Financial Armageddon for Dummies

Great Debates
81

Others have answered this question well, but credit is involved in even more places. For instance, all field service personnel pay for their trips on credit. Imagine a big pharma requiring a manufacturer’s calibration for a piece of equipment without credit. How is anyone to even know the cost of the trip before one takes it? e.g., the cost of a hotel? OK, one calls the hotel. But that cost suggests a room is available, which they will hold for you if you give them… credit. A small business cannot have people in every major market; instead people have to fly everywhere. Supposing it were simple to buy plane tickets with cash, what about renting a car? Instead of a $300 hold, you’d give them $300 cash. (Or maybe more! I don’t know what’s at work here.)

So here’s your guy servicing equipment, he needs cash up front for hotels, planes, rental cars, gas. The company will give him this, but of course they need to get it from the customer. But this means there can effectively be no negotiation on price, because each time a different thing is proposed, the hotels and cars and plane ticket prices need to be reassessed because there’s no way to just hold something. (This is credit!)

How would we, as a society, get around this aspect? Well, pretty simple: we all put a bunch of money in savings accounts, and have secured credit: it’s not really credit, as there is cash backing it, but we can avoid the cash transactions if we don’t need them. But this is not a good thing compared to credit, it is a bad thing, because of the massive opportunity cost involved in having $10,000 sit in a crappy account doing nothing. I’m an honest guy, you can trust me. (And most people really can be trusted. I’m not making a joke.) Let me use my $10,000 for better things.

You can always replace credit with cash, but I think you have it backwards when you suggesting pricing credit higher. It’s having a bunch of cash sitting around doing nothing but securing promises that’s expensive.

82

Because you have to.

I have a small consulting business. I agree with you completely and I put a high importance on keeping both my business and my life simple and manageable.

But, to be immodest for a second, I am also very good at what I do and every time I do a project I meet several new parties that like me and have a need for my services. So that leads to more work. Soon, I need help to handle all this work so I hire people to help out. When I have more projects that means I am supplying more materials, so I am buying more stuff and spending more money. That is inevitable.

The only alternative is to tell these people I can’t do their work. If I say no once they probably won’t ask me again. Then they will hire someone else to handle their project. If that company is good they will meet several new parties that will hire them in the future. Soon I won’t even have the small amount of work I once did.

Because I really do not believe in expansion, I have settled for keeping my business “scalable”. I did have to hire more people but I hired subcontractors with their own companies. The cost per hour is substantially higher then if I had employees but I do not have to worry about having stuff for them to do every day. I did have to spend a lot more money but I am lucky to be in a business where we do not have to extend credit and our hard costs, if not our profits, are paid to us upfront.

Please note that this is not standard business practice and I have taken crap for running my business this way for years…I also refused to expand laterally by offering more products and services. I got a lot of criticisms for this as well.

So now that Armeggedon is imminent, I am the small business equivalent of the crazy survivalist with the bomb shelter.

If business slows down tremendously, I can run it from my sofa with a laptop and a cellphone and still make enough money to survive intact, plus I have a deep rainy day fund…but I digress.

Most businesses can’t run the way mine does. A good electrical contractor ( for example) will get every increasing business based on word of mouth. They will need to hire labor to do this work and meet their payroll. If they continue their good reputation they will need to hire even more people. If they turn down new work, especially referrals, they won’t get any more referrals so expanding is all they can do.

They will need to buy lots of wire and lights and switches and appliances for their customers and trucks and tools for their employees. Unlike me, they will not always get paid up front. They will need to supply a lot of this stuff before they get paid for it, so they will need to borrow money from their bank and pay it back when their customers pay them.

The Armageddon hits. People lose their money and can’t afford to build a new houses. So, our electrical contractor only has half as much work, so he doesn’t need as many workers. So half of them get fired. When they go to look for other jobs they find that everyone has less work so they can’t get new jobs. The contractor is also not buying as many switches or as much wire. So the people that make wire and switches, and the distributors that sell wire and switches and the delivery services that move wire and switches and the bankers that finance the wires and switches have less to do and are making less money and need to fire some of their workers. They are also buying less copper and plastics to make wire and switches and fewer trucks and less gas since they don’t have to drive so much stuff around. So the people that make trucks and gas and plastics and copper have less to do and need to fire some people. Now all those jobless people can’t afford to buy party clothes or go to nightclubs so the people that sell and make party clothes and run nightclubs have less to do and have to fire some people. They are also buying fewer buttons and bows and fog machines and bar equipment, so the people that make fog machines and buttons and bows and bar equipment need to fire some people…These people suddenly can’t even afford Wal-Mart so there is less stuff for the people of China to do…

83

Strictly speaking, isn’t paying one’s staff also, essentially, credit?

