Friday, September 26, 2008

In Response to Joe’s Question

Joe asked,
"I feel like this is a bad time to know as little as I do about economics, credit, and Wall Street. One expert I heard (not that I trust experts) believes that the problem necessitating a bailout is that with all the bad debt out there losing money, lenders will be less likely to loan to even solvent businesses and citizens, thus slowing progress to a halt.

What are your thoughts on the bailout? I can't quite tell if you're entirely against it or not."

To the first question, "what the hell happened to get us here?" I would refer y'all to Barry Ritholtz's recent post on The Big Picture. Basically, what got us here is that banks were allowed to deregulate (because a certain "free market's always good"-kind of Ayn Rand-loving faction of those in power began working overtime during the past decade) in such a way that banks were allowed to lend and sell credit as an asset.

Now, credit is simply a promise to be repaid. An asset is something of value that can stand in the place of credit that is not repaid; it's also known as collateral. Many, many, many a loan officer was encouraged to make loans to people that simply should not have been considered for mortgage loans.

Why were they so encouraged? Because of the new deregulation one firm could bundle up a bunch of these loans and sell them to investment groups (like hedge funds) and say that these were assets. Why was it considered an asset? Because there was real property backing up the loan (the physical house). But here's the thing. With this deregulation it was possible to sell shares in these mortgages. So it wasn't the case that you had one bad loan that went into foreclosure, and one investment firm. It was more like, this investment firm is entitled to the windows on this foreclosed house.

The problem with the foreclosure is that you gotta pay all these people to do all the paper work to get the house back, for one. But then, when the bank that forecloses tries to sell that property, everyone wants a deal. No one wants to pay what the newly-foreclosed paid. Why? 'Cause they know that the bank is taking a loss already, now they want to know how much of a loss the bank is willing to take.

This is the fundamental assumption of our economic theory, right? People will always try to maximize profit rationally.

So, let's use the old mantra, "as above, so below," and discuss what's happening at the macro level.

Imagine that you're an investment bank, or a regular bank like WaMu. You, like your peers at firms that have been mythologized over the past 30 years as "too big to fail." Given that mindset, during the housing boom of the past 10 years or so (fueled by the deregulation because now people weren't buying one house, they were buying two or three and "flipping" them), your bank became exposed (that is, took ownership) of a lot of these kinds of loans where people put little money down because they were borrowing on the anticipated value of their home in the future. Everyone's been telling each other for years (hell, it's the American dream) that owning a home is always the way to go because homes always increase in value (and they do, but it takes generations, not tens of months).

So your this exposed bank, with loans that no one wants to buy for the amount the banks originally said they were worth. Say you had a loan for $1.00 and had been doing all your accounting assuming that the loan would either be paid on time or that you could sell that loan to someone else for at least $1.00 if not $1.30.

Problem is now everyone knows that these hot potato loans are no good, so now people are making offers to buy what the bank thought was worth $1.00 for maybe $0.30. That's called current value.

The bailout that's been proposed until today, when McCain came in and screwed the pooch by insisting he had answers to the problem (this is the same man who a week ago said the American economy is fundamentally strong and we had nothing to worry about; his economic adviser even had the chutzpah to say that all this economic recession/meltdown talk was due to America being a country of whiners).... Anyways, the problem with the bailout is two fold:
1) it doesn't give a realistic value for the value of these loans its about to take on (so the Fed will buy those loans for $1.00 and then hopes to sell them; but will likely only be able to sell them for at most $0.60; so tax payers lose a lot and the people who sold those loans to the Fed will just swoop in and buy them back for $0.60 thereby making a killing)
2) it has as its goal reintroducing credit into the economy, trying to get banks to lend money to each other again (which is like giving Isaac Mendez heroin so that he can paint the future for Mr. Bennet).
So, I think that America has a choice: either go ahead and let the economy spill out into a depression by allowing that wave of deregulation go full circle or go ahead and bail out these banks.

I think the bailout as it's structured now will lead to at least a recession and probably won't allow us to avoid a global depression anyways. I think a depression is a given. I think the further problem with the bailout as it's set up, though, is that it creates a system that in the future is going to do more to harm the American people than help them.

I think not offering a bailout that emphasizes that the tax payers become the primary beneficiary of whatever "assets" they acquire by purchasing all these loans will not only lead to recession at least but also is a $700bn slap in the American face.

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