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The Financial Crisis

So the economy kind of went to shit, huh? I guess we’ve been hearing about this for a while – but man – I did not expect anything like last week. Times are bad, and unfortunately, this whole thing is really complicated, which means politicians get to spin the hell out of it.

The Republicans are blaming liberals for this mess because they wanted banks to give more loans to poor people. This is crap. They’re trying to ditch the Community Reinvestment Act, which is one of the only pieces of regulation they haven’t burned to the ground yet.

In response to the misleading stuff I’ve seen floating around, I thought I’d try to summarize things as best I could, even though I’m not an expert in this subject or anything. I just think that people need to have a pretty good idea of what’s going on, or certain politicians will screw us yet again.

I’ve sort of thrown this together after looking at newspapers, wikipedia, cable news stations, and also talking to a couple smart people I know. So please, take it with a grain of salt – and if you notice any errors – let me know about them in the comments section. This is the beauty of POPTEN – we aren’t claiming to be experts here, we just have a lot of opinions.

After the jump, my personal thoughts on what happened and why it happened…

This all started way back in the 70’s – back when hair (and beards) were big, skirts were short, and young ladies were losing that pesky fear of pregnancy. It was good to be alive (not that I would know – I’m an 80’s baby – but I’m guessing it was a lot of fun).

While Andy Warhol was partying at Studio 54, there was a bunch of guys over on Wall Street dreaming up some really crazy new ways of making a whole lot of money. They don’t get as much cred, but the financial innovation that started in those years was just as dazzling as the computer revolution that was setting up shop in Silicon Valley.

Then the 80’s began, Ronald Reagan was elected president, and a whole bunch of Alex P. Keatons flooded the government and began dismantling regulations on Wall Street. To be fair, this was probably needed at the time. As financial geniuses came up with really creative ways of making money, the system needed to change to compensate. But, instead of putting in good, new regulations to handle the shifting landscape, they decided to just scrap everything.

Well, not quite everything.

One of the sneaky things that Conservatives have done is re-write and complicate a lot of regulations (especially the tax code) so that the guys who are already at the top have the advantage. For example: right now, Fortune 500 companies are supposed to give about 35% of their profits to the US government. This is pretty high actually, it’s one of the highest corporate tax rates in the industrialized world. But guess what… they don’t actual pay it! If you look at the effective corporate tax rate (meaning how much corporations actually pay) we have one of the lowest ones out there.

This shouldn’t be surprising… corporate lobbyists have been writing the tax code for years. It makes it really easy. If you’re Exxon, you can just have your tax guys write the code, make it really complicated, and then build in loopholes so you don’t have to pay anything. That way, you’re competitor has to spend a whole lot of time and money to understand the loopholes. Or they just pay more money. And yet, for years they’ve been blaming the complicated tax code on the Democrats!

Heads you win, tails I lose. Sounds like the free market at work, right?

Back to the Reagan years – A little while ago, I read a great book called Liar’s Poker – it was written by a guy name Michael Lewis who had been a trader at Saloman Brothers in the early eighties. It’s a surprisingly fun read – sort of like the documentary version of American Psycho. It chronicles the creation of the original mortgage securities market, and it’s subsequent crash in 1988 – otherwise known as the Savings and Loan scandal.

Those same mortgage backed securites were responsible for the current crisis, and understanding a little about how they work helped me a lot in trying to understand what happened.

Here’s how I think it works:

The mortgage process seems simple: You want to buy a house, so you go to the local bank and ask for a loan. A Loan Officer checks you’re credit score and a bunch of other stuff and decides whether he thinks you’re going to pay him back. If he thinks there’s a good chance you’ll do it, he gives you the loan. You buy a house, pay your mortgage, and everything is hunky dory.

However, something is also happening with the Loan Officer – lets call him Joe Loan Officer in Honor of Sarah Palin’s cheery little Joe Six Pack moniker.

Joe Six Pack

(is this the joe six pack she was talking about?)