I get paid every two weeks. Payday follows the payroll close date by a full week. So part of every paycheck is for work that I did three weeks before. I am, basically, working on credit, assuming that the company will pay me.

Even if I’m paid at the end of every day, I’m still working on credit. I work in the morning, assuming I’ll be paid in the afternoon. Otherwise you’d have to have a payroll person following me around and giving me a penny and a half every second of the day.

A pervasive notion, this, when one follows it out.

84

How do we know the financial institutions are not just holding back credit to get the bailout. ? They all dried up at the same time.

85

Because it is implausible bordering on paranoid? Thousands of different banks and different credit officers conspiring for… maybe a bailout of several American banks?

86

Color me a little confused. You seconded the idea the Bill Gross article was a good reference now you reject it (and Bill’s) central claim, which is that those CDOs can be valued. Warren Buffet seems to think so to. He said so today in a Bloomberg interview. In fact, I have a tough time imagining a bond trader thinking such valuations would be impossible. Bond traders do them. There is nothing particularly challenging in a CDO versus, say, a CMO. You just have to take the time to analyze the components.

Even if one simply took a course in Finance and read the chapters on Bonds and the Time Value of money, one is going to be given familiarity with the basic process.

An increased default rate risk is not a particularly troublesome complication. What is it that you suppose makes these bonds impossible to value on a hold to maturity basis?

Again, it’s a little odd. You offer me advice on this market suggesting that it needs to be devalued, yet apparently are also completely unaware of the fact that it was devalued several months ago.

Also, after all the explaining I’ve done about the difference between liquidation pricing, and hold to maturity pricing, and the statement that these were trading at liquidation pricing, it’s odd to think you’d be surprised that these were trading at 20 cents on the dollar or that this contradicted the fact that they are still paying interest. At around 7% all such pricing implies is an investor assuming a 15 month duration to default.

I can. Bill Gross can. Warren Buffet can. Maeglin can. Pretty much any mortgage backed trader can.

At any rate I’ll take Bill Gross and Warren Buffet’s word on this as it concurs with my own experience.

Ummm. What insurance are you referring to? The ones backed by government agencies typically are not at issue. It’s the one’s based on uninsured, ya know… “Subprime” pools that we’re referring to for the most part. Those are not insured, but protected (if at all) with credit default swaps.

There are several other ways around the problem as well.

Let’s say you do manage to find a CDO issue which is too complex to deconstruct and value, or you feel the assumptions leave too wide a distribution curve for effective pricing. One could lay off that risk by buying credit default swaps from a reliable issuer and narrowing the curve, forcing the seller to bundle it with such before purchase, or by assuming the risk oneself buy discounting the price one would pay by the cost one would expect to incur if one were to do so.

Certainly the government could afford to do this last as they would be purchasing 700 billion dollars worth of such instruments. Simply discounting the price by the assumed cost of a credit default swap distributes the risk.

Or… One might purchase derivatives such as Bear housing index notes.

Or… One might take an example from the recent 12 billion dollar Singapore and have a partial default put back with the seller or a third party.

These may or may not be desirable for the Government but they certainly demonstrate how the default risk can be laid off or determined. Since these instruments are hybridized it’s certainly within the realm of possibility to deconstruct particularly troublesome elements out of the securities and recombine them in more pleasing and predictable fashions.

Having been both an analyst and a designer of credit based derivatives you should be familiar with such techniques.
Perhaps they do things differently in Hong Kong.

87

It will depend on the CDO and its current pricing. CDOs are not particularly standardized. What they do have in common is that they are typically backed by one or more pools (or tranches of pools) of similar mortgages. “Subprime” simply means that its not up to snuff for standard Fannie or Freddie backing. This doesn’t make it a bad or a good mortgage. It might simply have some weird features. So, for example, one that is backed by 2005 6% fixed 15 year single family mortgages with an average of 10% down in, say, the Southeast with 130% collateralization (I’m making a pool up) is probably going to be ok. One would expect it would still hold up well with even a 50% default rate.

Many of these things were also packaged together with various derivatives to either enhance them, or ameliorate risk (mostly enhance.) Many of these derivatives appear to have been created from a brainstorming session fueled by a five day cocaine and cuervo bender, and are not particularly reliable. One needs to either remove or otherwise discount them.

