Understanding the Global Financial Crisis

(Originally published at Greater Democracy.)

Over the past week, financial markets have been in turmoil as one firm after another faces difficulties. Everyone has opinions about how this has happened and what should be done about this. I have my opinions as well and have been writing about this in various venues. This post pulls together many of my thoughts from different discussions into an overview that will hopefully help others make sense of the global financial crisis.

Personal background

I should start off by providing a little background to my own involvement. I started working on Wall Street at Lehman brothers in the late 80s. I worked in technology, and specifically on programs to analyze and evaluate various types of mortgage backed securities. Over the years, I’ve had various roles on Wall Street, but they have always been technology related. I worked with executives, traders, analysts, and on models themselves, but I’m not an economist. For a much more personal essay on my role in all of this, I would encourage people to read this blog post.

The big picture

When we start talking about who is bailing out whom, I hear lots of
concern by people who haven't worked on Wall Street expressing concern about the Government bailing out Bear Stearns, Fannie Mae, Freddie Mac, and now AIG. Why aren't we, as individuals, getting bailed out? I can tell you, that question resonates very well with me right now.

Perhaps this is best expressed in Arlo Guthrie's rendition of Tom
Paxton's song, “I'm changing my name to Chrysler” as presented in a great YouTube video:

Yet perhaps we are all getting bailed out. Perhaps by bailing out some of the firms above, the Government is preventing a much more devastating financial collapse.

Already, I’m hearing friends in politics, on Wall Street and in the media talking about a 1930’s style depression. Is this a fear tactic to get people to support bailouts? Will the bailouts we’ve been seeing prevent a 1930’s style depression? Will they make the current economic malaise longer but shallower? Everyone has an opinion and is encouraged to share them here.

With that, let me explore in a little more details of how we got to where we are and some of the issues we face.

Financial Innovation

This is an area that I've been pretty involved with. I started off on Wall Street working with mortgages and related products (CMOs, IOs/POs, etc.) While many of the financial innovations make sense when you think about them, some of them can get very complicated. They are only possible because of increases in computing power.

This raises an important issue. Many of the financial instruments of today can only be evaluated or priced if you have a powerful computer running a complicated model. The first question is, how do you know if the model is right? Just a small error in the model can make a big difference. Add to this, the ability of investors to understand what they are investing in.

Not to give credence to the trickle down economics of the 80s, but some of this trickles down to regular people. As I mentioned in my personal essay, Orange County went under because they were investing in things they just didn't understand. Ultimately, I believe that this is a key part to all of the crises. Mortgage companies issued mortgages at ridiculously low rates that would reset to higher rates later. In the mortgage companies’ viewpoint, these resets would protect against risk going forward, but they didn't properly account for people being unable to pay for the resets.

Don’t get me wrong. I believe that financial innovation is a good thing. However, the ability of regulators and even investors to understand these innovations have not kept pace with the innovations, and this is part of the problem.

The Housing Bubble

Because of this great availability of credit, housing prices soared.
This was fueled by the view that the value of land never goes down. To borrow a line from Irving Fisher, "Stock prices have reached what looks like a permanently high plateau" (shortly before the 1929 crash).

As the resets started coming in, and people couldn't afford the resets, in part because the economy was already in difficulty for other reasons, this lead to sales, foreclosures, and a decline in housing prices which has just snowballed.

For an interesting graph on this, I'd encourage people to take a look at this graph of median housing prices.

Based on my back of the envelope analysis of this graph, I would suggest that housing prices are probably still over inflated by about 12%. However, as with any other correction, prices will probably need to drop much more than 12% and then rise back up to that level.

The Keynesian Beauty Contest

I guess this is probably a good point to talk about the Keynesian Beauty Contest. It isn't about picking which person is most beautiful, but about picking the person that everyone else thinks is most beautiful, or more accurately, picking the person that you think everyone else with think everyone else thinks is the most beautiful (carried out to as many levels as you see fit).

So, what is the proper Keynesian Median Home price? One key factor, prior to the collapse of the housing bubble was that it was at least what it had been last month. That support level is gone, and no one knows for sure what the new support level will be.

The Domino Effect

Yet with that, we also find the domino effect. With the falling of the adage that the price of land never decreases, we start seeing other things happen, such as institutions too big to fail actually failing.

