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Subject: The Financial Crisis: simple explanations (not a joke) rss

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Walt
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A friend sent me a link to one of these shows, and I found the other. They are very easy to understand. The first explains the mortgage crisis. The second explains the hedge fund crisis.

This American Life #355: The Giant Pool of Money
http://www.thislife.org/Radio_Episode.aspx?episode=355

This American Life #365: Another Frightening Show About the Economy
http://www.thislife.org/Radio_Episode.aspx?episode=365

These are about 1 hour each by podcast. The first has a transcript available, and I presume the second will in time. It is well worth your time, but I will attempt to summarize (far less entertainingly):


The Giant Pool of Money is the money banks, insurance companies, mutual funds, etc., etc., etc. invest to try to make money. Banks make loans, especially home loans, but due to regulations put in after the Great Depression, they are required to have cash reserves so they don't fail (run out of money) if a loan goes bad. So, someone had this great idea: let's buy up a bunch of loans from banks and resell them to the Giant Pool as if they're securities. Banks love the idea because with the loans gone, they can sell more loans NOW instead of waiting 30 years for the loan to pay off. The Giant Pool loves this because they make more money than most investments and the investment is, well, safe as houses. The rating agencies, who the Giant Pool depends on, love these, because if one loan is safe, a bunch of loans together are even safer--I mean, just look at historical loan default rates: very low.

So everyone is happy and wants more loans and more mortgage backed securities. Since lenders have dumped their loans into the Giant Pool, they can make more loans without violating those pesky reserve requirements. (Technically, this increases the money supply, just as if the government was printing money--more money is in the economy.) Since you've got more money chasing the same number of homes, housing prices skyrocket, more homes get built, people make lots of money flipping homes, and home loans look safer and safer. So, lenders make riskier and riskier loans--hey, worst case, they sell the house for more than the loan, even if they're lending at 100%! Finally, loans get so risky the historical data is completely meaningless, people start defaulting, the bubble bursts, and the Giant Pool finds out their AAA investments are so much toilet paper--which is a base slander on toilet paper.

The Giant Pool has gotten their fingers burned (madly mixing metaphors), and decides they don't want better yields, they want safety! Like, US Treasury bonds and nothing else. Suddenly, any loans of money to do anything goes away. The money supply shrinks drastically, and no one has any money to buy bits to put into game boxes, meet payrolls, go Christmas shopping--anything.


The other show is about insurance for those or similar bonds. It's not technically insurance, so (where have you heard this before) you don't need any reserve requirements. So some investor buys a million dollar bond. He figures, just in case, I'll make a private contract (so it's not insurance) with someone to pay him in case the bond fails. The insurer (I'll just use this obvious term for simplicity, but remember it technically isn't insurance) gets maybe 2% or $20,000 a year. Markets being markets, prices change. Let's say the bond gets safer. Now someone is willing to cut the same deal for 1%. Well, the insurer can insure his insurance, still make $10,000 a year, and have no risk! And when the market goes up to 3%, someone will write the policy (if not at 3%, then at 4%--this is what markets do!), then they'll hedge their bets by buying one of those other insurance policies, to make a little more money or be a little safer, as the whim and their financial models bite. After a while, that $1,000,000 has tens of millions of dollars of insurance riding on it, so when it does go bad, lots of people lose money, and the effects ripple through the economy.

The other thing is that guy B insures guy A, guy C insures guy B, D insures C, and A might even insure D. The point is that a long chain of dependencies is established. Sure, each link is pretty safe. But put together enough links, and a link is guaranteed to fail, just by (im)probability. That starts the whole ripple process, which causes more failures, which cause more ripples--it's like an avalanche, just needing a pebble falling a the top of the mountain to bury a town at the foot.

(This show is also about the bailout, which is a little too complex to summarize.)


Now, three things strike me as common between these two stories.

First, is the fanatic belief that no regulation is needed because no responsible businessman would ever take a chance or make a mistake. No one would ever build the Edsel, give a loan to someone who would default on it, make a TV show or movie that flops, sell pet rocks--wait! that one worked.

