The Economic Crisis. Part 1: The Problems

The economic crisis – and given the latest figures on the so-called real economy (production orders, unemployment, etc.), this really is more than a financial sector crisis – actually has a rather simple breakdown. Unfortunately, the laws of physics and the law of unintended consequences prohibit a rather simple solution. I like to break it down in a manner similar to the logical proofs I used to do in Prof. Dolan’s (R.I.P.) freshman logic class.

“What we have here is a failure to communicate.”
Basically, the banks do not trust each other. They do not trust each other’s solvency, nor do they trust the collateral pledged for overnight loans is worth anything. Thus, they do not lend to one another. Banks therefore have to get their money each night from the Fed’s discount window. The Fed, unlike any sane commercial actor (are there any sane commercial actors left in the financial industry?), is willing to take CDOs (think of them as sandwiches of questionable freshness) as collateral. Yes, that’s right, the Fed is willing to take on other banks’ toxic bonds.

This should be enough, right? I mean, if the lender of last resort will take them at value, why shouldn’t we? Well, the banks remember that if the Fed fails, the Treasury will automatically bail it out. Thus, the Fed’s courage to hold onto the toxic bond waste is not reassuring at all. It’s like comparing apples to oranges, but where the oranges are backed by 300 million taxpayers and nearly infinite capacity from whom to draw debt. Commercial banks are not quite so lucky.

The other reason why the Fed opening up its treasure chest to hold the toxic CDOs is not a silver bullet goes to the nature of overnight lending. Overnight lending is meant to be one of the shortest loans in the market. Banks take out overnight loans so that they can meet their legal requirement to hold a cash reserve equal to 10% of their total assets. So, in practice, the banks are using as much cash as possible to try to make more money so that they can avoid failure. Well, how is that working right now? What lines of credit can a bank offer that can, in the aggregate, make up for exfusion (is that a word? Should be) of their cash. Think of it like this. Bank of Brokeback gives out a $1 million loan, with 10% interest. It might take a month for the first $100 thousand payment to come back in. If Bank of Brokeback exfused all of its cash reserves in similar loans, they would need to find an overnight loan equal to 90% (or thereabouts) each night until the loan payments start coming back in. Recently, Bank of Brokeback could just build CDOs and sell them off for a huge cash infusion each night. That’s dried up.

“You put what in that sandwich?”
So, the reason why the banks won’t trust each other comes down to fear of what’s on their books. Like Jaws in the water, those CDOs are out there waiting to eat up the banks’ balance sheets.

Here’s why the CDOs are a problem. Imagine building a sandwich. You get some tasty ciabatta. Some pickles. Some smoked chicken. Fresh tomatoes. Lettuce (or arugula, depending on your politics). Some salt and pepper. Looks like a AAA rated sandwich to me! But, wait. What’s the sauce? Well, what if I told you that the mayo had been left out overnight. How much would you pay for that sandwich? It could be just fine. Or, you could end up behind the uninsured people at the emergency room. Want to take that risk? Who wants to eat that CDO?

“The turd in the punch bowl.”
Or, to maintain the metaphor, I wonder who left the mayo on the countertop overnight. Strangely, though this is actually the least sophisticated aspect of the equation, it is the most complicated. Hence the lack of trust in the CDOs. Mortgage defaults are nearing or surpassing historic levels. This fact is not limited to subprime and Alt A mortgages. Prime 30 years are defaulting at about 3%, which is a staggering number of defaults given that most mortgages today fit that description.

There is a lot of blame to spread around for the defaults. First, buyers behaved as though the price values of houses would forever rise at 10% per annum. Enter stage left The Flippers. Enter stage right The Fools. But, really, it gets worse. There is a lot worse activity out there in the mortgage industry beyond imprudent purchasing by wannabe homeowners. The people charged with clearing up this mess have uncovered a disgusting amount of fraud on the part of the mortgage brokers. For example, Johnny Acorn went in to buy a house. He’s a self-employed community organizer. He claims he makes $60K per year and he can put down 5% on a mortgage. Somehow, he gets approved for a $500,000 loan. Do that math! Later on, the regulators get their hands on the CDO portfolio of a failed bank and they see that the paperwork submitted by the loan originator make it look like Mr. Acorn could afford to vacation every weekend in Hawai’i. Prediction: Acorn defaults within 90 days. Result: Acorn defaults within 90 days.

“The measure of injustice in a society is not what’s illegal, but what is legal.”
Eat that, comrade! Our people own their own homes. Your people are commie slaves. Oh, and, property law since the Magna Carta has supported the concept of freely flowing property to be put to use for economic means. Locke knew that. One more thing to consider in terms of the society-wide impetus that drove us to this crisis: free money. Mr. Greenspan made money so dang cheap, even poor people could afford it. Sounds great, right? But, not really. Not when there was a regulatory environment that permitted mortgage brokers and investment banks to operate outside the purview of the law, and beyond the reach of state legislatures due to federal preemption. A system ripe for abuse was abused. Duh. Can’t hardly blame ‘em. I want to make more money, too.