When he decided to give you the loan, he put a number value on the likelihood of you making you’re payments. Then he calls up a broker, like the guys at Lehman or Goldman, and says, “Hey Buddy, I made a loan today… wanna buy it?” and Joe Goldman says “Sure, why not?” “Let me just throw them in a bag with a bunch of other mortgages and then I can sell ’em off! We can even call it a Bond if we want to! That sounds faaaannnntastic”

Joe Goldman takes the bag ‘o mortgages and calls up his friend at a Hedge Fund and says, “Hey Joe Hedge, I’ve got a big ol’ bag of mortgages here, wanna buy em?” and Joe Hedge says “Sure Joe!”.

Now, when you write a check to the bank, you’re money actually gets passed all the way through to Joe Hedge Fund, and he makes a tidy little profit off the interest you’re paying (along with the interest from a bunch of other homeowners).

In itself, this all makes perfect sense. Supposedly, that bag of mortgages (these are really big bags, by the way) was rated by an independent agency, and supposedly, the mortgages in that bag should have an even distribution of risk. This means they mix high risk loans with low risk loans to come out with a relatively predictable rate of return. It’s called securitization – and they do it for all sorts of things.

But here’s where the problem comes in – how can you tell which loans are risky?

Joe Loan Officer doesn’t really care if his risk number is right, because he knows he’s about to turn around and sell the mortgage to Joe Goldman. Joe Goldman doesn’t care because he’s going to sell his bag to Joe Hedge Fund, and Joe Hedge Fund doesn’t care because he can always sell his bag to Joe Lehman if he feels like it. The only people with any interest in the quality of the loans are guys like Joe Moody who work for a securities rating company. They have really complicated systems for calculating risk, which is then converted to a rating and attached to the bags of mortgages. Once they have a rating, everyone can buy and sell based on it. As the loans get repaid over time (or default as the case may be) the mortgage bond changes in value, and people buy and sell them based on their prediction of how long that will take. Ta-da! We have a market!

Now think about that for a second. If you’re Joe Loan Officer, wouldn’t it be tempting to lie about the quality of the loan? Maybe you fudge the credit score to make it seem a little more valuable. Or maybe you set it up so that in, I don’t know, seven years, the mortgage suddenly gets a lot more expensive. He certainly doesn’t care about that – seven years is eons away, and by that time, the mortgage will have been bought and sold hundreds of times so it won’t matter to him if the homeowner defaults…

It’s like a big game of hot potato and everyone’s invited!

Also, in the last few years, Joe Moody has been raking in cash by teaching Joe Goldman how to get a better rating for his bag of mortgages. Joe Moody doesn’t want to lose his lucrative contract, so maybe he fudges a little on the rating and gives it a B instead of a C to make his buddy more money. Or maybe he just gives him enough info to game the system… either way, the ratings start to get a little out of whack.

And most importantly, all this time, the Joe Goldmans and the Joe Lehmans of the world have been funneling millions of dollars to Joe Lobbyist on K Street. Joe Lobbyist wines and dines politicians and convinces them that we should deregulate the markets. Often he just writes the bills himself and passes them on to congressman. This is key, because, just like the tax code thing, there is a massive competitive advantage to being the guy who writes these deregulation bills.

There is some truth to the idea that markets eventually level out and give a fair shake to everyone, but it takes a while. Often as much as a few years. In the intervening time, however, a few people can make a shit ton of money if they know a little bit more than everyone else. In the short term, It’s actually to the advantage of Wall Street brokers to have a constantly changing regulatory structure rather than none at all, because it creates volatility, which means more money sloshing around to grab at. But only if they’re writing it themselves, and building in clever little bits and pieces that they can take advantage of…

And it’s not like we didn’t know all of this already. You may have heard Obama say something about McCain and his involvement in the Keating Five scandal. In the press, it has been portrayed as a simple association/character attack thing to counter McCains new plans to reinject Ayers and Reverand Wright into the race. Not true. Keating Five is much more relevant to the current economic crisis than people seem to realize. Back in ’88-’89 the country was going through the Savings and Loan crisis I mentioned earlier. Same problems with mortgage bonds, just on a somewhat smaller scale.