But yes, overrall, increasing default rates will tend to devalue the hold to maturity value of these CDOs. Right now, many of these are depressed to the point where a hold to maturity value must assume an unrealistically high default rate 70-80%. They are priced at such a level not because anybody beleives default rates will be so (well not many) but because that’s where they have been marked to the market by institutions engaged in forced liquidations.

For example, you might have a car that you know is worth 10K if you took the time to place an ad and show it and sell it over time. However, Guido the legbreaker is going to burn your house down if you don’t payoff your gambling debt today. Therefore you sell you 10k car for 3k because you absolutely must have the money today.

Or, if you sell you 3k rolex for $500 because you lost your wallet and need to buy a plane ticket to get home fast because your wife is going into labor with your first child.

That’s the way these things are priced. It has very little to do with their intrinsic value and everything to do with the need for immediate cash.

So, probably, the government is safe buying them at these levels plus some more.

Again, it’s not really a problem. It’s not the default rates that are making these things so illiquid. Many of these things are overcollateralized. There are ways of laying off or mitigating this risk that have been in use successfully since the 1980s.

No. When you take out a mortgage, you own the house. You’re not renting it. You only lose your ownership if you default.

It’s a credit crunch. Those will happen again. As for “this” happening again. Honestly, you probably don’t need any new regulation. Known issues typically don’t create disasters like this. Once something like this happens people know it’s a danger. It’s the unknown dangers that typically cause disasters like this. This is unlikely to get us again anytime in our lifetimes. The next disaster will come from something else. That being said, some reform in lending practices and securities law is clearly in order.

To some degree. The pools themselves tend to be pretty homogenous. It’s the ways they’ve been tranched and collateralized and “insured” with derivatives that makes them problematic.

Necessity. They feel it might utterly collapse the markets if allowed unchecked.

I don’t know. Probably not. I’m thinking it’s a lesser of two evils.

88

Dinsdale:

Credit is the lubrication that allows business to happen.

You’re using credit every time you pay your bills. For example, do you pay your cell electricity bill in advance? No. You use electricity all month, and you owe the money for it. They extend you credit. At the end of the month they send you a bill and you pay off that credit.

Most transactions beyond dimestore types have credit as a component to them. In turn the transactions that set up that transaction have credit. When you examine them, there are whole chains of people extending credit. i.e. the electric company takes a delivery of coal to generate the electricity you use. The coal company bills them but is letting the electric company “borrow” the money for the coal until they get paid. When you keep tracing these transactions back and back you get to a few very very large transactions where banks are lending each other vast sums of money for short periods of time; the money markets. In order for these markets to function properly they lenders and borrows need to be comfortable with each other, and that comfort has to do with the collateralization. Attached in this chain, though not directly, are things like these CDOs. When they become illiquid the banks become in jeopardy of not being able to make good on these large short term loans, or not meeting their collateral requirements. They are forced to sell, and cut down on the credit they extend.

Slowly this works its way back up the chain and suddenly you need a 740 credit rating to buy a car, and your contractor wants to be paid 100% up front because his supply house won’t let him buy material on 30 day credit, and the electric company wants you to pay in your advance, and your credit card has its rate raised and its limit reduced, and the company you work for can’t borrow the money to meet its payroll, and has to lay you off, and then you’re fucked.

So yeah, credit is good and necessary to the world we live in.

89

REp. from California says he will vote against it because it is Bush and Paulson promising the Chinese and Saudis that our tax payers would make up for their losses due to poor fiscal management. He said when he wanted to make a provision that American tax money would not bail foreign investors, they said it was a deal buster. He said at least half will go abroad.

90

This is kind of a bizarre response…unless, of course, I’m missing something. Not your post in particular, Scylla; this particular quote just happened to be the last one that mentioned how “credit is necessary”. And I’m a little surprised that Dinsdale hasn’t refocussed the question…unless, again, I’m missing something.

As I’ve said elsewhere, I’m not all that conversant in economics. This thread has been tremendously educational thus far, and I’m totally ready to be taken to the woodshed for a beating with my dose of economics edumikayshon. But OK, everyone reading this thread gets that credit is necessary for the operation of the economy…but to focus on the pertient part of Dinsdale’s post #71:

He didn’t say there would be no credit available. I don’t think that’s what he meant, either. There seems to be some kind of fallacy of the excluded middle running rampant here. Assume that employers will be able to pay their employees. Assume that people will still be able to get car loans, mortgages, etc. Assume that businesses will be able to borrow for their expansion. But also assume that it won’t be quite as easy to get credit; that there will be a higher premium on riskier credit.