We see a backlash against propping up these institutions and the Government letting one of these institutions actually fail, but then coming in a few days later and taking over another. We see this rippling to other institutions that just a few months ago seemed safe. Some of this is because of how closely interlinked everything is.

Commercial Paper and Money Market Funds

Many commercial banks, investment banks, and funds had money invested in Lehman Commercial Paper. Commercial paper is short term financing for institutions. As such it is considered very safe. Yet with Lehman's collapse, their commercial paper is essentially worthless.

This led to concern about money market funds. The idea of a money market fund is that it remains at a stable value of a dollar, and any gains go into dividends paid on the fund. One fund 'broke the buck', that is, had its net asset value drop below a dollar, back in 1994. With Lehman's collapse other funds have broken the buck in the last few days, and it has created a run on money market funds, causing some to close. This has resulted in the Treasury Department offering another backdrop that people may not have noticed. The Treasury is stepping in to guarantee money market funds, to the tune of $50 billion from the Exchange Stabilization Fund.

Short selling

Another ripple effect is starting to show up in short selling. People may be focusing on what the SEC is doing to curtail short selling, but there is another factor going on that isn't getting much focus. To sell short, you need to borrow securities from someone that has them. This is the securities lending part of Wall Street.

Typically, large asset management firms lend their securities to investment banks through securities lending, so that the investment banks can make sure that all the shorts are balanced out with actual securities. However, given the collapse of Bear Stearns, Lehman and Merrill, and the growing concerns about Morgan Stanley, major asset managers are curtailing their securities lending to Morgan and Goldman, making short selling even more difficult.

Many believe that short selling has made the financial crisis worth, so they may view this one as a domino falling in the other direction.

Mutual Funds, Retirement Accounts, and Gold

Let's push the dominos further. With the value of Fannie, Freddie,
Lehman and AIG all recently wiped out, mutual funds that have had holdings in these companies have had notable losses. Mom and Pop investors, who have their retirement accounts in these mutual funds end up seeing the value of their mutual funds decline, which may result in more mom and pop investors fleeing to quality, by seeking investments that will ride out the economic downturn better. Traditionally, this has been U.S. Debt, and for the more wary, Gold.

Bankruptcies, Credit Cards, and More

Those that lose all their investments will join the throng of people filing bankruptcy, and this will end up particularly hurting the credit card companies, but will also hurt many other businesses, including notably utility companies. Already, we are seeing some utilities seeking rate hikes because of increases in defaulted payments. We will also see this in municipal governments as property values decrease, driving down grand list values, and as people fail to pay their local taxes. These taxes are not forgivable in bankruptcy, but it can still result in major delays in receipts for local governments.

Then, of course, as we see people cutting back spending, not only because of fuel and food prices going up, but also because the value of their investments decreasing, we start seeing the traditional cycle; reduced spending, leading to companies laying off people, further reductions in spending, until some sort of stimulus turns things around.

Looking forward

So, let me talk about possible winners. First, I have to have a caveat. If this meltdown is more like the 30's I'm not sure the dust will settle in two years. However, I will suggest that under the current regulatory environment, the large commercial banks are probably best suited towards survival.

Let's look at who is buying whom. JP Morgan Chase has bought Bear Stearns. Lehman has folded. Merrill has been bought by Bank of America. Rumors are that Morgan Stanley is in talks with Wachovia or the China Investment Corporation. The Government essentially bought Fannie, Freddie and AIG. Bank of America also bought Countrywide (mortgages) and MBNA (credit cards).

So, commercial banks and sovereign banks, and anyone who has been sitting out the credit markets recently are likely winners. Warren Buffett, who back in 2002 said he viewed derivatives as time bombs, and is now sitting on lots of cash is positioned to do well. Where is he putting his money? Recent reports are about Berkshire Hathaway buying Constellation Energy, a supplier of energy and owner of nuclear power plants.

Beyond that, the key thing is, what will provide the economic stimulus we need to pull out of this? Will it be another world war? There are politicians that seem to be hoping for this. Will it be some sort of government driven program? Will we see a new WPA with great work on infrastructure? Will it be finally tackling issues of energy and a move towards a green economy? One can always hope.

Yet again, we need to look at the beauty contest aspect of it. To a certain extent it becomes about what everyone thinks will lift us out of the mire. So, I'll keep talking about a green economy as being the key to economic recovery and hope that it grows more legs.

Enough for now. I look forward to responses.

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