Well, Charles Keating owned one of those savings and loan banks, which was making loans to people and then selling them off like Joe Loan officer in the example above. These weren’t really true banks and they weren’t regulated like banks, so Mr. Keating was able to write a whole bunch of bad loans, defraud a whole bunch of investors, and then go down in flames. For a while though, he was making a lot of money, and he did this by giving 1.3 million dollars in campaign contributions to five senators and “encouraging” them to deregulate the market. One of those Senators (and supposedly, his closest social friend of the five) was John McCain.

Ol’ Johnny boy likes to talk about fat cats on Wall Street and cleaning up Washington, but he’s one of the guys that’s been running around doing the dirty work for years. To be fair, McCain did say the Keating thing was the biggest mistake of his life (he seems to have a few of those, doesn’t he? Going into Iraq anyone?) and it did encourage him to go after campaign finance reform. But it doesn’t seem to have stopped him from continuing to deregulate the markets! So what does that get us? Weak campaign finance laws and a massive steaming dump of a financial system? Good deal if you ask me…

And now…

Welcome to the Sub-Prime Mortgage crisis!!

In the late 90’s, banks came up with a new type of loan – called a sub-prime loan – one that could be offered to very high risk borrowers. They put escalator clauses into them that would go into effect later in the mortgage (that seven year thing I was referring to). They also sold the shit out of them. They spent a lot of time and energy and money convincing people these were good ideas. The argument was simple: home values always go up, so when your mortgage gets more expensive, you can just refinance based on the new value. Everybody wins!

This works great as long as home values are increasing, but what happens when they start going down? Then people can’t refinance, and can’t afford to pay the higher rates, so they default. The bank forecloses on the house, which makes everyone else’s property value drop. More Defaults, and then Kablammo! That bag of mortgages Joe Goldman bought? Not worth so much now.

Suddenly, all the banks and brokerage houses are watching a massive chunk of their portfolio turn into worthless paper.

And don’t let them tell you that this was all Fannie May and Freddie Mac’s fault… sub-prime mortgages were designed to go to people who couldn’t qualify for Fannie and Freddie! Obviously, when the entire housing markets goes down the drain, the largest single holders of mortgages are going to run into trouble. And I’m sure there was some bad dealing going on – the incentives for the loan officers were just out of whack across the board.

But it was mortgage backed securities that created the bubble, and sub-prime loans that popped it. Don’t let anyone tell you different.

So then Conservatives try to blame this on the government pressuring banks to give out more loans… it’s funny how they’re only willing to admit that the government can effect the economy when it gets them off the hook.

No – what really happened is that banks realized they could relax their lending standards and get a whole bunch more loans to add to this bag we’ve been talking about. Then, they could get a whole bunch of money from guys like Joe Goldman. Who cared if the loans were ticking time bombs? Joe Bank CEO thinks “Hey, we’ll deal with that later – and besides, I’ve got a hundred million bucks in the bank and a golden parachute. I’ll just retire to my yacht if the whole thing goes down.”

Their only task was keeping Joe Moody from realizing that all these mortgage bonds were atrociously overvalued. Luckily, that big fat consulting contract acts as a really effective bribe. This is when regulation should kick in – it used to be that companies like Moodys weren’t allowed to get so close to companies like Goldman. It’s the same reason accounting firms weren’t supposed to be getting bought off by companies like Enron. Remember that whole mess with Arthur Anderson?

Conservatives have been breaking down those barriers for years… arguing that they imposed artificial limits on the market.

Yes.

Sometimes we need artificial limits.

Why is it illegal to bribe policeman? Because it would be bad for everyone except the rich guy who can afford to do the bribing.

Why would it be okay to bribe a rating company? This whole structure only works if they are independent!

This is why we have laws about insider trading, because otherwise, the people with the most money have an unfair advantage and we end up with monopolies. A well run market system relies on competition, and excessive deregulation can choke that competition just as much as excessive regulation would.

Plus, we have these rules about how much money banks need to keep around, just in case something like this happens. A normal bank will take the money in your account and spend it on all sorts of fun ways to make more of it. Some of this is giving out loans, some is investing in stocks and bonds and the like. However, they’re required by law to keep a certain amount of cash around, just in case they do something really stupid.

