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August 16, 2007

Information, please

Friedrich von Blowhard writes:

Dear Blowhards,

I am just an ignorant small business owner who is many decades past his college economics courses. I am looking for information and instruction regarding the current credit markets flap set off by the problems in subprime mortgages.

Nearly a week ago I read articles that discussed the injection of liquidity by various central banks. These stories are full of statements like:

In a statement on Friday morning, the Federal Reserve said it was "providing liquidity to facilitate the orderly functioning of financial markets" and offered to provide reserves "as necessary" to promote a federal funds rate close to its target rate of 5.25 per cent.


It follows concerted action from central banks in North America and Asia to inject liquidity to calm fears of a credit crunch and allow borrowers to meet short-term lending needs.

These particular quotes, by the way, is from a Financial Times article of August 10, which you can read here.

These statements and others like them, repeated endlessly in the popular and financial press, strike me as Orwellian in their weirdly impersonal tone; they communicate almost nothing to me except that apparently I am not supposed to understand and I am not supposed to ask questions.

Questions I would like to ask would include the following:

(1) What, in concrete terms that even an idiot like myself can understand, in the present context, is meant by facilitating the orderly functioning of financial markets?

(2) Exactly what types of transactions are we talking about?

(3) What does orderly mean in this context? What would a disorderly functioning of credit markets look like? Why should I (Friedrich von Blowhard) care?

(4) Who at this precise moment in time has their tail caught in a crack as a result of the failure of markets to function in an orderly fashion? (If possible, I would like specific names here.)

(5) Who will profit from or be prevented from losing money by this injection of liquidity? (Again, names if you can manage it.)

(6) Is it possible that these people are actually in trouble for reasons having little to do with orderly markets, and perhaps more to do with imprudent investments or unfortunate contractual commitments? Am I just being paranoid?

(7) Whose interests are being served by the decision of the Federal Reserve to talk in this weird, imprecise, vague, euphemistic manner?

(8) Most euphemisms are intended to cover for distasteful or troubling subject matter. Is something distasteful or troubling going on here?

Please keep all explanations very concrete and simple; obviously, I am not smart enough to talk Fedspeak.



P.S. In an update on this continuing saga, I read today (Friday, August 17) that the Fed made a half-percentage point cut in its discount rate on loans to banks. The Fed explained itself thusly:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.[emphasis added]

The tone here is still both Olympian and oracular, but I do notice that the Fed seems to be working its limited rhetorical tropes pretty hard to avoid the suspicion that they're acting to bail out people in the financial service industry who have made pots of money making, securitizing and investing in ridiculously lax loans to questionable borrowers. They clearly want to suggest that they're simply being judiciously proactive to protect the interests of the country as a whole...despite the pesky admission that there is not much evidence to date that the country as a whole is actually at risk. Be it possible that the Fed doth protest too much?

Or am I being paranoid?

posted by Friedrich at August 16, 2007


It means that the Gilded Elite are going to use taxpayers' money to buy all this crap CMO paper. You're going to pick up the tab for the Finance Pirates who bet wrong. Like the S&L debacle in the 80s.


Posted by: Don McArthur on August 16, 2007 9:01 PM

Would love to help you out, Friedrich, but I can't even define a "derivative". And what the hell is a "REIT" all about? Come to think of it, I can't even explain how the bond market works, much less what these pin stripe shysters at banks are up to. I used to watch "Wall Street Week with Louis Ruikeyser" just to get the vicarious thrill of being a high roller at the New York Stock Exchange. Peggy Noonan recently wrote an article on finance types in which she wondered aloud how you can possibly trust people who engage in a business that is more mysterious than nuclear physics. Indeed.

Posted by: Charlton Griffin on August 16, 2007 9:56 PM

I've worked in policy for the Federal Reserve, so let me see if I can explain.

The basic rule is that modern economists believe that the Fed can only control inflation in the long run - not unemployment - and further that we can only control inflation by managing expectations of future inflation. In general, all Fed communications are based on the idea that major price-setters understand that we will do everything possible to keep inflation around 2%.

As for your specific questions, the problem is not that people like Bear Stearns and BNP Paribas are losing money, but that credit scares are essentially very large bank runs. Another major purpose of the Fed is to limit bank runs by acting as a lender of last resort. That is, if no one wants to lend money, the Fed offers overnight loans to banks at an interest rate called the Fed Funds rate. These loans are secured by, for instance, bonds held by the banks, so it's not a giveaway; in fact, the Fed (to my knowledge) has NEVER had a default on an overnight.

