Mechanism of credit crunch after financial crisis

What would happen if all the banks and companies that own these “poisonous” financial instruments (that the government wants to buy from them in the proposed bailout) just write off all that amount as a loss?

“Collapse” of the whole economy has been suggested, and that will most likely be the result of credit drying up. Businesses won’t be able to borrow, they can’t start new projects, unemployment rises, etc

But, as a non-economist, I’m curious as to the precise mechanism behind the drying up of credit.

Yes, if the banks and companies don’t get the bailout, many of them will lose billions of dollars, and many of them will disappear. But then what? How does that lead to credit drying up?

It’s not the loans per se that caused the current crisis, but the combination of bad loans and “innovative financial instruments”. If the surviving banks go back to sound loan practices and do away with the “innovative financial instruments”, why would they be hesitant to give out credit?

Will the collapse be due to some other reason? What percent of the total market capitilization on Wall Street are the firms that hold these poisonous assets? These are big companies, and we are talking about billions of dolllars in market cap lost if these companies go belly up, but as a percent of the entire market cap of the market, it is not that high, is it?

Shit happens. No matter how conservative a lender’s standards are, some loans will not be paid back – ventures fail, houses burn down, people die. If lenders can’t cover their bets, no one will lend to them.

Also, the American economic machine thrives on risk. The capacity for risk-taking depends on assets, and writing off all that paper will destroy a lot of assets.

I am not an economist, and I believe I feel the same way as you. But the reason people are afraid of doing what you suggest is the “crisis in confidence”. It isn’t so much a question of loaning money to start a new business, it is a question of allowing you to continue to write checks against your existing funds. Because as I am sure you know, the money you put into the bank isn’t there any more. It was loaned out-some of which went to bad loans. So, if the banks just wrote off their bad debts, they wouldn’t have any money to pay off the checks you write. This possibility tends to make people nervous so they decide to withdraw all their money and… you know the result. As long as you and millions of other people believe Uncle Sugar will pay you your deposits back, you don’t pull out your money. So the Gov’t keeps saying everything is fine, not to worry, when in fact they are running around in circles in DC. But the feds know that ultimately they are on the hook for deposits. They would much prefer to pay out that money in the comfort of some wall street office than stand in front of crowds of upset voters at 9AM on a hot Monday morning. But they know they will pay out either way. In sum, by buying up the bad debts from wall street the Feds at least reduce the paperwork.

I know that I believe that my local institutions would never be stupid enough to participate in the housing bubble. That is just so dumb… My institutions would only invest in highly rated bonds from big-name banks like Lehman Brothers and “collaterized debt instruments” that have almost zero chance of going bad. The fact that none of my local institutions have taken out ads bragging about how they saw this coming and they had avoided this mess just means that they are being prudent with my money. Sigh.

So yeah. it effects all of us. No bank is safe. Not just because every financial institution in the world has at least some money in bad loans (I am willing to bet on that but I have noticed few institutions are publicly discussing their exposure), but because if there is a bank panic, even the US government could be overwhelmed. Certainly by definition no bank can survive a run without outside intervention. If they could, they would be a hole in the backyard, not a bank. Whether the paniced folks on wall street are correct in believing that such a run would ensue if they lose their bonuses, I don’t know. The consequences of being wrong on that are pretty severe.

I am an economist. The mechanism works like this:

There are a bunch of assets that have been mispriced due to stupidity, policy failure and/or fraud. But because they have been mispriced for so long, no-one quite knows who’s got exposure to them. And prudent firms may well have acquired exposure because, unknown to them, their customers or suppliers or their customers or suppliers may have exposure.

So even the prudent firm may find that people dealing with them will not extend them credit and the prudent firm may well decide not to extend credit to its customers. A loss of trust that bills will be paid means that even firms with no direct exposure can be starved of the funds required to operate or face hugely increased costs. This is contagion: if people fear that a firm is vulnerable to its customers’ supplier’s bank’s portfolio decisions over the last five years they might be wary of dealing with it. Everyone becomes wary of dealing with everyone and credit dries up. Credit oils the wheels of commerce and the real economy suffers, sales disappear, people get laid off and then the whole thing spirals.

Now if the location of all the toxic assets is known, this won’t happen. Some people will go bust and that’s it. Good businesses will (mostly be able to) refinance, good financial institutions will be rewarded etc.

This is one failure

This is a second failure.

If we ignore the first failure for now, who is responsible for the second one?

