Thoughts on the Economic Meltdown...

I'm gonna put in my 2 cents about this economic meltdown... I've been following it since 2004, mainly on The Big Picture and The Agonist. There are good reasons why I started saving a majority of my income as cash way back in 2006, and avoided the stock market... one of them is that I came to realize that the game was rigged, and I didn't want to get caught in the inevitable crash.

I've read a lot on the subject... I'm not an economist, but I'm going to try to put this into my own words.

Why the hell did this happen?!?!

Essentially, both Washington and Wall Street starting acting like a rabid pack of free-market fundamentalists instead of pragmatic capitalists. The deregulation and tax cuts that spurred the economy back in the Regan era were a pragmatic reaction to the sluggish, over-regulated economy. But, tax breaks and deregulation are neither necessary nor sufficient for economic growth. Don't believe me? Then please explain this evidence: in 1990, we had more regulation and higher taxes, and the economy BOOMED... but in the 2000s we had less regulation and lower taxes, and the economy CRASHED.

No matter how you look at it, tax breaks and deregulation are merely tactics to be used when appropriate. Saying that they are always good is woefully ignorant... Only a fool keeps using the same tactics over and over, especially when it comes to something as complex as the economy. If you still don't believe me, ask arch conservative Francis Fukuyama for more reasons on why Republicans who merely coasted on Regan's achievements have only succeeded in destroying them. Our banks are becoming nationalized, and we're effectively socialists, all thanks to those dense dittoheads.

Some industries -- like technology -- don't need much regulation... whereas others -- like banking -- need LOTS of regulation.

Blame The Poor!

Its popular amongst free market fundamentalists to blame this problem on the poor... especially for the Fannie May / Freddie Mac meltdown. They blame Clinton for lowering lending standards, so lower income people could be home owners. Now... I have minor technical objections to Clinton's plan, but according to the mortgage brokers I know, this was never the problem. Low income lenders paid back their loans faster than anybody else. Besides, even if Clinton's plan had bad side effects, Washington had plenty of time to fix it if they were actually paying attention... Blaming Clinton for the current mess based on something he did 10 years ago is as pathetic as blaming your parents because you hate your job. It might make you feel better, but its a whiny cop-out, and doesn't solve the problem.

No... the true problem was the middle class overextending their credit with complex, hybrid mortgages. Suddenly, individual lenders were incented for making bad loans!

For a long time, the banking industry wanted mortgage brokers to be more regulated... because these brokers kept hiding the real risks of the loans. Mortgage brokers eventually started doing NINJA Loans. This means No Income, No Job or Assets Loans... and making tons of money on fees and closing costs. People didn't have to prove they owned anything in order to get a loan. Eventually, after Washington refused to regulate, many normally sane banks decided to get in on the action. The ones that didn't are the ones that are currently still solvent...

As one former mortgage broker told me, "it was like a competition between the brokers and the bankers about who could make the stupidest loan!"

The poor could not have caused all of this problem on their own: there simply aren't enough of them. Yet.

Eventually, people weren't able to repay their loans... and the money that the banks expected to get in monthly payments simply didn't arrive... which means less capital to work with. Banks get skittish, and the ones that don't fail want to hang on to their cash for longer and make fewer loans.

When foreclosures increased, then the bloggers started screaming about what was going to happen next: the derivatives market was going to crash and burn...

Blame Derivatives!

Now we get into crazy land... What is a derivative? The Week has a good was to describe it: legalized gambling.

Now, this isn't a bad thing... probably the most common derivatives are stock options and commodities futures. The former is pretty common for tech people: they bet that their company stock will rise, so they hang around at a job they hate, for the "option" of selling their stock at a higher value. Commodities futures allow farmers to sell crops now when they don't have them, so they can get quick cash to improve the productivity of their farm. These are both fine...

The bad boys of the derivatives market are credit derivatives. In essence, this is simply "insurance" that you will get money back if a stock goes down, a bond goes down, or somebody doesn't pay back their mortgage.

Offhand, these sound like a great idea... and they are! But only if you do the math correctly... which they didn't!

Part of the problem was that a lot of these credit derivatives promised to pay insurance money if somebody didn't pay back their home loan. But, instead of individual loans, they made promises on mortgage-backed securities... which are thousands of loans bunched together as one. Again, these aren't a bad thing... as long as you do the math right. Which again, they didn't!

