About that financial crisisFri, 3rd Oct '08, 6:15 pm::

A lot of people have been asking me what this whole "economy in crisis" situation really is. How can banks in the world's most prosperous countries run out of money? Is it because the houses were overvalued? Is it because the people aren't saving? Or is it because of a variety of reasons like health-costs, unemployment, inflation, gas prices, or political instability? On the surface, it would seem prudent to say that it is a deadly combination of all of the above that's causing the financial crisis. We hear statistics being quoted on the news constantly that inflation rose, unemployment rose, new-home sales fell, auto-sales fell, and stock prices crashed. As I see it, these are the effects of the financial crisis not the causes. The causes are far too murky and boring in details for the average person to identify and enumerate. Luckily for you, I have all the time in the world and I love talking in metaphors instead of confusing finance terms when explaining something, so here it goes.

We have to remember that at every level of business and economy, different people are looking at different pieces of information. What you and I hear in the news is what the media has decided is the information most relevant to us. So unemployment, foreclosures, inflation, and most importantly gas prices are the things we hear as the cause of the crisis. This is the same information that the industry leaders, lobbyists, and politicians use to tell us why the bailout was necessary. However, this is not the information they are all personally looking at. Warren Buffet has sailed steady through enough business cycles to not flinch at above-average foreclosures or rising oil prices. What he sees and bases his decisions on, is an entirely different zoo of numbers.

One of the most seemingly benign creatures that is and will considerably affect the economy of the entire world is "Credit Default Swap" (CDS). Economists and some smart people (pdf) have been warning against CDS for a while but nobody seemed to care. After all, what is CDS and why would it ever affect anyone not involved in big-business? Here's how I explained CDS to a friend. The names and figures are merely for illustration and not accurate.

A few years ago, Lehman Brothers bought certified poop for $10,000 dollars and asked American International Group (AIG) to insure them for up to $10,000 in case the poop starts to stink. AIG took $100/year in insurance premium and said "Sure! Why not? This $100/year premium sounds wonderful." Thereafter the executives at Lehman and AIG proceeded to pay themselves $50 because man, this is an awesome deal! Now you have to remember that the folks at AIG were a smart bunch and didn't really want to ever pay $10,000 to Lehman or the ten others like Bear Stearns, Merrill Lynch, and Morgan Stanley that they had similar contracts with. So, they got Bank of America (BoA) to insure them for up to $100,000 for only $500/year in case they ever had to pay off anyone. Bank of America obviously said "Sure! Why not? This $500/year premium sounds wonderful. " Thereafter the executives at AIG and BoA proceeded to pay themselves $250 because man, this is an awesome deal! And just like AIG, BoA bundled up 10 of these $100,000 contracts and found themselves yet another insurer. Sometimes, they would even go back to AIG to get them to insure $1,000,000 for $1,000/year!

Now a few years later, Lehman's poop surprisingly starts to stink. So does the poop that Bear Stearns, Merrill Lynch, and Morgan Stanley bought. AIG has to pay up now. So AIG goes to BoA for the money, which goes to Barclays which goes to a subsidiary of AIG and that's when AIG puts its hands up in the air and says "OMG! I have no money! Somebody help me!" Lehman and Merrill Lynch go belly up. All the companies start to freak out because everyone's certified poop starts to stink, they cannot resell the poop to anyone, and nobody can pay them for the stinky poop even though they had insurance in the form of CDS against it.

Now multiply all the above numbers by something like a billion and that's where we are at currently. The total amount of money currently outstanding in CDS is over $54 TRILLION. To give a slight perspective on that, the amount of money that the entire nation of US spends on buying everything from food to houses to electronics to airplanes to space telescopes to rebuilding Iraq is $13 trillion a year a.k.a. the US GDP. The entire world GDP is $54 trillion and the CDS is currently slightly more than that. And this CDS is outstanding against just a handful of financial companies around the world.