How is it possible that “no-one quite knows who’s got exposure to them”? Who’s fault is it? The companies who bought assets? The regulatory system? Stupidity? Incompetence?

To me, it seems outrageous that not only is this meltdown happening, but that “no-one quite knows who’s got exposure” to these assets.

Thanks for the explanation.

I was just thinking, though, on a day-to-day basis, I’m coming to work every day as are all my coworkers, we are doing the same job as before, my company is producing the same gadgets as before, all companies are producing the same stuff as before, people are going out and buying the same stuff as before, etc. The daily economic activity seems disconnected from this crisis, and yet, it will slowly be affected by it.

How does it start to affect daily economic activity? I guess one way is: someone like General Motors wants a big loan in order to start a big project, they can’t get the loan, the project is cancelled, people are laid off, those people can’t buy as many goods, economic activity is impacted. Is this sort of the mechanism?

But why would someone like General Motors not get a loan? Even if they have “exposure” to toxic assets, what does that mean? Doesn’t it mean that they have some investments that are worth less than they thought a while back? That’s not such a big deal. Their market cap is not wholly based on their investments, only a fraction of which are toxic.

Same with many companies with an unknown exposure to “toxic” assets. The bottom line is that their investments are less worth that they thought. Why is this leading to a crisis in confidence? Unless you are an investment firm, your company’s value comes from more than just the value of your investments, so even if your investments would crash, your company still has worth, and the bank can give loans based on that remaining worth.

What am I missing here?

Why would anybody give GM a billion dollar loan if they didn’t think it would be paid off? GM is in horrible shape already. They’re losing billions of dollars. There is serious talk of bankruptcy. If people stopped buying cars, or even a large percentage didn’t, they wouldn’t be able to meet their loan obligations.

Multiply that across the entire economy. The economy works entirely on loans and credit. Banks are already falling behind their credit requirements, which would mean that they can’t legally make any loans. Those in better shape could make loans, but how would they know who indeed was a good credit risk? Because they were before is not a good answer. Because they have a good rating by the rating agencies is not a good answer, because the rating agencies screwed up royally in their evaluations of many of the loans that have gone bad.

A collapse of the economy means a situation in which banks can’t make loans, or can’t decide who is worthy of a loan plus companies that can’t do further business because no one can take out a loan to buy their goods and they can’t get a loan to manufacture them in the first place. It’s an interrelated system that falls apart if one piece goes.

If GM is in serious trouble, then it was not a good example. Take another company, that is having good sales.

Why would people stop buying cars?

This is a chicken and egg thing. People expect that consumers will be hurt by the crisis, which means that spending will be reduced, which means that sales will go down, which means that companies’ revenues will go down, which means that they won’t be able to pay back their loans, which means that they can’t get loans, which leads to layoffs, which means that consumption will go down, which is exactly the assumption we started with!

If the above mechanism is correct, then if people just stopped assuming that the crisis would have an effect on consumer spending, we wouldn’t be in such a vicious circle of having a self-fulfilling crisis.

If consumer spending stays the same, then even if companies lose money from their investments, they still have other assets and revenues from sales, so it should not be the end of the world.

Because they can’t get a loan to buy one.

In the UK, car sales to private individuals fell 24 per cent from August 2007 to August 2008. These are the worst figures since 1966. Many potential purchasors are holding on to their existing vehicles for a longer period of time. Those who do buy will be weighing the relative merits of a new car against a second hand one.

It’s probably a similar scenario in the US, but someone tell me if that’s not the case.

Why can’t they get a loan?

Because they have a shoddy credit history?

Is the whole market dependent on selling cars and houses to people who have a shoddy credit history and can’t afford them? Once we start rejecting loans to these people, suddenly the economy stops working?

Companies used to do just fine selling cars and homes to people who can afford them, I don’t see why going back to that won’t work.

Well, it would “work”, but it would involve a contraction of the economy. The economy, for better or (it’s becoming obvious) worse grew dependent on a larger portion of the populace being able to buy cars and homes. Everyone’s going to spend and make less money now.

I did fine back when I made $32K a year. This doesn’t mean I’m not better making more now and that it wouldn’t be painful going back. I wouldn’t die, but it would take a while for me to adjust being fine again at that level.