Why is this function important? Well, in a bank run, there's only a problem if everyone runs to the bank to withdraw their money at the same time. They would only do this if they believed that the bank would go under and lose all their money. Likewise, a credit crunch is only worrying (in a more general sense) if everyone stops lending money in a sector (say housing) because they believe that mortgage companies, for instance, will all go under because no one will lend them money. You can see the cyclicality here.

I can ensure you that none of the top people at the individual Feds considers "bailing out Bear Stearns" to be a policy goal. Nothing like that ever comes up. But preventing the modern equivalent of bank runs and ensuring inflation is low is quite important.

Finally, about the euphemisms: you're reading financial news. The language isn't particularly strange to economists and finance types. Think of it as if you were reading an article about a cricket match in The London Telegraph. There's a log of jargon, sure, but the writers don't really consider it necessary to spell out what's meant by a sixer or a googly. Likewise, the WSJ isn't going to spell out how repo loans and the discount window work, but there are a number of very good, everyday guy articles on this. Try looking at the magazines put out by the 12 regional Fed banks if you're truly interested (while understanding that monetary policy is a bit dry!)

Feel free to comment on with any questions and I'll do my best to answer.

Posted by: cure on August 16, 2007 10:21 PM

"(3) What does orderly mean in this context?"

Not having a cash shortage. A lot of commerce is paid for by loans against expected near-term income. If the spare cash for those loans dries up, companies start postponing or even canceling commerce, which hurts their fundamental value and drives up the cost of products. And what do people do when companies decrease in value and prices rise? Sell financial assets at a loss and hide the cash in their mattress, which makes short-term loans dry up even more. It's the smoldering version of a bank run.

To prevent this, the Fed makes loans (prints money and gives it away). From a kindly perspective, this temporarily fronts the cash needed to keep our just-in-time economy running. From a cynical perspective, they are causing inflation to scare people out of watching their capital waste away while it is stuffed in the mattress.

I'll let the experts comment on exactly who gets the handout, if anybody, and whether this system is more stable than the alternatives.

"(7) Whose interests are being served by the decision of the Federal Reserve to talk in this weird, imprecise, vague, euphemistic manner?"

It's industry jargon. For a less formal audience, Fed Chairman Ben Bernanke once said he would drop bales of cash out of a helicopter if that's what it took to keep the engine of the world running.

"Is something distasteful or troubling going on here?"

A matter of taste. Some say that fractional reserve banking is a tool of tyrants and Satan's usurers. Some say it is a loyal servant of progress and economic stability.

Posted by: Daniel Newby on August 16, 2007 10:26 PM

Here are a couple of paragraphs from an article in the business section of today's NY Post:

The mortgage industry meltdown may be about to claim its biggest victim yet.
Countrywide Financial, the nation's No. 1 mortgage lender, appears headed for a financial crisis as speculation swirled on Wall Street yesterday that the company is having trouble finding buyers for the ultra-short-term corporate debt it uses to fund its daily lending operations.
CNBC reported yesterday that Countrywide couldn't find any takers willing to buy its asset-backed commercial paper - the ultra-short-term corporate debt that funds its daily lending operations - at 12.54 percent. Only a week ago, the company had no trouble getting financing at a little over 5.5 percent.
While getting shut out of the commercial paper market might not be immediately fatal to Countrywide it virtually assures that the company has to hold much of its loan production on its balance sheet.
If debt piles up on its balance sheet and it's shut out of the commercial paper market, Countrywide would likely have to curtail its lending and seek much more expensive bank financing to fuel what loans it makes.
Adding to the market's jitters about Countrywide's liquidity, a Merrill Lynch analyst yesterday cut his rating on the company's shares from "buy" to "sell," warning the company could be headed for bankruptcy if the cracks in the mortgage industry continue to deepen.
"If enough financial pressure is placed on Countrywide or if the market loses confidence in its ability to function properly, then the model can break, leading to an effective insolvency."