The top-level executives see this figure and realize that a pretty big chunk of $54 trillion worth of CDS would have to be paid if every piece of certified poop starts to stink. If that ever happens, every company even remotely involved in CDS will go belly up just like Lehman Brothers. So they get the daddy governments to fix this mess they have gotten themselves into. The bailout that Wall Street has now won is nothing more than a $2 can of air-freshener they hope will mask the stench for a little longer. While $850 billion is a huge number, it is still only 0.17% of the entire CDS. This means if even 1% of CDS has to be paid, the companies will bleed money. If you have 100 pieces of certified poop, guess what percent will eventually start to stink? The executives at all these companies know that answer and are justifiably worried.

Now I have to add a big disclaimer that not all companies were as mind-numbingly dimwitted as those that have already gone belly up or are on the verge of. Some were instead pretty smart and actually bought CDS against these companies so in case these companies went belly up, they actually got money! Then there were companies that bought CDS against dirty socks and used towels which may not stink as bad as poop but still aren't sweet-smelling roses from the fertile lands of Bulgaria. And obviously there were many companies that bought CDS against those sweet-smelling roses in the rare case that the smell went away. So in reality the $54 trillion CDS is a mix of the good, the bad, and the despicably smelly. While nobody really knows the exact breakdown of the good vs. bad CDS currently, it can be easily understood that the bad chunk must be large enough for the entire financial sector to lose sleep and shirts.

Failing CDSs are just one part of this financial train-wreck. The larger part is of course the certified poop, known in more respectable circles as Collateralized debt obligation (CDO) and Mortgage-backed security (MBS), often backing some arcane Structured investment vehicle (SIV). MBS is the part that involves housing market, mortgages, and foreclosures. CDO is what magnifies the problems of faulty MBS exponentially. And SIV is what banks did to enable them to continue lending beyond their legal limits. So when I said above that Lehman Brothers bought $10,000 of poop, what I really meant is that they bought share in a bundle of house mortgages for a lump-sum of $10,000 in the form of a CDO, a CDO of a CDO, or a SIV backed by a CDO of a CDO backed by MBS. Even to me all of this sounds like a bunch of random letters thrown in without making much sense.

When I bought my house in 2005, I borrowed about $150,000 from a local bank here in Florida. They checked my credit history and determined that I was financially responsible enough to pay my loan for the next 30 years. However, dealing with all my payments is a chore because sometimes I want to pay extra, sometimes I want to pay a little early, and sometimes I want them to give me a detail of why my insurance and taxes requirements were increased. The local bank really doesn't want to deal with me and tens of others like me so they bundled up my mortgage with those of others and called up Citibank. Citibank did not care much about the quality of the mortgages it was buying from my bank because the executives who arranged these deals got paid on the potential revenues from this deal without taking into consideration the risk involved. Now Citibank bought ten mortgages from my bank, ten from another, and ten from another. Soon enough, they had a hundred mortgages that they expected to make a lot of money from over the course of three to thirty years. Now being smart like all these financial wizards are, they decided to do something productive with this money. Enter the insidious SIV, the infamous MBS, and the inscrutable CDO.

Thanks to the few remaining decent banking regulations, Citibank cannot loan out a lot of money if it does not have enough deposits. When Citibank bought my mortgage, it basically loaned out money to me and since I don't have any deposit in Citibank, I reduced their ability to loan more people more money. So the Citibank wizards decided to create a separate company, say CitiSIV which bought all the mortgages from Citibank. CitiSIV being a brand new company had no money so it borrowed a ton of money from the open market at low interest rates to pay Citibank for the mortgages. The lenders in the open market gave money to CitiSIV because after all, it's Citibank and everybody knows they are AAA rated. CitiSIV borrows money at low market rates but collects higher interest from the home mortgage payments. So CitiSIV make money. Then Citibank charges CitiSIV for loan origination and transaction fees so the money ends up back with Citibank. Not surprisingly, all of this is perfectly legal.

Now Citibank has a lot of money and none of the loans on its files. This means it can loan out a lot of money now and start the SIV cycle all over again by creating CitiSIV2. And there is where certified poop comes in. Lehman Brothers gave $10,000 to CitiSIV so CitiSIV could buy mortgages from Citibank and pay interest to Lehman Brothers. These mortgages that CitiSIV bought are now certified poop because the homeowners can no longer pay the mortgage. Why can't they pay the mortgage? Because most people, unlike me, bought houses much bigger than what they could afford and at variable interest rates that have now sky-rocketed, making it impossible to justify home-ownership with respect to renting. So there are a lot more foreclosures now. The mortgages that CitiSIV holds are not going to be all paid back and are effectively worthless. Why did people buy homes they couldn't afford? Because the local mortgage banks let them and even preyed on them.

