who is being investigated for libelling you. Your company is wonderful again, and hey! Shares are only $5! It’s a steal! Now everyone is trying to buy something that no-one wants to sell. The price goes back up, and my net worth increases.

And in all of this, nothing physical has changed - only peoples’ perception of the worth of your company.

16

It’s not an illusion, but it doesn’t correspond directly to green pieces of paper. If we all agree that something is real, and act on that assumption, then it is real. Isn’t it? Actually, the apparent absurdity of that is one reason why it’s difficult to write short, concise posts about economics :wink:

17

OK, I’m with you. So when Citibank, Merrill Lynch, Countrywide, Morgan Stanley and the rest of the pirates out there write down hundreds of billions of dollars did it just disappear from an accounting sheet or did someone out there actually take possession of those dollars?

18

That’s a “yes and no”, I’m afraid.

If you lend me $100 dollars, you can count it as an asset, even though you don’t physically have the cash - I do. It’s an asset because I am a trustworthy person who will make good on my debts. If I don’t, then the answer to your question is that yes, someone did take physical possession of the dollars: I ran off with them, I am up $100 and you are out $100.

But in the case of a loan for a house, it is generally secured on that house. The lender’s main redress if I piss off without paying my debt is to take possession of the house and sell it. But if they’ve lent me $100k and can now only sell the property for $50k, they’ve lost the other $50k.

Now if we think purely in terms of green bits of paper, the original seller has that missing money. But there’s more to it than that, since value is fixed when money changes hands. The original seller has done nothing wrong, and the bank can’t recover the money from him.

What has really changed is the value of the asset - the house. When the bank agreed to lend out the money, the debtor gave them something in return: a house. But the asset is now worth less than the money loaned. That’s the money that has “disappeared”, and no-one else has it.