The article, though it does not answer your questions directly, does give a picture of what a liquidity crisis is and also what a disorderly credit market is (when a company as large and vital as Countrywide can't find buyers of its commercial paper at 12.54 percent, one week after finding buyers at 5.5 percent, I'd assume that's disorderly). The Federal Reserve stepping in means, I guess, that the Fed will gaurantee the loans, at bearable rates, from banks that Countrywide will have to turn to if it continues to be unable to sell its commercial paper.
I think what this all boils down to is that Don McArthur is right: we, the taxpayers will have to eat it.

Posted by: ricpic on August 16, 2007 11:36 PM

One of the nicest things about buying a bond is that, if you ever change your mind, you can always sell it. You may not like the price you get, but so long as you're willing to accept the market price, someone will buy it from you. This ability to sell your bond for cash is called market liquidity.

If you weren't sure anyone would buy a bond from you, at any price, the bond would be a lot less valuable to you. If you happened to have cash, it would look a lot more attractive than bonds, so you'd sit on your hands until people started buying bonds again.

When the Fed injects cash into the system, what it is basically doing is lending money to banks and dealers on a very short-term basis, usually overnight, with the banks and dealers giving the Fed bonds as collateral. The Fed forks over the cash and takes the bonds off their hands, and the banks scramble to earn interest on this cash in order to pay the Fed its interest. A good way to do this is to buy bonds, preferably bonds yielding more than the ones you pledged to the Fed.

All of a sudden, people with bonds to sell are getting calls again. The prices of their bonds may have gone down, probably a lot, but hey, at least someone's willing to buy. So they sell. Now they have cash. What are they going to do with it? If enough people are buying and selling, news of the Fed's involvement is out, the market starts looking a lot more liquid, yields are really high, so maybe they'll take a chance and buy some more bonds, grab those juicy yields, much more assured now that if they guess wrong, they won't be stuck holding illiquid bonds.

Thus, the Fed has facilitated an orderly market. Yay!

The Fed has not so much propped up prices as allowed prices to drop to their proper level, usually a lot lower than they were before. So people will still lose a lot of money, but the markets can move on and start functioning again.

Also, the Fed hasn't spent taxpayer money doing this. The banks and dealers it makes these overnight loans to almost always (maybe even always?) pay it back.

An interesting question is: Why do people stop buying in the first place? What causes a liquid market to seize up like an engine suddenly running out oil?

I think this can happen any number of ways, each highly unusual. That's why this kind of thing happens so rarely in the US and Europe -- maybe once or twice in a decade, or so.

One way this can happen is markets can usually absorb all kinds of shocks without problem. People hear the news, adjust their strategies, and very quickly the market prices adjust accordingly.

But sometimes markets don't adjust immediately. People hear the news, but don't know what to do. They retreat to the sidelines, scratching their heads, not sure how to adjust their strategies. If enough people do this, buyers start disappearing. And as buyers disappear, the likelihood of getting stuck holding a bond goes up, so you have to be very certain you're right in order to buy, and hold, so if you're not really sure you just sit on your hands. And the whole thing just feeds on itself.

I think that's what happened last week, but I don't know why it happened. I've seen a lot of explanations, and many sound plausible, but none I've seen explains why other equally bad news didn't cause liquidity crises in other weeks or months or years. It's a mystery to me.

Posted by: Alan Bickford on August 16, 2007 11:54 PM

Hope this helps for some of the liquidly questions.

Suppose you are a bookie(mortgage lender) accepting bets on a fight. The odds are even between fighter A and fighter B so a ten dollar bet for either fighter costs $11.00 to place, the one dollar difference is your juice (profit)(Loan fees). You don't care who wins because as long as the same number of people bet for A as B you make money. The more bets the more you make.

But fighter A is a home favorite so you get three times as many bets for him as fighter B. You have a problem so you sell (lay off)(CMO bonds to the stock market) the bets to the bookie in fighter B’s home town and buy some of his over supply of bets on B. The bets are balanced and you have an orderly market.

Now suppose that the police (stock market stops buying your CMOs) arrest the bookie in B’s hometown before he buys the bets. Now you no longer have an orderly market. If fighter B wins you can’t cover the bets. If that happens you (the mortgage company) are out of business. The betters (home buyers) don’t get paid plus can’t make future bets (refinance) and lose everything.

So you go to the mafia (the fed) and sell the over supply of bets to them (increase liquidly so you can accept more bets (Loans)) and stay in business. Now you again have an orderly market.