While I know a bit about complex financial transactions from my background in Economics, most people don't and shouldn't be expected to. School teachers, research scientists, and office workers may know everything about their own fields but not much about ARMs, LIBOR, or HELOC. Most people can be expected to be moderately smart about their finances but that doesn't mean they know everything. What these borrowers weren't informed three to five years ago is that adjustable rate mortgages (ARM) and interest-only mortgages are only for those who know exactly how to invest their money. Selling ARM to an office manager was like selling drag-racing car to a soccer mom - both can only end in disasters. This means, the local mortgage companies loaned money to people who couldn't afford it after a couple of years. Why? Because they made money on sales and not on long-term payments. Real-estate agents and mortgage brokers got hefty commissions every time a house was sold so why should they care if the person who bought the house couldn't afford it?

Here is the wonderful game of hot-potato that has resulted in the current crisis. The home-owner didn't risk much when they bought the house because they got to "own" a fancy house without any down payment and could now potentially borrow money against this house. The mortgage broker did not risk his money, the mortgage bank did. The bank did risk money but only for a short time because it bundled up a bunch of these mortgages and sold them to Citibank. Citibank didn't worry about the risk because it sold SIVs against the mortgages. The people who bought the SIVs, say Lehman Brothers, didn't worry about the risky SIVs because they had AIG write CDS against these risky purchases. AIG didn't have to worry because BoA has insured them against all of these risky CDSs. BoA has no worries because Barclays has them insured. Barclays has nothing to worry about because AIG has them covered. So in the end, we have more money involved than most minds can fathom, resting on transfer of risk from one entity to another, all of it relying on the promise of the music-teacher who makes $25,000 a year that starting 2009 when his mortgage readjusts, he can pay $2,000 in mortgage payments a month.

This is how screwed up things are. And apparently $850 billion can help make things better. The politicians claim that $850 billion will be used to buy the bad mortgages from companies like CitiSIV/Citibank, sit on them for a few years, and then once the financial crisis is over, sell them back to companies like Citibank for a profit to the taxpayers. You would have to be brain-dead to even for a second think that somehow the bad mortgages will become valuable in a few years once the crisis is over. The music-teacher is not going to make $115,000 in a few years and will not be able to afford $2,000 a month in mortgage anytime soon. The bad mortgages will remain bad and significant portions of them will not be bought back from the US Government at a cost to taxpayers.

The solution to all of this? Suck it up. Let bad companies go bankrupt. Let bad investors lose all their money. Let investment bankers, mortgage brokers, and insurance underwriters be fired. And unfortunately, let people lose the houses they cannot realistically afford. If the government wants to help, they should first help those in dire need.

There is no painless way to heal a gaping wound but to stitch it up and bear the pain once. The sad thing about good economic policy is that it takes a while to take lasting effects and it makes a lot of people miserable in the short-term. Bad economic policy tries to help a few people immediately while making everyone else miserable in the long-term. $850 billion is nothing compared to how much it will cost to try to "fix" this crisis by throwing money at it. A lot can be done to improve the situation by giving direct help to the homeowners and small business owners who actually need it. Not much will be done by giving money to the same exact banks that took foolish risks, lost money, and begged the government for handouts. The bailout will infuse the markets with additional cash, reduce the value of the dollar, and once again, encourage bad investments because no investment is risky if the government is willing to bail companies out with taxpayer money.

Just think about it. You pay taxes. The government is taking that money and giving it to the banks. Now the banks will lend you money to buy a car. You will pay interest on that money, a part of which is actually your own money that you paid in taxes. You will pay interest to use some of your own money! This isn't some exaggerated doomsday scenario. This is right now. The bailout bill has passed and next month when I want to go buy a car, I will pay interest to borrow some of my own money. Meanwhile, the CEOs of all these companies will continue to get stock options, unlimited perks, and golden parachutes. Who said life is fair?

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