The credit crisis in a nutshell
A friend of mine passed along this fairly comprehensive explanation of the current problems on Wall Street, which is easy to understand even for those who, like myself, are novices in the workings of the financial markets. The author, Jerry Pournelle, writes:
As often (but not always) happens when government interferes with economics, the origin of the collapse was due to good intentions. Aristotle tells us that democracy is rule by the middle class, and the middle class are those who possess the goods of fortune in moderation. Most political scientists, economists, and intellectuals in general are agreed that ownership of one’s home is a key element in defining the middle class in America…and the more people who own homes, the more people with a stake in America and the existing social order. People who own houses work hard to keep them. Home ownership is good for the owners, and it’s good for America.
It was decided that the usual market forces weren’t sufficient to spread the joys and benefits of home ownership, and government help would be needed… Eventually a solution was found. Private corporations called Fannie Mae and Freddie Mac were established with government backing, and by implication, government guarantees. These firms, managed by executives paid on the modern scale (millions to hundreds of millions in ‘incentives’ and bonuses), were sent forth to make it easier to own a house by making it easier to get a mortgage loan on that house.
This meant that people who couldn’t convince bank loan officers that loaning them money would be profitable were able to borrow money because the government guaranteed the repayment… Given those loan guarantees to lenders, people who otherwise would not be able to buy a house were enabled to do so. And of course as more people were able to enter the housing market, more bids were made on houses, and housing prices rose. As prices rose, the construction industry was stimulated to build more houses. Employment went up. For a while everything worked about as hoped.
My excerpting probably doesn’t do this article justice, so I suggest you read the whole thing, especially if you don’t yet understand the current Wall Street troubles or how we got into them.
19 Responses to “The credit crisis in a nutshell”
I figure we’re going to get a lot of explanations in the near future about how this cluster wasn’t caused by unrestrained greed and unregulated markets.
We’re going to hear a lot about how shiftless poor people brought this mess upon us. How this forced businesses to promote the idea that people should take out second and third mortgages and drain the phantom equity out of their houses, I don’t know. Nor do I know how these businesses were forced to bundle these mortgages into opaque and poorly understood financial instruments.
But, it can’t be the fault of the infallible market or of the people the infallible market gave substantial amounts of influence over the infallible market.
I was curious. I just googled “economic crisis, Fannie Mae” and what did I find? I found the entire right side of the internet busy working overtime trying to hang the blame for our current crisis on Fannie Mae and Freddie Mac. So I’m not that surprised that you tried to join in the fun, Eric. I am surprised though, that you chose to post this “comprehensive explanation” from an American science fiction writer and skeptic of both human contribution to global warming and evolution. C’mon Eric, you can do better than that!
Here’s what an actual economist says about Freddie Mac’s and Fannie Mae’s contribution to our current economic crisis:
“Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.
Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.”
BTW Eric, The NY Times reported that Freddie Mac paid $15,000 a month from the end of 2005 through last month to a firm owned by Senator John McCain’s campaign manager, Rick Davis.
Just read some additional factors involved in the blowup. First, there was too much reliance on the assumption that real estate values always go up.
The more interesting observation was that the credit risk came to live too far away from those who profited from the origination of the loan and that those who assumed the risk were not diligent enough in assessing whether the risk was as advertised: i.e. the collateral was actually worth its appraised value and the mortgagees were as solvent as advertised. The originators had every incentive to puff up the appraisals and the financial situation of the loan applicants because they took their profit and then walked away as the mortgage was sent up the chain.
Fannie and Freddie didn’t have much to do with this crisis for the reasons Jerry cited above. Also of note is that the entire real estate market went haywire over the last decade, not just the low and mid cost properties insured by Fannie and Freddie. (By the way, I don’t see the relevance of Jerry’s dig about McCain, since Jerry and I both don’t believe that Fannie and Freddie caused the problems).
IMHO, reasons for the current crisis: (1) growth in popularity of Adjustable Rate Mortgages, “ARMs” over the past 10 years. These were never used until recently, and people did not fully understand them when they signed on for them. (2) Easy credit and poor fiscal policies of the current administration, along with fairly low interest rates for the better part of the last decade; (3) Poor tax policy in the makings of the mortgage interest deduction and the non-taxation of most capital gains derived from residential housing.
While item 3 is probably the least contributor to the crisis, I also want to say that the external benefits of home ownership are vastly overrated, and it is amazing how much lower our tax rates would be if not for the tax deductions for home ownership.
In summary though, the three items mentioned above were all significant factors in creating a perfect storm where the market got out of whack. I still think we should do something about it, but what the hell do I know.
Well I suppose it’s good that the bailout passed. Wait, what??? Republicans set up us the bomb!@
The idiotic belief among the House GOP that killing this bailout will hurt the people who practiced bad business more than it hurts the public at large is a train of thought that I can’t understand.
CJ, I think the biggest thing getting lost today is that every time Congress rushes to do something after a disaster (Patriot act recently comes to mind) it winds up just being a whole new disaster on its own.
The reality is…the plan the Congress beat today was a bad plan and a worse bill.