Posted by: Ron on August 16, 2007 11:57 PM

My pathetic mind balks at the very idea of "buying debt" ... Hard to imagine what that might involve, let alone why anyone would want to spend their day doing such a thing.

Posted by: Michael Blowhard on August 17, 2007 12:20 AM

For some reason, right now I'm reminded of the 1996 Simpsons episode "Treehouse of Horror VII" in which flying saucer aliens Kang and Kodos abduct Presidential candidates Clinton and Dole and impersonate them:

Springfield holds a Dole-Clinton debate. Clinton is giving the opening speech:

Clin-Ton (Kodos): My fellow Americans. As a young boy, I dreamed of being a baseball, but tonight I say, we must move forward, not backward, upward not forward, and always twirling, twirling, twirling towards freedom.

Dole (Kang): The politics of failure have failed. We need to make them work again. Tomorrow, when you are sealed in the voting cubicle, vote for me, Senator Ka... Bob Dole. [applause]

Clinton (Kodos): I am looking forward to an orderly election tomorrow, which will eliminate the need for a violent blood bath. [applause]

Posted by: Steve Sailer on August 17, 2007 12:57 AM

Okay, isn't the basic idea hear that the Fed will cause inflation (which will diminish the value of the assets held by all us savers, but in such thin slivers that we'll never notice) in order to prevent financial operators who are "too big to be allowed to fail" who have been making a big reward from risky activities from having to face the full consequences of that risk?

Posted by: Steve Sailer on August 17, 2007 1:02 AM

You don't get what they're saying?

They're saying that international capital markets are curbing the tools of orderly fail-rate commerce in the verification community. The strength of the global macro-investment debenture diploid/haploid matrix comes from the liquidity in the indices of a seminally diversified risk market without the aid of turbulent funds management.

It couldn't be simpler. It's S&L 2.

Posted by: Fred Wickham on August 17, 2007 2:05 AM

I appreciate everyone's attempts to wise me up. However, I hope you won't think me rude if I still complain that your explanations seem way too generic, and not nearly specific enough.

My complaint goes largely to my question #5, to wit, who will profit or lose less money as a result of government intervention. Ricpic's story, with a little digging, suggests one such winner: Countrywide's CEO and Chairman, Angelo Mozilo. According to press releases, he has sold 4 million shares of Countrywide stock this year for $152 million; he still has stock options for some 8.6 million additional shares. And since Countrywide's multibillion dollar "bailout" by some 40 banks, which presumably would not have occurred without the kindly injections of liquidity by the omnibenevolent Fed, those 8.6 million shares are sure worth a lot more than they were when the lender was headed for the boneyard.

Also, aren't all organizations whose business models utilize a great deal of leverage to produce their returns--which certainly include hedge funds and most private equity funds, to say nothing of Countrywide--getting some kind of implicit subsidy by being able to count on predictable injections of liquidity by the government when things get rocky? It would seem likely that, without the virtual certainty of such government intervention that businesses would be wildly imprudent to be so highly levered--and thus their returns would be far, far lower. So I would include all financial firms with high leverage (which would seem to be most of them) as winners under our current monetary regime. And the senior members of such firms, who are clearly as a group the most highly compensated people in the world, would appear to be doing pretty well out of this whole injection of liquidity business--no?

My question derives from regarding the fate of, say, a corner baker. If he makes poor decisions, sells too much to one customer on credit, and the customer defaults--well, he's toast. But it appears that some of us, and some of the wealthiest people in the country, have a rather better deal going on.

Or am I just being paranoid?

P.S. Cure writes:

I can ensure you that none of the top people at the individual Feds considers "bailing out Bear Stearns" to be a policy goal. Nothing like that ever comes up.

You may well be right, but I still seem to remember a remark made back in the 1980s by a senior financial regulator: something about certain institutions being "too big to fail". One suspects that the collapse of, say, Goldman Sachs would be considered a systemic risk by the Fed--and it would react accordingly. And I think that the people that work at Goldman and the people who trade with Goldman all know what the Fed would do--including dumping money out of helicopters--in such a situation. Which I think works in the favor of such organizations...don't you?

Posted by: Friedrich von Blowhard on August 17, 2007 2:17 AM

Ever buy a bank CD? That is a form of "buying debt."

Posted by: ed on August 17, 2007 5:25 AM

Here's a good FAQ on the Fed actions by Stephen Cecchetti.

