What’s happened is that banks have mortgage backed securities that they had counted as assets, that they used for collateral for short term loans, as well as credit default swaps, etc. It turned out that those mortgage backed securities aren’t worth what they thought they were, so they have to retain more capital to cover the various loans and contract obligations they made. And it gets worse, because their credit rating is getting downgraded, and everytime they get downgraded, they need to hold more capital. It’s basically an inescapable spiral. They’re all so overleveraged, that as soon as their bonds get downgraded, they’re either going bankrupt or getting bought out, or both.
What this means is that these banks that are on the edge of insolvency literally cannot lend money without charging exhorbitant rates. It doesn’t matter how good your credit is, they don’t have any money to lend without tipping themselves over into insolvency. They need capital and they need it now, that’s what this bailout is supposed to accomplish. It’s supposed to give them a buffer so they can write off the bullshit Mortgages they own and get back into the business of loaning money.
The root of the problem
The problem is over leveraging, and the reason it gets to be a problem is that people put too much trust in a formula:
It’s a formula for pricing options and derivatives that allows you to balance every investment with a hedge in case something goes the other way. That’s what futures contracts and credit default swaps are about. The reason there were trillions of dollars of these out there is that they thought that everything was so carefully balanced and hedged, that no matter what happened, they’d be covered.
The problem is that when your models are based on faulty assumptions, you’ve gone so far out on a limb that you’re absolutely fucked when things go wrong. It’s what brought down LTCM a decade ago.
Say you have 100% to invest.
You want to earn as high a return as possible.
Now, you COULD loan that money out to someone for 3% interest. That’s pretty good.
But if you have really good credit and you can borrow money at say, 2%, then you can loan out 100 at 3% interest, and use that loan (which is an asset) as collateral to borrow, say $1000 at 2% interest and then loan it all out to a slightly riskier person for a 5% return — so instead of getting back $3 yearly, you’re now getting $50 yearly and have to pay $20 yearly in interest — boom, you’ve just multiplied your income by 1000%. Now, that 5% interest loan is a little bit riskier, so you kind of spread it around as 10 $100 loans instead of one big loan. But even then, you’re kind of fucked if more than 1 or two of those loans go bad — you’re still on the hook for all the money, but you’re not getting the returns to pay off the money you borrowed.
So what you do is you buy insurance from a third party for, say 1% of the loan, which pays you off in case any of those loans default. That’s basically a credit default swap. Now, with that in place, you can borrow and loan an almost unlimited amount of money nearly “risk-free”, with almost no initial capital investment.
You can see how this quickly gets out of control, particularly when you then decide to start selling insurance of your own. Now you have a bunch of banks essentially creating money out of thin air, and it’s all beautiful as long as the loans you’re making to the only actual source of wealth (ie, workers) don’t start defaulting in large numbers.
Which is what happened here. Suddenly all that free money has to be spent all at once, and *poof* it evaporates. All the money you thought you had is gone. It may not have been a problem, if they had kept a large enough cushion, but they counted all this money as ‘profit’, and kept siphoning it off into dividends and huge payments to executives/brokers, etc.
Long story short, there’s really nothing wrong with any of this as long as there are limits to how much you can leverage yourself to loan money out. People thought that hedge funds would eliminate risk, and what hedge funds do is externalize risk. Hedging eliminates your personal risk, but the risk still exists, it’s just been moved out to another company. That company then needs to hedge its risk out to another company and so on. It just expands and expands and expands until the economy literally can’t take any more risk on and then it all bursts, which is what we just saw. The economy is a closed system, you can’t remove risk entirely, ever.
What could happen next
The US stock market tanks. Bank shares collapse, as do the valuations of all highly leveraged financial institutions. Weaker versions of this occur in Europe, in Japan and in the emerging markets. CDS spreads for banks explode, as will those of all highly leveraged financial institutions. Credits spreads generally take on loan-shark proportions, even for reputable borrowers. Again the rest of the world will experience a slightly milder version of this. No US bank will lend to any other US bank or any other highly leveraged institution. The same will happen elsewhere. Remaining sources of external finance for banks, other than the facilities created by the central banks and the Treasuries, will dry up. Banks and other highly leveraged institutions will try to unload assets at fire-sale prices in illiquid markets. Even assets not viewed as toxic before will become unsaleable at any price.
