Weakly Discourse

Oh what the hell. After attempting to solve this by last week only to have it completely stalled (partially after McCain’s trip to Washington even so far as to suspend his campaign, yet only causing confusion and parroting a secondary plan), they came up with a bill that was largely expected to pass (including some concessions to the idea of both including oversight, as well as requiring the Treasury to come up with that alternative insurance plan even if it wasn’t required to use it). Instead, we get nothing by twenty-three votes and are forced to watch as the the DOW plunges more in this single day than in the day the markets opened after 9/11.

An article and a forum post I stumbled across both illustrate partially why this happened and why we need this bailout (and also why some form of a bailout is going to come eventually, even though every day of stalling simply creates more uncertainty in the market):

Shattering Glass-Steagall

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Necessary. The current problem is largely in two facts. The primary factor of illiquidity in mortgage backed securities, the secondary factor in credit derivatives. The second part hasn’t hit, and if it does, there will be no bailout big enough to fix the problem.

At this point in the game, the question is not, “what got us into this situation”, we know that. And as well, the question is not “who do we punish” the problem is too large for that.

A good analogy would be like a refrigerator. If you leave it sitting the food inside will rot. Proper regulation of your refrigerator will assure that a minimal amount of food goes bad and a maximal amount gets eaten. But, at some point of letting it sit, letting it sit further does not fix the problem. Sure molds will grow and end up consuming all the food in the fridge, then die when its expended. Eventually. No, you have to throw it out, as much as you would like to save the energy in the food, its impossible.

That is pretty much where we are at with the bailout. It needs to happen and it needs to happen in the manner prescribed(buyout). As i was saying earlier, the primary problem is illiquidity in these securities market. This occurred as people stopped trusting the return on these securities. Why this happened is complicated, it had to do with an increased rate of foreclosure, and the expansion of CROs from rating companies to rating individual securities, deregulations that made trading these types of securities easier and easier to create[I.E. cut up], and a lack of incentive on the part of the brokers themselves to produce deals that produced results(this ties into the CRO issue). This list is by no means complete, but it comes down to the fact that deregulation and maleficence(which is to say, SOP) had created an atmosphere where these securities were valued way above their real value.

The core of the illiquidity is that now that people are not trusting these securities at all, they are not trading. Mark to market be damned, that only has to deal with their reporting, if people were doing due diligence they can find the value of these things if they want. Mark to market has nothing to do with whether or not they can get loans unless the other party believes the market price is right. Since everyone is trusting the market in not trusting these assets what you have is a bunch of people who can’t get loans because no one trusts what collateral they could pull.

Modern financial companies operate on leverage.[another big problem, the sec changed leverage rules for a number of companies]. Basically this means that the companies borrow 10 times more money than they can pay back[SEC ruling changed that to 40 times for a number of companies]. Since very few people want their money all at the same time, they can then use this leverage in order to make more loans and increase their margins. In order to keep this system flowing, they need to keep getting short term loans. If they don’t they can’t cover their costs during spikes of activity.

Now lets combine the two issues. Companies which need loans to operate can’t get loans because everyone thinks that if the company fails to pay back its loans[which is entirely possible because they think the company is making bad investments]. Such, the companies fail[its not quite so cut and dry, its gradual and goes through stages, but that is the gist of it].

Loaning them money doesn’t do anything[and creates inflation, which is very dangerous], since they use the money to pay off their debts but still can’t get loans in order to continue their operation. They can’t pay insurance cause they don’t have any money, the cost of the insurance would offset the value increase of the securities[since they would then be guaranteed], and no one trusts the securities any more than they did before.[this is a big more complicated, there is also then trust in the Govt to be able to pay out the insurance when it comes due, and trust in the Govt to be able to do that are probably slim, this is a really bad plan]. So, someone has to take the assets off their hands. And that means the U.S. govt has to step in and buy these assets.

Will the govt get fleeced? Unlikely. But possible. The markets for these securities are small since they are not commodified across the spectrum. Which means the possibility in power imbalance at the auctions is distinct[holding auctions for non-commodity products is another problem in and of itself]. However, this amount of problem is likely to be low, it doesn’t take many sellers to make competition valuable, and since there are very few buyers, the U.S. govt holds a strong negotiating position. As well, the market price of these assets being so low already may offset any gouging that goes on.