Second, is that the people in both of those processes are looking down soda straws. They see one link in the chain, see a way to make money on it, and do it--with no regard for the rest of the chain they're depending on. The broker sells a loan to someone who really can't make the payments because the broker still gets his commission; the loan consolidator doesn't care because he still sells his security with the loan in it; and so forth.

Third, these are very close to pyramid schemes--technically, they are greater-fool investments, a greater fool will buy your investment from you. Sooner or later you run out of people to buy houses, buy loans, buy insurance on insurance, and the whole thing collapses.
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John So-And-So
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These are both EXCELLENT programs. The Giant Pool of Money is TAL's most popular episode ever. Recommended very highly, and if you like them, give This American Life a regular listen - you can download their weekly podcast for free.
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Kurt
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Agreed. Outstanding shows. The show (as a whole) is worth listening to normally, but these are outstanding.

The Giant Pool of Money episode would be hysterical if it weren't actually real.
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Walt
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kdiddy13 wrote:
The Giant Pool of Money episode would be hysterical if it weren't actually real.

QFT
 
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Koldfoot wrote:
Heard both shows. Both were quite enlightening.

Well worth the time to listen.

When Cap and Koldie agree, it's a fact. Or, the end times have come.
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Excellent shows, very informative.

Tall_Walt wrote:

The other thing is that guy B insures guy A, guy C insures guy B, D insures C, and A might even insure D. The point is that a long chain of dependencies is established. Sure, each link is pretty safe. But put together enough links, and a link is guaranteed to fail, just by (im)probability. That starts the whole ripple process, which causes more failures, which cause more ripples--it's like an avalanche, just needing a pebble falling a the top of the mountain to bury a town at the foot.


My (vain and foolish) hope is that it will somehow even out in the end when all of the $40 trillion or whatever of the credit default swaps are ultimately settled. A owes B $1 billion, B owes C $1 billion, C owes D $1 billion, D owes A $1 billion. Then we can all sheepishly laugh and go have a beer together. I guess that would be the Hollywood version.
 
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Kurt
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klide wrote:

My (vain and foolish) hope is that it will somehow even out in the end when all of the $40 trillion or whatever of the credit default swaps are ultimately settled. A owes B $1 billion, B owes C $1 billion, C owes D $1 billion, D owes A $1 billion. Then we can all sheepishly laugh and go have a beer together. I guess that would be the Hollywood version.
It would be nice, but it'll be tough to sort when C has declared bankruptcy leaving D holding the bag for everyone (and so on)... or so I understand it (using 'understand' in the loosest sense of the word).
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kdiddy13 wrote:
It would be nice, but it'll be tough to sort when C has declared bankruptcy leaving D holding the bag for everyone (and so on)...

The problem is, mostly we don't know what's in the bag, especially in more recent bags.

Imagine you've got a billion dollar fund. It's made of thousands of loans from all over the country: Cincinati, Vegas, rebuilds or refinances on the Gulf Coast, singed California homes. A bunch of loan originators, some now BK (bankrupt) made the loans. Consolidators put them together, some now BK. And then some financial firm wrapped them in a billion dollar bundle like a giant layer cake with thousands of layers, and sliced them into convenient vertical slices (shares) to sell--that company may be BK or bought with all its records in boxes or whatever.

Now suppose you have one of those slices--maybe a good sized slice, a bunch of shares, worth a million dollars. It's obviously a good idea to find out what it's really worth. Well, you can't take the word of the rating agency! They're the Nimrods who rated it AAA--as good as cash--to begin with! So what can you do? Go visit all the thousands of homes throughout the country? Recheck the credit of all the mortgage holders?

Part of this whole problem is that companies have these slices they thought were a million dollars cash that no one will buy. If no one will buy it, it's value is effectively zero. So this can't unwind quickly.