This is their reserve (and pretty important in a time like this) but bankers hate having to stick to it. That money could be out there running free and making friends and coming back to them all growsed up. So bankers figured out a way to get all their money off their balance sheets and over to other things which didn’t have all those pesky restrictions.

Now, instead of coming home after school, that money ran away to live with some dealer named Robby in Venice Beach, and next time the Banks see it, it’ll probably be homeless with track marks on its ass.

(this is what happens to you’re money if you’re not careful)

Then you have an economic armeggedon and you watch Goldman and Morgan Stanley voluntarily becoming banks so they have to stay regulated, and you start to think that those guys who put us back together after the Great Depression may have known what they were talking about.

So that’s sort of how the crisis started – the mortgage backed securities have been doing all sorts of crazy stuff since last year, but things didn’t really come to a head until just a few weeks ago. Why? Because we have now entered into the second phase… a big, balls to the wall, credit crunch.

The Banks and the Brokerage houses and Insurance Companies and other wonderful financial institutions had a pretty big chunk of their portfolios tied up in these mortgages. Not surprising really – there are a lot of houses out there, so a lot of this country’s money is probably going to end up tied into them. When the value of those start dropping like a rock, portfolios develop big holes in them, and everything starts to teeter. It’s like a big game of Jenga!

This was happening all through 2007 and 2008, and then finally on September 15th, 2008, Lehman Brothers went bankrupt.

And boom goes the dynamite.

At that time, Lehman was holding somewhere between 700 and 800 billion dollars in debt. Whose debt? Everyone elses! It was the last Jenga stick, because now, all of a sudden, financial institutions don’t trust each other enough to lend to one another, because you never know who’s going to go bankrupt tomorrow. The credit markets shut down, and everyone who was teetering starts to fall. The guys who weren’t as dumb and managed to keep their portfolios relatively solid then get to buy up everyone else, but there just isn’t enough money to go around.

Also – each bankruptcy sends a shockwave through the system, because now, everyone has to write off the debt they might have been owed, which means more holes in the portfolio, and on, and on.

So then, finally, with the country spiralling downward, the government gets its act together and tries to stop the bleeding. If you go with Jenga model a little bit farther, the government right now is trying to shove blocks back into the stack before it falls for good. Its not pretty, and its letting people off on a whole bunch of mistakes, but we don’t really have a choice in the matter. The collateral damage of an unmitigated meltdown would be massive. When insurance companies and banks go down, everyone loses. That’s Joe Six Pack’s pension sitting right there waiting to get swallowed up.

Also, I don’t know if you’ve been to an ATM lately, but all of a sudden, they all seem to be charging $3 to get you’re money out. I went to Commerce Bank last night and also checked out a Chase one, and yup, 3 bucks. Checked the news today and apparently Bank of America did it a month or two ago. To every one of their ATMs. Coincidence? I don’t think so.

The banks need liquidity, which means cash, which means that we all end up paying. Who knows what’s going to happen to all those little fees you see at the bottom of you’re bank statement every month. This sure looks a lot like a flat tax, doesn’t it? If you’re against the bailout, maybe you should reconsider. At least the government has the power to get cash to the banks and then redistribute the cost using progressive tax codes. In other words, the government just might be able to fix things and then have the IRS stick the rich Wall Street guys with a bill (assuming we elect someone who is willing to do that). If we let the free market do it, the banks will end up bleeding anyone who doesn’t have enough money to complain. That usually means the poor and the middle class, and that’s how we end up in a depression.

And so we reach today – a few days after the Stock Market briefly dropped under 8000 exactly one year after it hit an all time high at a little over 14,000.

The stock market is already rallying, because stocks are inherently undervalued right now, but it won’t stick unless the credit markets open up. Right now, businesses can’t get loans. If they can’t get loans, some of them won’t be able to make payroll, and some of them are going to go bankrupt.

The credit markets will stay shut down until the government can convince banks that lending to each other is a good idea – All this bailout stuff is about trying to get the banks enough cash to start lending again, but it hasn’t happened yet.

