Bill Cutshall’s Weblog

September 30, 2008

Grossly Oversimplified

Filed under: Economics,Intellectual Crush — billcutshall @ 1:25 pm

It is an election year and nothing is pressing on people’s minds more than our economy.  Suddenly everyone I know would like to have an opinion but most will freely admit to a dangerous lack of knowledge concerning things economic.  This is where I step in to make matters worse.  I will gladly offer a grossly oversimplified explaination of the issues at hand based on how I see things.  As with all things modern, there is nothing so bad that it cannot be made worse by using the Internet so I will now offer my grossly oversimplified explaination of socio-economics to all who are interested enough to search out and adopt unsourced, uncredited opinions on the Internet rather than pick up a book and read.

It’s All About Money

Money naturally tends to flow from the poor to the rich.  Give money to the poor and they will spend it on necessities sending it back into the pockets of the rich.  Give money to the rich and they will keep it.  This tendency creates a gap between segments of society which left unmanaged will widen and the rich will get richer as the poor get poorer.  Most modern political beliefs can be differentiated based on their opinion of how big that gap should be allowed to get.  Communists believe the gap should be eliminated entirely, socialists believe that a range should exist but keep tight caps on the upper and lower limits, and capitalists allow those limits to fluctuate to varying degrees.  In the US, liberals work to narrow the gap while conservatives leave it to grow.  The chief tool used by government to manage the redistribution of wealth is taxation, specifically income tax.

Why Should We Bail Out the Market?

Whether you are a free-market proponent or favor regulation, whether you believe in a narrow gap or a wide gap, you need a healthy market (and by market, I mean economy in which people buy and sell stuff) in order for your socio-economic tools to be effective.  If your chief tool of redistribution is income tax then you rely on people earning income to generate your tax revenue.  Every time a dollar gets spent, the government taxes it (both as sales and income tax) and has the opportunity to close the gap.  If dollars don’t get spent as quickly, the governement has less opportunity to affect society.  Our current situation is such that without action, a chill on consumer spending is looming which trancends issues of free vs. regulated market policies.  If the government does not step in, a total collapse of our financial services industry is possible which would eliminate the credit structure that greases our economy, bringing us to a virtual halt.

Why Is Everything Collapsing?

It’s complicated but in a nutshell, leverage is the culprit.  What is leverage, why do we need it, and how can it go bad?  Imagine that you are a businessman that owns a sandwich shop.  Your shop does well enough to pay the bills but not so well that you are swimming in money.  You would like to open a second shop but need a loan to get it running and thus put your first shop up as collateral for the loan.  You now have two shops that can make twice the money but you also have a loan that, should you be unable to make payments, will cause you to lose both shops.  You doubled down and that, simply, is leverage.  Businesses, especially financial institutions, do it all the time and done within reason it is a fairly safe practice.

Financial institutions tend to use leverage to increase the effectivness of their money’s ability to earn money.  Grossly oversimplified, if I buy a share of stock for $100 and sell it for $110 my $100 can be said to have earned a $10 profit or 10%.  If instead of buying one share at $100 I buy two shares by using the first as collateral for a loan to buy the second, when I sell them and pay off the loan I will have $120 representing a $20 profit earned by my $100.  By leveraging I was able to double my return.  I also doubled my risk but in some situations that can be appropriate.  In the case of traditionally non-risky products (bonds, deposits, etc…) even multiplying the risk might not make it greater than that of the market in general.

Why Are Banks Going Bankrupt?

Ratios.  In the leverage example where I used a single share of stock as collateral for a loan to purchase a second share there is no mention of why I did not then turn around and use the second share as collateral for a loan on the third share and so on.  It comes down to credit limits.  A $100 share of stock is a pretty poor piece of collateral for a $100 loan.  If the share decreases in value, it leaves the lender exposed to potential loss.  To cover that potential, banks are subject to coverage ratios or more simply put they are not allowed to gamble with more than they have.  If the value of the assets they use to collateralize loans they took out drops, they are forced to reduce their exposure to risk by selling.  Were a bank or financial institution to invest too heavilly in one type of financial product a small dip in price multiplied by the leverage accepted and the coverage ratio they are subject to could force them to sell everything and still be short of meeting their obligations.  This is how a bank goes bankrupt.

But Why Are They All Going?

If you are forced to sell something, you do so at a discount.  When financial institutions sell securities to meet coverage ratios after a drop, that discount pushes the market price even further down.  As the price drops, other financial institutions that might not have been quite as leveraged start to get exposed to coverage requirements and are forced to sell, perpetuating the problem.

Normally financial institutions do a pretty fair job of estimating risk and mitigating exposure to it.  Even when something does go wrong, it is generally limited to a narrow segment of the market and a narrow segment of their investment portfolio.  The problem this time was created by a relativly new type of security (financial product) called a CMO or collateralized mortgage obligation; specifically, a bundle of home loans.  The CMO was created in 1983 to turn a relativly understood stream of income into somthing that could be readily bought and sold by investement firms.  In the late 90s and early 2000s the number of home loans issued in the US increased drastically as a result of a 1993 change to the Community Reinvestment Act of 1977.  The change, which required banks to increase access to mortgage credit for inner-city and distressed rural communities, caused the issuance of more mortgages to people not traditionally deemed credit-worthy.  These mortgages were bundled and sold to financial institutions.

Long-term collateralized debt is generally a pretty safe investment as evidenced by the low interest rates available to purchase a home or a car compared to the rates of a credit card.  Safe investements are often times leveraged to make the return more appealing for the financial institution.  Leveraged investments can force an overly invested financial institution into bankrupcy which can then force normally invested financial instutitions into bankrupcy.

So Why Did the Value of These CMOs Drop?

Simply put, people didn’t pay their mortgages.  More precisely, people defaulted on their mortgage obligations at a higher than expected rate as a result, I believe, of the legislated issuance of mortgages to traditionally uncreditworthy borrowers.

What’s With This Bailout?

The proposed bailout is really merely a shoring up of the collapsing mortgage market.  The bill under discussion proposes that the government offer to buy the distressed inventory of CMOs thereby putting a floor under their value.  The financial industry then has a little breathing room to get their affairs in order in an orderly fashion rather than during a forced collapse.

Opposition to the plan has come mainly from three areas.  First, the purchase of these securities is likely going to be a bad investment for the government and as such questions are being asked about mitigating that risk by taking an equity stake in the banks being bailed out.  Second, the proposal specified discressionary investment powers without judicial oversight.  Third, putting the failing banks back on sustainable footing will allow their CEOs to leave under better contract terms than they would have if the institution had collapsed.

My opinions on the three areas are as follows (feel free to adopt them or form your own):

1. I believe that giving the US government ownership in the financial institutions of the nation is bad for freedom and should be avoided at all costs.

2. Big decisions with giant consequences need to be made quickly by people with a very specialized set of expertise.  Asking these people to bear a legal burden for mistakes they may make in the process puts an undue burden on them.

3. Contracts are contracts and as much as I hate to see someone benefit while the country is suffering through the chaos they are at the center of, I also recognize that I have never tried to hire a qualified individual to function as CEO for a bazillion-dollar company and I don’t fully understand the risks to their future income-earning potential I would be exposing them to by asking them to run my bank.

A Final Caveat

All of the above information is delivered with no warranties expressed or implied.  There are a lot of smarter people out there with better opinions than my own.  There are also a lot of people paid actual money to spend time understanding this stuff.  If you want to make an informed decision that will affect your financial future or that of your family, don’t just take my word for it.  Research this stuff.  Talk to people.  Ask questions.

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