Ones and Zeros

I’ve been applying my little-used economics degree to understand our current crisis. Hindsight is useful; it helps to predict future trajectories. But this post is mostly to help me understand the largest financial crisis of our lives.

It’s clear that this situation was set up by excessive borrowing, but by whom and how did they do it? And what are the steps that led from borrowing to meltdown? For some years, if not decades, the US savings rate - the percentage of people’s disposable income that is not spent - has been quite low. We’ve been trained to believe that debt is not a problem. We have been strongly encouraged in this by credit card companies and banks. They share some responsibility. Nonetheless, we should accept personal responsibility for our own debts and purchases, in specific, houses that we can’t afford.

Books will be written on this subject but I’m not writing one here. My non-technical summary of the steps to this crisis is:

1. In the Clinton years, many restrictions on investments by banks were lifted to encourage a broader range of financial services. This helped feed a increasing array of mortgage types and services. Adjustable mortgages and home equity loans became much more common. While this didn’t create the crisis it did lay some ground work.

2. The Community Reinvestment Act was passed and, in part, encouraged home loans to individuals who traditionally didn’t qualify for home loans. The conservative “Investor’s Daily” points to this as a cause. But the CRA didn’t force banks to loan to people who couldn’t pay; it just provided an avenue for them later on.

3. In the 1990’s mortgage-backed securities became popular in the financials markets. Banks offering mortgages began to package and sell groups of mortgages. Banks and investment houses began buying mortgage-backed securities.

4. As the mortgage-backed securities business became more popular and the types or of mortgage-backed securities became more complex, the Bush administration (through the SEC) loosened the leverage restrictions on this type of investment, eventually upping the capital restrictions to 30-1. For every dollar of assets, $30 could be borrowed. The general feeling was that the market would resolve any problems. But that’s another post.

5. With this leverage, the mortgage-backed security business continued to expand greatly. There was a strong need for more mortgages to package as securities. This helped feed the housing bubble. This need encouraged mortgage companies to loan to increasingly marginal prospects and the sub-prime market was launched. The ground work for an eventual crisis had been laid. Paul Krugman has a paper in which he makes an interesting statement in the middle of page three: “The implied demand curve from HLIs is therefore upward-sloping, because of the valuation effects on their balance sheets. This is, of course, the key to the whole story.” (HLIs are Highly Leveraged Institutions such as investment banks who mortgage-backed securities.) The more that HLIs buy mortgage-backed securities, the more they want to buy.

6. As the types and structures of the mortgage-backed securities became more and more complex, it became harder to figure out what they were worth. Banks also started to use CDSs (Credit-Default Swaps) in an effort to protect themselves against risk. This is basically a kind of insurance policy, but one that does not operate under the same rules that insurance policies do, requiring certain asset ratios in case of losses. This resulted in even more leverage.

7. Some of the ARMs (Adjustable Rate Mortgages) started to have their rates adjusted upward as their initial terms expired. At the same time, the federal debt was rising and crowding interest rates. This, together with natural business cycles, led to an economic slowdown. As a result, an increasing number of people started defaulting on their mortgages. This pulled the trigger on the crisis. Interestingly enough, the percentage of number of mortgages to trigger this mess.

8. What’s the value of a foreclosed house? Well, whatever the market pays for it. What if no one in the market is buying; what’s the value then? Well, somewhere between nothing and the original price. This uncertainty in valuation began to cause problems. Since the mortgage-backed securities and CDS contracts were all based on the value of those mortgages, that meant their values were under question too. This led to questioning the value of the companies involved.

9. Now the leverage kicks in, negatively. As values declined or were questioned, the companies loaning to banks and investment houses involved began to call in their loans. At a leverage of 30-1, there weren’t enough assets to cover the questionable securities. The CDSs were triggered in some cases. These were leveraged also and created the same rapid de-escalation in value in other companies (AIG for example).

10. At some point in this process, the markets started to lose trust. Loans are built on trust. If I loan a company money, I trust that they’ll probably pay me back. The interest on the loan is partly a payment for the time I’m giving up that money for the loan, and partly a risk premium. If the risk premium goes high enough, I simply stop loaning money. That’s why the credit markets have dried up.

11. Since access to short-term credit is part of the operational profile for most businesses, the drying up of the credit markets has started to affect many businesses. They will delay payments if possible, layoffs may loom. Expansion or new product development is cut back.

12. A measure of the level of the problem in the credit markets is that the dramatic declines in the stock market are really a secondary side effect. The market sees future business prospects as bleak and falls. After several successive declines, people who have investments or income from the market start restricting their spending, further contracting the economy.

So far, the government has promised $700 billion to buy up bad securities to clean up the financial services companies. It has also injected funds into the economy through the Fed and the banking system as well as the purchase of commercial paper (short term loans). However, none of these steps addresses the crisis of trust in the credit markets. No one yet sees the bottom, so we don’t know what we can trust.

Based solely upon charting (suspect, but the only thing I have) I can see the Dow stopping at around 7500, but if it falls through that, the next stops may be around 6500, 5500, and 4000 successively. That’s assuming this market pays attention to charts - not at all a given.

This entry was posted on Friday, October 10th, 2008 at 17:57 and is filed under economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.