Now, why does this need to happen? Because there has been a spate of deregulation that has allowed a number of institutions to get so large they “cannot fail”. One of the purpose of merger regulations is to keep financial markets diversified exactly for the purpose that if one organization needs to fail, it can[Fannie and Freddie may be an exception, since they had implicit govt backing, which means that they couldn't fail no matter their size]. How do we know when a company is too large to fail? Well, its pretty much when it failing will depress the supply of money to an unacceptable point. Now, i am not talking about money supply, but in the ability of people to secure loans. When the ability of people to secure loans is depressed, the entire basis of a modern economy ceases to function.

The basis of a modern economy is basically that capital can be allocated to be most efficient as quickly as possible. This works when someone thinks they can make a profit off of taking out a loan. E.G. you take out a loan to start a business. If you saved to start a business you would start 5 years from now. If you get a loan, you start now, and 5 years later your loan is payed off and instead of starting a business you’re making money doing something profitable, you’ve gained essentially 5 years of start up, so 5 years of profit from your company for the cost of the interest. It works the same way when buying a house, a car, or any capital expenditure.

So what happens when loans get depressed? The efficiency gains in capital allocation are depressed. What happens when the efficiency gains in capital allocation are depressed? People stop hiring people. What happens when people stop hiring people? Those people who aren’t hired, cut back expenditures. What happens when people spend less? People start firing people. What happens when people start firing people? People spend less

Then you have a recession or depression. In this case it would be a depression. A recession might have saved it from being as bad [by inducing inflation or by enforcing proper regulations on the capital markets you stop a violent correction at the cost of a small downturn]

The economics are cut and dry here, the Chicago school is holding onto a dying ideology that simply does not work in large currency based economies.

Edit: Forgot to talk about CDS. Credit Default Swaps are a credit derivative[which means it gets its value from the credit worthiness of a company] that operate like an insurance policy. One person pays an amount of money regularly and the other one agrees to pay off the return of a debt if it goes south. The catch? You don’t have to own an asset to buy a swap. Its basically a bet against a debt failing. The risk involved in a CDS is the liklihood that the debt holder will repay, and the liklihood that the swap issuer can pay you.

A lot of companies looked at CDS as basically free money. These companies weren’t going to not pay their debts. Because of that there is roughly 60 trillion in CDS that could be collected if these debts are defaulted on. That is more than the GDP of the entire world, and nearly 10 times the value of the entire sub-prime mortgage market[note, values are usually bigger than GDP since they are accumulated capital]. The issuers ignored both systematic risk as well as made unreasonable expectations on these debt repayments for a number of reasons. But basically, once institutions start failing, other institutions may be on the hook for their debt in the form of these default swaps. But the default swaps are likely to, at this point, have to pay out many times over what the debt was. If you have two swaps on the same debt and that debt fails you are on the hook for twice the value of the debt. These institutions are then likely to not be able to pay those. They fail. Anyone hold CDS on those institutions? Well, now they’re probably going to fail too. Then the entire market implodes and a slight recession or depression looks like fun, as we would have to rebuild our capital markets from scratch, which would be no easy task given the likely investor mistrust and take a lot of time.

fake edit: CRO’s play a huge part in this, but i didn’t have much time to talk about them. Basically they are a company that rates credit of a company or security at the time the security is issued. However, they are payed only if the security deal goes through and have no implicit guarantee of their ratings. In the past they have been very reliable, but that was before they expanded into rating individual securities where they now have an incentive to lie about the value of the security. An apt analogy would be like trusting a home inspector who said “i do not guarantee my work” and only got paid if the house closed.

/end wall of text

edit 2: You thought I was done: Electric Boogaloo

The other benefit of the buy is that the govt can forgive and restructure any loans it wants[so long as the end result is beneficial to the mortgage owner], so some of the people who got suckered into bad loans and were unable to get out as housing turned down would not lose their home. This can be a pretty important efficiency boost for the govt since it doesn’t have to sell it and since it has an interest in the general welfare[which is not necessarily served by anyone buying a house]