Posted by: ed on August 17, 2007 5:28 AM

Several things happened: After 2000 the Fed (Greenspan) started cutting interest rates. Banks stopped having to spend their own money to finance home loans because hedge funds had become popular and would buy the loans from banks in bulk. Since the banks weren't using their own money they didn't look too closely at loan applications (or the appraisal prices for refinancing). Also, the rating agencies made a lot of money in fees for rating the bundled home loans and had a interest in giving them a better rating than they deserved.

It got to the point that people would obviously lie on their loan applications (not to mention manipulate their home's appraised value). By that I mean, on some of them people would have to show proof of employment but not proof of income. If they proved they were employed they could claim any income they wanted. They would hand in official paperwork from their employers with their income blacked out (because it showed they were lying) and the banks would give them a loan! The bankers nicknamed these “liar loans.”

And a lot of people got adjustable rate mortgages. They would pay a low initial interest rate (the only one they could afford) and refinance when their home's value skyrocketed. Everyone (the banks, rating agency's, hedge funds, and home buyers) believed home prices would keep rising.

There was easy money. Supply and demand happened. Inflation happened (caused by the easy money?). The Fed started to increase interest rates to fight inflation. And as soon as home prices stopped increasing the “system” was bound to break down. (In the Fed's defense, they probably helped make this happen sooner, when the problem was smaller, by raising interest rates.)

Now banks are having to use their own money to fund loans and being understandably cautious. Hedge funds (and a lot of foreign banks it turns out) have home loans that they can't value (because no one knows how much to pay for them). Problem is, they have to tell investors what their hedge funds are worth. When they can't, people want their money back.

Winners and losers:

So far we haven't seen a lot of unemployment. It looks like the homebuilders are firing their illegals and that's saving American jobs. (Maybe the illegals will go back to Mexico?) The problem hasn't hit commercial building yet, but we should expect it to within a few months.

Anyone trying to buy or sell a house, or refinance, will have problems. Unless they are buying with lots of cash at fire sale prices.

Greenspan is looking smart but bad. He cut interest rates in the first place. He also encouraged adjustable rate mortgages. But he also knew to leave before the problem became appear ant.

Hedge funds and banks which own the loans are in a position to loose lots of money.

The rating agencies might get sued out of existence. I have no idea who else might be sued.

Anyone trying to get a loan now, even if they have good credit, can expect higher interest rates. That includes businesses. This may cause a chain reaction of decreased consumption.

The Fed's “liquidity injections” have been short term. The real problem is if the Fed cuts interest rates and encourages inflation. Then you can freak out about the little guy having to bail out the elites.

We don't know who all the losers are yet, but anyone with lots of cash or government bonds is a winner.

Posted by: Jason on August 17, 2007 7:44 AM

Still, though, buying debt is a vital part of the economy, and neither is it a new invention. Newer ways have been invented to do it, naturally, but it's an old practice.

"Hmm. . ." says a canny financier. "Those people all owe money to that bank down the street. I think they're more likely to pay off than the bank realizes - they don't know what they have there. If I make the bank an offer, I bet that they'll sign those loans over to me at a bargain price, and think that they've unloaded a problem. . ."

Posted by: Derek Lowe on August 17, 2007 8:14 AM

I'd just like to thank the various people who took the time to answer. It is a complicated subject, and there is a curious lack of background articles in the MSM. (Maybe they figure anyone who actually cares already knows.)

Anyway, I'm very glad for Federal intervention. I understand there's going to be carnage, but I hate to see unnecessary carnage that's the result of temporary panic rather than changing economic conditions.

Posted by: Tom West on August 17, 2007 8:30 AM


I understand the concern about bailing out stupid firms - this type of moral hazard is always a concern. The problem is that the economy is a system, and we only have two choices: let these mortgage funds fail because of what is essentially a bank run, or give them liquidity (essentially, give one-day loans at a low rate to anyone in the economy who wants it) in order to stave off the run. Sure, Countrywide is a winner. But so is everyone else in the economy if we don't go into a recession because of a credit scare.

Now, if inflation rises because of an interest rate cut, that's a different story. For the mortgage firms, on the one hand, they'll have access to money to stay in business. On the other hand, all their fixed-rate loans are now worth less. For common people, they'll be poorer (the "cruel tax" of inflation), but if we avert a recession, it may be a wash. Certainly, every Fed governor cares much more about real growth in the economy than Bear Stearns stock price; it's not 1900 and the robber baron banking cartels anymore.