The idea behind these securities is that if any one person defaults on the loan, the security is still mostly OK... Even if everybody in the security defaulted on the loan, the security would still be valuable, because you bought "insurance" to guarantee its value! But there were problems... Since a mortgage-backed security is a mystery bundle of mystery loans, its nearly impossible to measure the actual risk! In most cases, the people measuring risk did a decent job of accounting for market risk, but they completely neglected capital risk. Basically, this is the fact that capital can sometimes get more expensive when the economy is bad, and banks are hesitant to lend.

In effect, they didn't charge enough money for the insurance they sold, because they measured the risk incorrectly.

Well... so what? As we all know, there is only a finite amount of capital in the world... and if you are a bank that lost money on a bunch of bad loans, and you also have to pay insurance money for people who bought your mortgage backed securities, where will that money come from? And because you sliced up all those loans into a million pieces, not you have a million creditors for each bad loan... so negotiating with your creditors in a bankruptcy court is an impossibility.

In short, these big, bad, financial geniuses never anticipated how the entire economy -- mortgage banks, investment banks, hedge funds, and insurance companies -- would completely collapse if a very small minority of people couldn't pay their mortgages on time... and then they proceeded to make loans that they knew people would not be able to pay back.

Whoops!

There's a reason why Warren Buffet called these credit derivatives financial weapons of mass destruction back in frigging 2003. They are a decent idea, but very poorly implemented, and completely unregulated... one bank failure will almost always cause another. Back in 2000, the market for credit derivatives was under $100 billion dollars... which is essentially $100 billion in promises to pay back money, if something bad happens to the economy. By 2007, this unregulated market has ballooned to $44 TRILLION dollars... which is approximately the amount of money on the entire frigging planet. Nobody knows how big it is today.

This market produces nothing, feeds nobody, and doesn't foster industry one bit... Its just insurance payable when something bad happens. The only way you can make money in this market is by making huge bets... so again, these geniuses decided that nothing bad would ever happen, so they collectively bet all the money in the world!

And they lost...

How Should We Fix This?!?

First we must recognize the truth: there is no room for fundamentalism in good fiscal policy. We'll need a blend of free market ideas, some tax hikes, some tax breaks, some government control, and basically a return to pragmatic capitalism.

The best options I heard thus far came from The Agonist. The fundamental problem is a lack of transparency. In the past, banks would loan each other billions and billions every hour, but these days they don't know who they can trust... so the Fed is forced to step in and make loans. This can't go on forever, so the banks need to step up, ask for the regulations they need to safely lend to each other, then get to it. Its what some people call a shot of adrenaline, and it goes like this:

  1. Give the FDIC an injection of cash to buy out banks that are too insolvent to lend. "Too sick to lend is too sick to live." You would be amazed at how many will start lending in preference to working for their Uncle Sam.
  2. Sell short term bonds and give these to the Fed to extend lines of credit. About 150 billion in addition to the Fed's already eased credit will do.
  3. Back the bonds long term with "fat cat taxes," which include taxing wall street for every trade they make, and additional taxes to the top 2% of American earners.
  4. Signal that the policy of allowing banks to be bought up cheaply is over

If Wall Street wants a bailout, they are going to pay dearly for it. They are going to have to take some risk, a lot of regulation, and accept the long-term consequences for their actions.

And the fundamentalists should be chased back to their caves...

comments

Bravo!

Bex,

Your comment on economic fundamentalism is absolutely dead on! I've been saying for years that the nation's problems are nodes on a complex matrix of issues, and that no single idealology can provide all the solutions. The demonization of the left and the right has only exacerbated the situation by blinding people to the real problems.

Thanks for your insight.

GREED

Nice post, I will restate here what I posted about over a year ago.

GREED and poor credit decisions have created a mess that the "average" American tax payer will be left to clean up.

Mortgage companies, Banks, Realtors and Consumers are all in this together. Where the "fault" lies in my opinion is with those making unethical decisions knowing full well many consumers were going to feel the crunch later.

The best analogy I have would be this:

Let's say I live in a typical suburban neighborhood and I decide to start a business to get average kids into the NBA.

I tell them if they buy my "program" I will make them into an NBA star. Now, this may very well be a legit program and of course every 12-15 year old kid in America wants to be an NBA superstar. The smart consumers will obviously not fall for this and when "Bobby" begs his mom to join the program, she politely breaks it to him that he will most likely never be an NBA star. Now where this crosses the line is when "Timmy" comes to my house with cash in hand to sign up for my program. "Timmy" is 5'2" and has cerebral palsy. I know with 99% certainty that he will never make it to the NBA but since this is a free market, I graciously take his money and sign him up.

The banking and real estate industries prayed upon the desire of consumers with the philosophy of "why pay now when you can pay tomorrow"

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