Adding my own question from posts above: is “that’s American culture” really the best explanation here?

91

Scylla, please respond to this. My friend postulates that the system is irretrievably broken. Do you concur?

92

A normal credit curve has credit easier the shorter and safer it is, and harder the longer and riskier it is. Depending on where the economy is and what the risk perception is that curve may be shallow or steep.

What you may be missing is that often times one is built upon the other. For example, the electric company may be floating risky junk bonds to upgrade to provide electricity for you. Without that money they would not have the liquidity to provide you electricity now and wait for you to pay your bill later. That risky long term credit allows the short safer credit to be extended.

Think about: If Scylla Electric decides to spend a billion dollars building a plant, that may be funded by risky bonds. I have to build the plant, get customers and manage it at a profit. Once I do, I extend relatively safe short term credit to my customers, and then use the profits when they pay me back to pay off the risky bonds. Without somebody willing to take the bigger credit risk on me and my plant, I can’t extend the shorter easier credit risk.

So, you need both. Otherwise how are we going to build electric plants? When my bonds cost me more, I have to charge more to my customers to pay them off. Maybe they are so expensive that I can’t build the plant. Maybe there’s not enough electricity and the price goes up until it’s high enough for me to make a profit funded by expensive bonds. Higher risky credit, means higher costs, means higher prices.

Obviously, there’s a happy medium.

93

Typically the government is always tampering with credit. You make credit harder when the economy is growing too fast, and make it easier when things are too slow. Credit is the main way the Fed adjusts the economy.

Every now and then you get a pocket where a certain type of credit is too easy. Fannie and Freddie mac exist to make a certain type of risky credit less risky. That pocket of artificiality got exploited and extended to other areas beyond the original intent. Attempts to check it failed, and it extended past the point of sustainability and collapsed.

94

No. Not really. Some of it is political, and I’m trying to be as nonpolitical as possible.

What your friend seems to be proposing is that we ignore the current problem and instead do something else that’s unrelated.

To do that, you need to make a value judgement as to whether doing the something is more important than fixing the current problem. That’s a political or personal opinion type question, and people’s answers will vary legitimately.

In this thread, I’m just trying to answer questions about how things work and what is happening so people can form their own opinions.

However, since you solicited my opinion, I will say that I think that the current crisis has the potential to send us into a recession or even a depression if not handled carefully. While I’m not a big fan of the government bailing out the financial industry as it introduces moral hazard, I’m even less of a fan of outright socialization which seems to be what your friend is proposing, taking over electrical generation, auto plants, etc etc. in order to “rebuild” them. That’s a centrally planned economy, communism. I’m not a communist, so I don’t like that.

In all practicality it breaks down because to build infrastructure requires a strong economy and strong credit markets, unless you want the government to run the whole thing.

Again, though. Since the idea is basically “ignore this problem and do something else,” I don’t like it.

These kind of events and failures are historically extremely rare. There’s a pretty long and glorious track record of success for our financial system. I don’t think we just throw it away.

It’s not really the whole financial system, either. It’s one part of it. Even that part has a pretty glorious track record. Fannie and Freddie Mac, the government, and private industry accomplished an astounding feat over the last thirty years. It made housing affordable to vast numbers of americans. The housing industry boomed and fueled our economy, and let poor people who might never be able to accumulate the wherewhithal to make a down payment and buy a house do so. It also let other people live in nicer houses than they might be able to otherwise afford and have some money left over. It let banks make money helping these people do these things.

Sadly, it also, in the end, allowed for extremely predatory lending practices, and promoted financial suicide for the unwary, and then clogged our credit markets and threatened our whole economy.

The idea is sound. The working of it was sound. This crisis didn’t have to happen. It was simply abuse in several different ways that forced it.

It can be fixed though, and we can take steps to help ensure it won’t get abused again.

95

More of a guideline. A really bad guideline. A misguideline, if you will.

96

apologies as i’m posting from a pda and brief by neccessity. answers in line

[quote=“brickbacon, post:68, topic:465953”]

I have a few questions:

  1. If housing prices continue to drop, won’t more people just walk away from their houses, further depressing prices and devaluing CDOs?
    Yes, but so far in practice we haven’t seen mass walkaways. of course as prices drop the risk reward profile changes toward walking.