The interaction of a growing lack of funding liquidity and increasing market illiquidity will destroy the banks’ business models. Banks will stop providing credit to households and to non-financial enterprises.Banks will collapse, both through balance sheet insolvency and through liquidity insolvency. No bank will be safe, not even the household names for whom the crisis has thus far brought more opportunities than disasters.
Other highly leveraged financial institutions collapse on a large scale. Households and non-financial businesses revert to financial autarky, among wide-spread defaults and insolvencies.Consumer demand and investment demand collapse. Unemployment shoots up. The government suspends all trading in financial stocks until further notice.
The government nationalizes all US banks and other highly leveraged financial institutions. The shareholders get nothing up front and have to wait for an eventual re-privatisation or liquidation to find out whether they are left with anything at all. Holders of bank debt get a sizeable haircut ‘up front’ on the face value of the debt and have part of the remainder converted into equity that shares the fate of the old equity.
We have the Great Depression of the 2010s.
http://www.youtube.com/watch?v=nUukDJCyqfM <— some opposition, well explained to the bailout
and here is a Very long, but excellent analysis of the current situation
But really, we are in uncharted territory. It’s very hard to say what will happen next.
It’s like cloning cattle..without genetic diversity one virus kills them all. We are a victim of lack of real diversity. The same weakness, reliance on mortgage-backed securities, and flawed mathematical models of guaranteed wealth will make EVERYTHING crash. The bailout will help for a very very short while, unthaw the economy for a tiny while, but our entire system of financing is broke. Hedge funds don’t hedge anything. Risk is not eliminated. Recession / depression is inevitable.
The mortgage crisis is not really the cause of this mess, but our entire system of economy (profiting from debt). All it does is encourage banks to lay more and more debt on the working class.
Workers are the only source of real income, it’s the real economy. Wall Street is this nether realm of a 2nd economy that speculates on where the real economy will go. It’s imaginary money rather than real money. If it wasn’t mortgages as a vehicle for debt, it would be something else.
And now the working class will have to pay off the speculative economies greed via probably a decade or more of indentured servitude.
Hedge funding did not shield risk at all, and just like cloning an entire herd of cows subjects them ALL to the same genetic flaws (one virus wipes them out without genetic diversity) our economy is going down the tubes by the same flaw since there never was any real diversity. Everything was spread out so thin in order to shield risk that ironically, everyone now would go down by the same risk..like dropping a single drop of poison in a glass of water the entire glass shares the drop of poison alike.
So to summarize: Predatory lending on the working class by banks fueled by an economy that like some sort of money vampire feeds off debt is the root cause of this. The bailout will only keep the banks afloat to lend to the public again in some other speculative debt-fueled economic push. It will start all over again and as always, the working class suffers.
Why do you think there was such a push to get the american people to own homes from 1938 onward? For home ownership, it is NOT because it is the wish of the Government to ensure every american gets to fulfill the american dream and own their own home. It’s because they want you to get a 300,000 loan. No one ‘buys’ a home. ‘Owning’ the home is an illusion. If you fail to pay on your home what happens? The bank takes it, because it’s their house. What you do own is an enormous loan.
Everyone gets a HUGE loan and then slowly, painfully slowly pays it off. The American economy feeds off debt. Thats the reality..thats what we all have to wake up to. Normally, someone getting a 500,000 loan to buy something when they earn, say, 60,000 combined household income would seem insane. But it was encouraged by the government because again, massive debt is what the economy thrives on.
Debt is a horrible thing to base an economy on. Keeping the public enslaved in debt to fuel the profits of the few at the top is immoral, it’s modern slavery. You are toiling in cotton fields for the master in his warm house and go to bed at night in a mud shack eating leftovers from their table as your dinner. Debt-fueld economy is nothing more than an enormous pyramid scheme, doomed to failure with only a tiny few at the top raking enormous, obscene profits.