Money has been destroyed--that million dollars of "cash" is now worth nothing--and because of that, you've got less money chasing the same goods, so we're primed for deflation, the opposite of inflation: prices go down, but so do wages (largely from people losing jobs and being forced into poorer paying jobs). How do you get inflation? You increase the money supply, so more money is chasing the same goods. You may have seen the news about the 231 million percent inflation (that was a couple days ago, so it's more now) in Zimbabwe. This is often caused by uncontrolled money supply growth, like the government printing money. http://www.telegraph.co.uk/news/worldnews/africaandindianoce... But we have the opposite problem: deflation, less money chasing the same goods.

The timing is horrible because the US political system is about to freeze due to the election, the inauguration not until next year. Retailers need money to get product and hire seasonal workers for Black Friday. (Black Friday is the day after US Thanksgiving when retailers traditionally sell so much they go from red ink--net loss for the year--to black ink--net profit.) And consumers need money to actually buy stuff on Black Friday, so maybe the store can pay its employees (so they can go shopping) and buy more stuff to sell. (Sounds circular and crazy-making? Just wait.) So the potential is for a lot of retailers to go BK this season. And for a lot of tense and unhappy holidays.


Non-economists think of money as cash, but it isn't. Money is the cash in your pocket, the money in your checking account, the money in your savings account, and the equity in your house (+) and the loan on it (-).

It's rather crazy-making, but when the bank gives you a loan, they're essentially printing money, because you have the money, but so does the depositor! The money gets paid to the previous owner, who puts it down to pay for his new house, and back it goes to the bank. So now the bank has two loans of the same money and the deposit. This continues until the bank hits its reserve limit, 10% in the US. So, they can make $10 million of loans for every $1 million of deposits. Recently, of course, they securitized those loans, sold them off, and loaned another $10 million--rinse and repeat--so they essentially had no reserve requirement. Zoom! Money was created:

http://en.wikipedia.org/wiki/Money_supply

Okay, but now a lot of that money has gone poof. Here's an interesting thought experiment. Suppose everyone's wallet bursts into flames consuming all their cash. What happens? In theory, at least, everyone mails their monetary ash to the Treasury. The Treasury figures out how much money was burnt, sends a check to you to replace the money, and schedules printing of some more paper money. What does this do to the federal budget? Aside from the "friction" of going through all these motions, nothing. The Treasury is replacing money, not creating it--no fiscal impact.

So we've got this retail holiday death spiral looming. We had uncontrolled money supply growth for housing only, which is what inflated housing prices. But now huge amounts of money have been destroyed (and are continuing to be destroyed as banks drop credit limits and call in business loans), and we're facing deflation. How do you prevent deflation? Make more money.

Now, we would not want to replace the money that went up in flames in those bad securities. It's the moral hazard argument: you don't want to protect people from bad investments or you start having to save every bad film in Hollywood, etc. But to prevent the holiday death spiral, it probably would be a good idea to increase the money supply, and very fast! Remember how all the talk about trickle-down and supply-side economics ("voodoo Economics", as GWH Bush famously described it) disappeared and $600 checks were given to Joe Sixpack earlier this year? The same thing now would be a very good idea. The really interesting thing is to remember the exploding wallets: you can make a case that this would just replace destroyed money and therefore does not have to be budgeted. You don't need to sell treasury bills or increase the national debt. The money is being replaced, not created. If one feels really strongly, one could bump the reserve rate to 11% to reduce the money supply on that end (maybe fair enough since banks aren't loaning so much right now).

Anyway, interesting times--in the Chinese sense.
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Kurt
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Thank you for the response. Each time I read or hear something like this, I get a slightly better picture of what's going on. I would never claim I fully understand it (I doubt few could), but I feel a little less 'in the dark' about the whole thing.
 
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Walt
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You're very welcome. Every time I explain it, I feel I understand it better.

Perhaps even more key to understanding than knowing some Economics is not having been indoctrinated by an Econ school. A laissez faire (totally free market) economist might have more trouble understanding this because it just shouldn't happen under laissez faire assumptions. And then there's the school that believes markets always price perfectly, so someone buying an AAA rated security that is only worth 50% of its value simply cannot happen. A Gold Bug--someone who thinks paper money should only be printed to match actual gold reserves--would insist that that policy would have prevented the problem (but loans increase the money supply anyway, and they've been happening since before paper money--and you can see in the chart how little money is actual cash!)
 