  2. Would it be effective to make all mortgages recourse mortgages so that buyers could not walk away as easily? That should help at the margin. trouble is for all those people that could barely afford the intro price, they still can’t afford 30 year mortgage at 5% no matter what the disincentive is.

  3. If the government buys all these CDOs, do they own the collateral, ie. the houses? If so, could they just “rent” them to people already receiving social services, like Section 8 vouchers, in order to have them filled?

trouble is the gvt is probably a terrible landlord. much better to get the properties to a clearing level and existing market mechanisms take over.

  1. What regulatory changes need to be made to prevent this from happening again?

None of this goes off balance sheet (that’s where Enron hid their radioactive waste, independant mark to market checks, increased capital adequacy ratios for the total exposure (on & off balance sheet), ability to have ‘hidden’ reserves like HSBC, etc
5. If the government buys enough of the bonds, will they be able to “unravel” the underlying collateral in ways to make them more closely resemble themselves? My question is if they can ever get to a point where the instrument is reflective of a few specific mortgages instead of a bunch of unrelated loans?

better to understand the overall risk profile and do a macro hedge. cost of unpakaging & managing the CDO’s is high.

  1. Why have they banned short-selling? Is this a good thing? short term bandaid trying to stop the market from really dring down the share price of financial shares. A lot of unintended consequences.

i’m unapologetic supporter of short selling for an efficient market (although i also believe in banning naked shorts). without short selling, you can’t legitimately hedge. one has to put up with the gamblers that short for the hedging - IMHO much greater good for the majority. Also an effective exchange listed plain vanilla options market, which greatly benefits underlying transaction volume and reduces volatility, is dependant on short selling.

97

How about, “People are better off when they can buy more and work less”?

98

Actually, they used to be pretty common…until we began to build a regulatory framework in the 1930s.

Panic of 1819.

Panic of 1837.

Panic of 1857.

Panic of 1873.

The Long Depression (1873-96).

Panic of 1893.

Panic of 1907.

The Great Depression (1929-41).

Which is why maybe a strong regulatory framework is a good idea.

“Those who forget history,” and all that…

99

Right. That’s both empirically and theoretically true, as far as I know. But I’ve read many people that lay blame at Greenspan’s feet for keeping interest rates too low, thereby increasing easy credit to an unsound point (at least, in retrospect). Then there’s the criticism of no-down or otherwise “loose” mortgages, also serving to make credit easy to get. I’m sure there are other examples that I could give if I were more knowledgable about the details.

But the question, as quoted, is: “why EASY credit is necessarily a desireable thing?” My understanding of (one part of) market regulation is that while yes, it puts a drag on growth, it also serves to limit potential fluctations and volatility. That is, it makes the peaks less peakier, but also the valleys not quite as low. And I’m sure we’re all familiar with the “rising boats” argument, phrased above like so:

As far as I’m concerned, and I’ve stated it in threads past, this is a devastating argument for “freeing up” the markets (or, “against market regulation”, if that’s actually the converse). Except that now we have (yet another) object lesson and concrete example of why “too easy credit” is bad. Actually, not just bad, but possibly catastrophic. Going back to what Dinsdale said in post #74:

Again, allow me to refocus it – why is it good that businesses expand at the fastest rate possible? (Assume here that “access to credit” can stand in for “business expansion”; feel free to correct and/or add to or clarify this correspondence as you see fit.) Personally, I think Dinsdale’s posts were given short shrift and responses were overly dismissive.

And allow me to pose an additional question, that will hopefully bring up some other details of which I’m ignorant: what mechanisms might (feasibly) be used to tighten credit availability while still allowing markets to work? Yes, I understand that artificial restrictions may ultimately be undesirable, and that furthermore there may be unintended consequences. Again, this is simply a way to get a better exposure to details for me…

100

I realize that my posts here might be considered a hijack, as they’ve gotten away from the technical and GQ nature of most of the thread. However, I like to think it’s excusable because I’m attempting to get into specifics. With that preface…

I’m in the midst of reading Agency’s ’04 Rule Let Banks Pile Up New Debt, an article in today’s NYTimes that may be interesting to others (free reg. required, I think). Taking “allowing more debt” as the other side of the “easy credit” coin, the following is an example of both a mechanism to restrict credit availability and how removing that mechanism has contributed to the current mess:

So that’s a good example, I think, of making credit less easily available. Might a major part of keeping this from happening again in the future really be as easy as maintaining, by law, a lower leverage ratio (i.e., require more assets)? Perhaps an imposition of a graduated scale, in some measure proportional to the total dollar value of an entity?