As I understand it, the problem is that for a lot of these bad loans, no one single person or entity owns it. Instead, the loan was packaged with a whole lot of other loans, and shares of the packages of loans were sold off. I believe that people took it to even higher degrees: buying shares in disparate packages, packaging those shares together and selling shares in the package of shares. So now you have a bunch of financial institutions who own shares in packages of shares in packages of etc, etc, and the whole thing has to get unwound before they know how many of the loans underlying the derivatives have gone bad, and thus their exposure to the bad loans. In the meantime, they’re being very cautious with the cash they have now.

As to why people would buy financial instruments they fundamentally didn’t understand, well, that’s a topic for GD. Or maybe the Pit.

You can see the results in almost any seasonal or cyclical business.

Take your local supermarket. The biggest days for supermarket sales are Friday and Saturday. By Monday the shelves are pretty bare. So the supermarket uses the cash it got on the weekend to buy enough to restock the shelves on Monday.

But meat, milk, bread, eggs and produce all get old fast. The supermarket needs to constantly restock. By Thursday, the supermarket needs to replenish those stocks, but it used all its cash on Monday.

No problem, the local suppliers are happy to deliver on Thursday, but not collect payment until Monday when the supermarket again has cash. Or the supermarket can tap into a line of credit it has at the bank for just that kind of short-term cash flow crunch.

Now suppose the local bank decides it can’t cover the supermarket’s line of credit anymore. Realizing that, the suppliers want cash on delivery. Suddenly the supermarket can’t get fresh milk, meat, etc. on Thursday. Shoppers show up on Friday and Saturday only to find week old bread and produce that’s been picked over. They go to a different supermarket with better food, or they stay with that supermarket but only buy a little, figuring they’ll wait until there’s a better selection.

Either way the supermarket brings in less cash over the weekend. Monday rolls around and they have even less money to restock the shelves. The next weekend more customers are dissatisfied with what the supermarket has on its shelves.

Pretty soon that supermarket is out of business, and most of its competitors are in the same boat.

How true is this though? IIRC, real, inflation-adjusted, income for the average American has not increased by much in the past decade (if it hasn’t actually fallen), so it’s not like Americans were huge beneficiaries of this “expanded” economy.

Would the contraction hurt them even though the expansion did nothing for them?

Contraction means job loss.

Lets say back in the old days people only bought cars with cash. Say 50 out of 100 could afford this. So GM sold 50 cars. Then, because of expanded credit, 85 out of 100 could. GM sold 85 cars. Credit goes away, now GM has to go back to selling 50 cars-- only their whole business model is based on an expectation of selling 85 cars-- plant build-out, workforce, etc. Sure, they can go back to making a profit on 50 cars, but first they have a plant to close and people to lay off. Their suppliers have people to lay off. So do their suppliers.

I understand that, but if you look at the economy as a whole, and not focus on one company, if you look at the economy 10 years ago, when we weren’t so dependent on selling cars and homes to people with shoddy credit, and you compare it to today’s economy which seems to be dependent on selling cars and homes to people with shoddy credit, in those two economies, the average American salary, in real dollars, has not increased, and unemployment has not decreased. So we have the same number of jobs, making the same amount of money, so I don’t see where the gains from the expansion to shoddy home buyers went. Won’t the people who saw the gains also suffer from the contraction?

I suppose it’s a bit of a philosophical difference, but it is the (bad) loans per se that have caused the current crisis. If there weren’t defaulters in unanticipated numbers there wouldn’t be a crisis. Period. Defaulting borrowers are the disease. What frightens me is that we haven’t been in a general economic crisis over the past few years. Therefore that higher percentage of defaulters is a reflection of incompetent financial decisions on the part of borrowers. Toss in bad times on top of a cultural shift in borrowing money less conservatively, and…POW! . (Those bad times may be coming shortly.)

What the innovative financial instruments did is make it harder to sort out the bad loan exposure from all loans. They are the vaseline on the microscope lens that makes it impossible to figure out the extent of the disease. Is the loan portfolio worth 10 cents or 50 cents on the dollar?

When that extent cannot be determined, a crisis results. The first problem is not so much about who holds bad loans, but the extent of exposure to them–do they have extensive disease, or not? It reminds me of when AIDS was first getting off the ground. Coupla weird infections here; strange rash there; diarrhea over yonder…with no way to diagnose the underlying problems no one knew how extensive it was.

There is also a huge secondary issue of whether or not a company will be affected even if they don’t hold any direct exposure at all to bad loans.

Suppose I am a conservative and responsible company with perfect credit. One of my major shareholders has to liquidate their position in my company to raise cash because they also have holdings in a potentially diseased company and those holdings have become valueless. The value of my company tanks because a big chunk of it just got put on the market. Now a third company altogether, whose credit is tied to their shares in my company also sees its holdings drop in value, and has to dump my stock…etc etc etc.