Posted by: cure on August 17, 2007 10:41 AM

For the normal person, an answer to the questions, in order:
1) Keeping the banks from losing their shirts, and panicking.

2) Mostly overnight loans to allow banks to cover their reserve requirements.

3) Example of a disorderly credit market - the bank has a bunch of customers default on their loans. They need money to prevent their depositors from making a run on the bank. So they call your mortgage, car loans, and student loans. (Look in the fine print, they generally do have the right, in certain circumstances, to demand you pay your loans early. If they didn't have the Fed to rely on, they would write it into the fine print more often and extensively - a lot of people lost their farms in the depression due to such clauses.) If you don't pay, you lose your house, car, and savings. Meanwhile, the bank doesn't get enough cash from you, pays out to the first 100 depositors who show up and demand their money, and then folds. The depositors who didn't get to the teller's window first lose their money. (They are, after all, people who loaned the bank money - that is what your checking account is, a loan you extended to the bank.) 1930s-type banking crisis ensues. (Or 1980's style S&L crash, if Federal Insurance covers the depositors. Either way, fun is had by none.)

4) Well, you, if your are trying to pay a mortgage and your bank/mortgage company needs cash fast. Otherwise, bank owners, which means by proxy bank depositors and/or the FDIC. Yes, Countrywide CEO whats-his-face, and all of his employees. (Visualize being a random Enron employee whose duties include mopping the floors. Enron fails, you too lose your job. It isn't just the fools at the top.)

5) Countrywide CEO, and all of his employees. By extension, everyone all of these people will buy goods from that they wouldn't be able to afford if they lost their jobs. Like your small business.

6) Idiots exist, and may unfortunately be saved. It is the second order affected (the employees, depositors, and good-faith investors they drag down with them as they drown) whom the Fed is also helping that motivate this intervention. Think lifeguard at a busy pool. Some idiot has 10 hotdogs, swims, cramps, panics, and flails, grabbing at anyone nearby to hold him up ultimately dragging three of them down with him. Or the lifeguard grabs him, dragging his sorry ass out of the water, thus saving all four of them.

7) When the Fed doesn't talk in weird, euphamistic terms, the markets tend to react, well, emotionally. (Think the uproar around 'irrational exhuberance' a few years back. Now imagine the result if HRH Greenspan had said what he meant - "The people buying tech stocks right now are bloody morons. This is vaporware, people! When the merry-go-round stops, whoever holds these stocks will lose it all!")

8) Yes. An entire industry is now at the mercy of moral hazard. It used to be: banks loan money, and have to collect the payments. They were, thus, very careful to only loan to people they think will pay them back. Then someone had the bright idea to 'package' some of these carefully-screened loans, and sell them to investors. (More on that later).) This was fine, until the banks realized no one was watching whether the loans they packaged and sold were actually solid. Banks then minted money by loaning it to anyone who wandered in off the streets and stuffing their packages with these less well-thought-out loans. Now everyone who bought these packages, or owns a bit of these packages(like your pension fund), is finding out the banks stopped screening the loans they bought. (Caveat emptor and all that, but there is a good-faith expectation that banks don't loan money to people who won't pay them back.) The banks are home free, but now realize they can't sell more packages, and so are tightening up credit requirements. So are the 'mortgage companies' (businesses set up to explicitly loan money and package, without the other bank functions), but they are dying on the vine because of the inability to make more loans or sell more packages. If this continues, no one will be in business to loan money to new house-buyers. The extra credit will protect the package buyers, making sure all of these fine loaners can keep loaning, hopefully at least slightly chastened about loaning money to the odd unemployed car washer for a mini-mansion, while still loaning the worthy accountant money to buy a three-bedroom before his kid is born. Existing homeowners won't see their values crater as the accountant who they would sell to doesn't materialize.