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Well, never say I can't see the totally obvious:

Retail sales drop worse-than-expected 1.2 percent in September, biggest decline in 3 years
 
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Will that translate into huge discount sales on Black Friday? Will huge sales make a difference? Any idea?
 
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kdiddy13 wrote:
Will that translate into huge discount sales on Black Friday? Will huge sales make a difference? Any idea?

I suspect we'll see a lot of xx% off items to try to draw traffic and reduce inventory. Huge discounts? Probably only on stuff they really want to dump or they have good profits on even with the discount. Huge volume sales? Very doubtful. Huge sales would make a difference, but it's very unlikely.

The Christmas shopping season depends on consumers spending money, to state the completely obvious (though apparently it's obscure to some politicians). If another consumer stimulus plan can get through and get cash into consumer's hands before Thanksgiving, then--well, the best I'll guess is that it will soften the blow. Spending will still be down by anyone who's lost a job, a home, seen savings diminish in the market, and so forth.

House Republicans seem completely clueless:
Instead, House Republicans proposed a number of measures that, they say, will "turn the corner towards real economic growth," including:

[ 1 ] Removing legal barriers to speed up new offshore oil drilling. A law banning offshore drilling expired October 1, but Republican lawmakers say lawsuits could block new offshore rigs and want judges to quickly rule on the cases.

[ 2 ] Lowering taxes on income that U.S. corporations earn from their overseas subsidiaries.

[ 3 ] Eliminating capital gains taxes on the sale of homes up to $500,000 for a couple.

[ 4 ] Suspending capital gains taxes on securities purchased during the next two years.

[ 5 ] Extending government deposit insurance to business transaction accounts.

[ 6 ] Directing the government to guarantee inter-bank loans.

(1) Useless short term.
(2) Does nothing for consumers, and those taxes are effectively zero anyway.
(3) I'm sorry? In what alternate reality does anyone in trouble have capital gains on their home?
(4) No short term effect. Probably no effect: a good stock buy with 0% tax is still a good buy with 15% tax.
(5) Might help some businesses, but a scam waiting to happen. Effect on consumers is dubious in the short term.
(6) I think this is already done. In any case, not helpful getting money to consumers--they don't need credit, they need cash.

The political problem is that before the election, a stimulus package could look like a Democrat victory, and the Republicans have enough trouble as things stand. It's probably going to come down to which way politicians think will sway the most votes--base voters or swing voters. And whether W. will sign it.

After the election, for losers and from politicians who aren't standing for re-election, I'm afraid we may see some, "The public doesn't like me? Well, screw the public, then!" I hope not, but it's a concern. And getting something done after the election may be problematic.

Individually, all we can do is keep our own financial houses in order, and vote.
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Sigh. You know, I'd really rather be wrong about some of this crap:


"What, then, will the next stage of the downturn be about? It is likely to revolve around the worst slump in worker pay since — you knew this was coming — the Great Depression."

"Already, median pay today is slightly lower than it was in 2000, and by 2010, could end up more than 5 percent lower than its old peak."

From: Next Victim of Turmoil: Your Salary


"The whole subprime debacle was predicated on the fact that people said, "Well, this borrower is not really credit worthy and can't afford the house, but in four years it will be up 20 percent or more."

It was widely believed that if you had bad mortgages from different geographic areas that all those [real estate markets] weren't going to go down together. You had a pool of 100 bad mortgages from borrowers with low income or bad credit, that were each a piece of [expletive]. The idea was you put them together and now it's not a piece of [expletive]. People believed that through geographic diversification you can diversify risk. That was what undergirded the entire breakdown, and this was not a 3-year phenomenon, it was building for 10 years."

From: 'We're All Hosed': A Wall Street Insider on the Economic Crisis
 
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