3.19.2008

Bubbles lead to busts. Busts lead to panics!


Can’t Grasp Credit Crisis? Join the Club

Excerpts:

Raise your hand if you don’t quite understand this whole financial crisis.

...
I’m here to urge you not to feel sheepish. This may not be entirely comforting, but your confusion is shared by many people who are in the middle of the crisis.

“We’re exposing parts of the capital markets that most of us had never heard of,” Ethan Harris, a top Lehman Brothers economist, said last week. Robert Rubin, the former Treasury secretary and current Citigroup executive, has said that he hadn’t heard of “liquidity puts,” an obscure kind of financial contract, until they started causing big problems for Citigroup.

I spent a good part of the last few days calling people on Wall Street and in the government to ask one question, “Can you try to explain this to me?” When they finished, I often had a highly sophisticated follow-up question: “Can you try again?”

...
It really started in 1998, when large numbers of people decided that real estate, which still hadn’t recovered from the early 1990s slump, had become a bargain. At the same time, Wall Street was making it easier for buyers to get loans. It was transforming the mortgage business from a local one, centered around banks, to a global one, in which investors from almost anywhere could pool money to lend.

The new competition brought down mortgage fees and spurred some useful innovation. Why, after all, should someone who knows that she’s going to move after just a few years have no choice but to take out a 30-year fixed-rate mortgage?

As is often the case with innovations, though, there was soon too much of a good thing. Those same global investors, flush with cash from Asia’s boom or rising oil prices, demanded good returns. Wall Street had an answer: subprime mortgages.

Because these loans go to people stretching to afford a house, they come with higher interest rates — even if they’re disguised by low initial rates — and thus higher returns. The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer). Once bundled, different types of mortgages could be sold to different groups of investors.

Investors then goosed their returns through leverage, the oldest strategy around. They made $100 million bets with only $1 million of their own money and $99 million in debt. If the value of the investment rose to just $101 million, the investors would double their money. Home buyers did the same thing, by putting little money down on new houses, notes Mark Zandi of Moody’s Economy.com. The Fed under Alan Greenspan helped make it all possible, sharply reducing interest rates, to prevent a double-dip recession after the technology bust of 2000, and then keeping them low for several years.

All these investments, of course, were highly risky. Higher returns almost always come with greater risk. But people — by “people,” I’m referring here to Mr. Greenspan, Mr. Bernanke, the top executives of almost every Wall Street firm and a majority of American homeowners — decided that the usual rules didn’t apply because home prices nationwide had never fallen before. Based on that idea, prices rose ever higher — so high, says Robert Barbera of ITG, an investment firm, that they were destined to fall. It was a self-defeating prophecy.
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Bubbles lead to busts. Busts lead to panics. And panics can lead to long, deep economic downturns, which is why the Fed has been taking unprecedented actions to restore confidence.


Comment: I'm in that club (of not fully understanding the credit crisis)! What I am doing is avoiding my own personal credit crisis. I have seriously cut back on the use of my credit cards and I pay them off every month. I'm not sure where all of this will shake out (at the National and global level) but I'm trying to keep my own house in order.

4 comments:

  1. JP (or anyone else, if anyone else besides Jim and me read this web site), I like your website and I think you post a lot of interesting articles. First off, like you said, I have no clue where this whole thing is going to end up.

    At this point, do you think anyone in the general public really cares too much? You were an economics major (I think you said) and therefore perhaps have a personal interest in financial topics. But in the general public, so far I'm not seeing anyone really change their lifestyle too much and I don't hear people talk about economics too much. People are still interested in pro sports, the kid's soccer games, who's ahead on American Idol, etc. Those are all fine and dandy things and I'm not suggesting that anyone should do anything differently, by the way. Here's what I'm driving at: Like you said, no one knows where this will end up. But I am beginning to wonder if this won't turn out bad. Some serious (non rightwing nutcases) people are beginning to say that this could end up in a bad way, and my sense is that the general public is completely oblivious. I sure hope the negative, "sky is falling" types of people are wrong!! But a little part of me is beginning to wonder if this may be bad. Some people have even mentioned the word depression instead of recession.

    I have no clue where this will end up, but it's interesting to watch.

    Here's what I think might be a scenario: The dollar will collapse and people will be begging for relief and this will be the perfect time to introduce the Amero. A little conspiratorial?? Perhaps. But not so much if you take the time to keep up on what's really going on.

    Anyway, how 'bout them Vikings? :)

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  2. It's hard to know how this credit crisis will impact any one individual.

    Sadly for Bear Stearns' employees and stockholders it means a massive loss of personal wealth (not unlike Enron!). For some of them it will mean the loss of a job (Also Countrywide and other mortgage companies).

    It means that the "wealth" in one's own home is probably not as great as it was a year ago. It means selling a house will be more difficult for a while.

    It means that what one has in savings will garner a lower interest rate.

    Obtaining credit for a home will be difficult for some with marginalized credit.

    For all it will mean higher fuel costs (because of the declining dollar).

    For our missionaries (I feel for them!) it will mean that they probably need much more support (especially those in Europe). Some will need to come home on urgent deputation trips to raise that support.

    I'm glad that God knows me and I know Him and that I am safe in His mightly hand! (Psalm 37:24, "Though he fall, he shall not be utterly cast down;For the LORD upholds him with His hand")

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  3. Anonymous, you make some good points. I'd simply point out that even if Jim has only a few thousand readers, he's helping those few escape the traps that any would-be masters would set for us via debt and other poor financial choices, no?

    It's certainly hard to see in aggregate statistics, but the last place you see a trend is in the aggregate. Maybe some good is being done.

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  4. Good points, JP. I probably wasn't as clear as I should be. All those things you mentioned are happening and/or will happen in the very near future. But even more than that,I'm beginning to wonder if this is "the big one," where the whole things basically comes down. History has shown that fiat economies (money not backed by something) all eventually fail. This is just one of the reasons why Ron Paul has become popular - he tells the truth about our monetary system. I certainly have no clue when "the big one" will hit and this whole house of cards will come down and the dollar completely collapses. Maybe it won't be for another 200 years or much longer and we'll eventually recover from the current situation. But history does not seem to be on the side of fiat economies.

    Usually this kind of talk is reserved for far right-wing or left-wing kooks who think the sky is falling. But with the way things are going lately, even more mainstream and legitimate people are starting to get concerned. In any event, it will be interesting to see what happens.

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