The $1 trillion that was lost today on Wall Street wasn’t imaginary money, it wasn’t just money that came out of the hands of the rich, and it sure as hell isn’t the last trillion that will be gone without an injection of liquidity into the credit markets.
Sometimes a bad plan is the best plan available.
It’s worth noting that Pournelle is a repeat offender of blowhardism on such topics as global warming and intelligent design; if anyone with any credentials is disagreeing with him about the financial crisis, I wouldn’t treat his claims as worth the pixels they’re printed on. (His views on computer science are probably more worthwhile, I would expect.)
I recommend this explanation: http://www.thisamericanlife.org/Radio_Episode.aspx?episode=355
If believing in intelligent design and not believing in global warming is good enough for Palin, why can’t it be good enough for Pournelle? Those two things aren’t exactly intellectual disqualifiers among the right.
ID and AGW are completely irrelevant.
What they demonstrate is that what is irrelevant are Pournelle’s views on anything outside of science fiction and computer science.
And CJ, today illustrates the folly of treating wall street as though it is the whole economy, or putting too much emphasis on short term trends in the financial markets.
The whole economy will be much worse off than Wall Street, that’s why the bailout is needed. Short term interest rates are hovering at five to six points above base and the unemployment numbers, I’m forecasting, will continue to worsen and worsen.
Anyone who knows markets isn’t surprised that there are up days and down days. It’s the overall trend that matters:
http://finance.google.ca/finance?cid=983582
Wall Street sees the immediate effects, the rest of the country will see it soon enough in the form of accelerating unemployment.
What they demonstrate is that what is irrelevant are Pournelle’s views on anything outside of science fiction and computer science.
Commenting on topics outside his profession and specialized training – what does Pournelle think he is, a blogger?
If you want a professional economist’s opinion, try Hoover Institution senior fellow Thomas Sowell. Or Harvard prof Jeffrey Miron.
Jerry, you’re wrong in assuming that I posted Pournelle’s column because it supports some kind of ideological view. As I said, I posted it because a friend sent it to me and it was one of the more concise and readable explanations that I’ve read. I was not aware of Pournelle’s opinions on global warming and evolution–which, of course, are not at all relevant–I only knew (because my friend pointed it out) that he had M.S. degrees in statistics and systems engineering, and Ph.D.’s in psychology and political science. Slightly more academic accomplishment than just being a science fiction writer, as you so condescendingly noted.
I’m not at all interested in assigning blame for the credit crisis, but I don’t think anyone can credibly blame it entirely on government policies or entirely on the unfettered free market. There was clearly an unholy marriage of government policy and individual greed. See, for example, here and here.
Eric,
Sorry, I shouldn’t assume.
The credit crunch in a nutshell (as I understand it) is that big banks are refusing to lend to each other because they don’t trust each other. Here’s a pretty handy (non-ideological) guide to the credit crunch from Australia. It’s pretty comprehensive and written for the layman. BTW, the credit crunch is only one part of a greater economic problem related to the collapsed housing bubble.
Per the bailout, this may also be helpful in explaining the balance sheet issue, from John Hussman of the Hussman Fund:
Let’s return to the basic balance sheet of a typical financial company before the writedowns:
Good Assets: $95
Questionable Assets: $5
TOTAL ASSETS: $100
Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $3
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $100
Now let’s write-down the questionable assets – not all the way to zero, but to $2:
Good Assets: $95
Questionable Assets: $2
TOTAL ASSETS: $97
Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97
This shortfall of protection on the liability side of the balance sheet is what causes a run on the institution, because once shareholder equity is gone, the only way to get at the debt to bondholders is for the company to declare bankruptcy.
Then he explains why the Paulson plan as originally sold didn’t provide any real answer to the problem:
The Treasury plan seeks to buy up those questionable assets and thereby protect the institution against failure. Problem is, suppose the Treasury buys those questionable assets at their going value of $2. Here’s the result:
Good Assets: $95
Cash Proceeds from Sale of Questionable Assets to Treasury: $2
TOTAL ASSETS: $97
Liabilities to Customers: $80
Debt to Bondholders: $17
Shareholder Equity: $0
TOTAL LIABILITIES AND SHAREHOLDER EQUITY: $97
Does this transaction protect the institution against failure? No! If you buy the bad assets off the balance sheet at their market value, nothing changes on the liability side!
Today Iceland bailed out Glitnir Bank by pumping in the equivalent (per capita) of $850 billion US in return for a 75% stake in it.
I suspect people here will start screaming “Socialism,” but doing what Iceland and the Europeans have been doing, temporarily nationalizing insolvent banks, seems to address the underlying problem that the Paulson’s Plan and its variants don’t.
So, the Senate passed the bailout bill last night, and the stock markets are down sharply this morning.
I can only conclude that we should drop this whole bailout bill nonsense, because the increasing likelihood of having one is driving the markets down.
Either that, or we should drop this silly notion of deciding trillions of dollars worth of government policy based on fluctuations in the stock market and start paying attention to whether or not they’ve written a good bill.
balta1701
The Senate bailout bill will pass the House tomorrow. Here’s why.