Credit dries up on two counts: first is the fear of lending in general, but second is that you are lending to a company which may–entirely outside its ability to control–itself be caught in the flail.

Finally, of course, this disease acts a lot like gas gangrene. It perpetuates itself by rotting the next layer over and getting bigger. As companies shrink in value, work forces shrink. As work forces shrink, the ability to pay your mortgage shrinks. As mortgages default…well you get the idea.

Just to clarify things…

(note: this is a pretty simple overview)

As others have stated these loans are in the form of a derivative, CDO, security, etc. (You can thank the market distorting FNMs for that.) This means that they are bundled in some form or another and unbundling, or even trying to discover what in the portfolio is under/non-performing is logistically difficult (too time consuming, costs too much relative to the income derived from it, etc.) The general consensus is that sub-prime derived securities (whatever you want to call it) are bad, when even that is not the case (though I suspect more true than not).

Banks are regulated (a good one for a change) in the amount of deposits that they can turn into loans. A unsophisticated, though conservative/practical individual would take all deposited money and loan it all out on a 1 to 1 ratio ($1 deposit = $1 loan). Banks, through their supposed expertise, take on the risk and can probably go as low as a 1 to 10 ratio ($1 deposit = $10 loans). Less banks means a loss of lenders. Assets (CDOs, mortgage derived securities, etc., mortgages (whether or not in a depressed area)) with no ascertainable value (or perceived bad value) may be too risky to create a loan off of. Less assets, less ability to create loans, then the economy suffers.

The innovative financial instruments have been around for a long time, starting with derivatives. It’s the combination of 1) high return (or greed) leading to lax underwriting; 2) market distortions by FNM; 3) people not paying back the loans; 4) housing bubble (one could probably add a couple more) that led to this mess. I’m guessing, but this perfect storm probably came out of the internet bubble some how (I won’t speculate further, because I haven’t thought it out that thoroughly), and a combination of low interest rate and the unchecked growth of FNM. It finally burst with the collapse of the housing bubble, people defaulting on the loans, and the lax underwriting.

Again, the problem is finding where these “bad” loans are. I use quotations because, they haven’t yet defaulted, and the holder of the security backed by these “bad” loans is no worse for wear if the security keeps performing (i.e. someone like the government pays off the interest due). There also appears to be a lack of confidence. Investors are unwilling to invest unless they know their financial institution is going to be saved. Having Countrywide, Lehman, FNM, AIG and Merrill go down the way they did is very distressing to consumer confidence. Look at the market today (am of 9/25), the market is up because investors feel that the government is going to have a bail out package.

If all the loans were given the old-fashioned way, from the bank to the borrower, with no further bundling and reselling, and if the same number of people defaulted on their mortgages as have today, would the effect on the financial system have been the same?

If yes, then you are right, and the defaulting borrowers are the disease.

If no, then the “innovative financial instruments” are to blame, and the defaulting borrowers are merely a trigger. Just because someone gets a violent and near-deadly reaction to peanuts, you can’t call the peanuts the “disease”; it’s that person’s body which is overreacting, other people are fine with exposure to that external factor. Similarly, other financial systems might have been relatively fine with exposure to the sub-prime issue.

Which one is correct? Would we still be facing financial meltdown if all the loans had been of the old-fashioned, direct, type?

This is getting into GD territory, and I don’t want to hijack this thread, but issues like the above have been a pet peeve of mine. That is, how stocks are priced. Just because someone has to sell a large amount of stock (for reasons unrelated to not having faith in the company) the stock price goes down.
A lot of the problems with the system, as I see it, are due precisely to the fact that there are these positive feedback mechanisms built into the functioning of the stock market and overall financial system, and sometimes even a small trigger can snowball into something huge. /hijack

No

OK…your choice on how you want to see it. As I said, it’s a bit philosophical on how one looks at it. While we’re blaming the “innovative financial instruments” we should probably also toss in the folks who bought stock in the companies whose profits were increased by using them. That’s a lot of people to blame but those shareholders are the fundamental drivers for those companies and their money-making efforts.

There is a pretty simple mechanism in play for pricing almost all stocks (houses too, for that matter): supply and demand. I don’t really know what any other mechanism might reasonably be.

Are you saying that the 24 percent drop is due entirely or even mostly to people not being able to get car loans?