This means that the heart of the economy has stopped beating, and if it stays like this for too long, we start talking about brain damage.

I was going to speculate about the post-crisis future, but at this point, it’s pretty hard to guess how this will all shake out, and there are people who are much smarter who will probably figure it out first. You’ve got Russia and China using the opportunity to buy up everything in sight, and you’ve got the world markets on life support. International leaders are meeting in Washington to come up with a plan, so hopefully they’ll be able to pull it together. But when the economy is this volatile, relatively small events can have large unforeseen consequences.

You can be sure, there will be a lot of collateral damage from this crisis, and it will be a long time before we uncover it all…

One other thing – with all this drama going down, what’s happening in Houston? We just had a hurricane and now Credit is frozen. Ike looked like it wiped some serious shit off the map. Right now, no one can get a loan, so how are they rebuilding? This is a town with oil guys who are still probably pretty rich sitting around in their gated communities just a few miles away from some of the poorest neighborhoods in the country. I guarantee that the power came on first in those big houses. I’ve been to the Fifth Ward a few times for the stuff I do, and I know that there are homes there that weren’t built to handle a hurricane. Some good people have worked a long time trying to help those communities in a state that doesn’t really care about them. I just hope that everyone down there has food, water and shelter, because we might not hear about it if they didn’t. I looked for stories about Ike, and there aren’t a whole lot. I hope that’s a good thing, because if our government has dropped the ball again, some pretty bad shit could happen before it broke threw the noise right now.

In conclusion:

I’m not used to actually feeling sure about a presidential candidate, but I’m as sold on Obama as I’ve ever been sold on a presidential candidate. We need to get a handle on this mess and he saw it coming a while ago. I was already pretty convinced about him when I saw this speech below, but man, this definitely put me over the top. The Dude breaks it all the way down to Hamilton and Jefferson and reminds us that our country was built on a partnership between government and private business, and right now, the people who run the government have fucked it up and given the store away.

We need an executive branch who is willing and able to negotiate with Wall Street, instead of acting like a piggy bank. If the oil companies want to open up offshore drilling, then why should the government just give it away? Let’s make a deal! And if the fed bails everyone out, they should get some value from the transaction! If John McCain get’s elected, he’d get control over all this equity we’re buying up right now. If he holds true to the Republican form, I have this suspicion that he would sell it all back for cheap once the economy recovers. They would really have just used the government’s deep pockets to limit their losses, and then the survivors would get to make a killing off reselling government interests. The only loser there is the American People.

Heres Obama’s March speech. Pretty awesome if you ask me… I think he’s got a pretty good shot at fixing things… assuming theres something left to fix.

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4 thoughts on “The Financial Crisis”

  1. Jamie Antonisse says:

    An epic post, Christobal. I’m especially grateful for your visual aids… I didn’t know my money was such a slut.

    I am trying to solidify a visual of the worst-case bottom-out scenario here, because it is better to imagine it than sitting around trying NOT to. On a supply-demand level, I just can’t square myself with “we’ll all be unemployed and sitting around starving because there will be no jobs” because hell, people still need to barter and trade for the things they need.

    The absolute worst I can justify is “Grapes of Wrath”, where those sitting on a pile of cash abuse their leverage royally, and many of us are forced to work very hard (at whatever is available) for very little.

    You’re a far more informed speculator than me, however… I’d love to hear your Doomsday.

  2. Jamie Antonisse says:

    An epic post, Christobal. I’m especially grateful for your visual aids… I didn’t know my money was such a slut.

    I am trying to solidify a visual of the worst-case bottom-out scenario here, because it is better to imagine it than sitting around trying NOT to. On a supply-demand level, I just can’t square myself with “we’ll all be unemployed and sitting around starving because there will be no jobs” because hell, people still need to barter and trade for the things they need.

    The absolute worst I can justify is “Grapes of Wrath”, where those sitting on a pile of cash abuse their leverage royally, and many of us are forced to work very hard (at whatever is available) for very little.

    You’re a far more informed speculator than me, however… I’d love to hear your Doomsday.

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