(Later) Why buy 'debt'? Let's say I owe you $100 in a month, and am good for it. For you, that IOU is an asset - it is a claim you have on money in the future. Unfortunately, you need cash now to pay your book...keeper. So John over there is willing to pay you $90 now, in return for the $100 I'll pay you in a month. You get your $90, and John gets a $10 profit when I pay. We have now made the IOU 'liquid', meaning it can be sold for nearly its face value at any time. That being true, you will be more willing to loan money (knowing you can get cash when you need it), lowering interest rates. Everyone is better off - I get more favorable terms, you get more cash flow security, and the John gets the difference between the face value of the loan and the liquid price, if/when you sell. John is the one 'buying debt'.

Posted by: rvman on August 17, 2007 11:06 AM

Economic turmoil hits home, so to speak, because my grandfather was totally wiped out in the 1929 stock market crash.

A bankrupt investor jumped out a window and landed on his pushcart.

Posted by: Peter on August 17, 2007 11:11 AM

Is it fair to say that what can tick people off about things like this is that the people who created the problem for which so many are paying 1) are making out like bandits, and 2) aren't being punished, even as the problems they created are being cleared up?

Posted by: Michael Blowhard on August 17, 2007 11:51 AM

Is it fair to say that what can tick people off about things like this is that the people who created the problem for which so many are paying 1) are making out like bandits, and 2) aren't being punished, even as the problems they created are being cleared up?

Well yes. I would, however, be somewhat surprised if the mortgage situation doesn't result in a fair number of high profile DOJ and SEC actions against individuals and corporations involved. Retribution, if it comes, is unlikely to be immediate, though.

Posted by: Taeyoung on August 17, 2007 12:03 PM

MB, looks like Johnathan Pearce thinks along same lines.

Posted by: Tatyana on August 17, 2007 2:40 PM

Who are these "people" making out like bandits? Let's take the example of Mozilo, the head of Countrywide. Do you realize how much wealth he has lost due to the home loan crisis? What about all of the employees of those mortgage lenders and brokers who have lost their jobs due to the crisis?

Posted by: jult52 on August 18, 2007 6:11 AM

At the end of the day, the "winners" will be real-estate investors who sold last year, legions of mom&pop mortgage brokers who made very good livings for several years, and hedge-fund investors who owned these bonds and got their money out. Also, local governments who benefited from increased property taxes have to be numbered among the winners.

The losers will be basically the same as the winners, except for the timing.

The "middle guys" will be bigger mortgage originators and resellers like Countrywide, who did very well for a while, but now will take a dive.

Also, one could argue the winners include lower-income or younger people who don't currently own property and will be able to buy something they can afford as RE prices deflate.

I'm hoping that Congress doesn't try to bail anyone out here. The sophisticated losers knew the risks they were taking, and the people losing their houses typically bought them with 0% down anyway, so while they'll have an awful few months of getting back on their feet, they won't take much of a long-term hit.

Posted by: Foobarista on August 18, 2007 4:08 PM

Much as we dislike the idea of money
being spent to rescue those who made
unwise investment choices, there is a
very good reason why we cannot let
banks go under.

Once a bank goes under and people realize that it is foolish to trust
them with your savings, you may see a
return of that old standard method: under the mattress.

Sure, people could become savvy customers and learn how to tell good banks from bad, but saving your money under the mattress is a lot less work than doing your research ("never underestimate the power of laziness in the decission process").

Before you know, all the money which would otherwise be availabel for investment, some of it quite worthwhile and profitable will be lying in thousands of beds, waiting for better times.

Basically, you cannot allow people to doubt that it is wise to put their money in the bank.

Posted by: Adriana on August 18, 2007 7:19 PM

1) Banks extended loans to borrowers for real estate who could not afford the loan or any increase in interest rates on adjustable-rate mortgages--bad loans! Borrowers were thinking that real-estate would go up forever and bail them out of their excesses--wrong!

2) Banks bundle these crap mortgages, buy some investment "insurance"--derivatives--and upgrade the rating of such crap paper to investment quality, and many pension funds, money market funds, hedge funds, etc, buy such bundled loans.

3) Adjustable rate mortgages are re-set with higher interest rates, so bad borrowers are in over their head, fall behind on such mortgages, or fall into foreclosure. All of a sudden, said bundles of supposedly high-grade paper are not performing (able to pay interest), and the bonds are no good. As usual, word gets out, and nobody wants to buy any more of this bad paper, nor take it off the hands of unlucky investors who bought it previously.

4) All of a sudden, these bundles of paper are becoming worthless! Nobody will buy them, so no "liquidity", or the ability to sell an asset in a market, is available. Huge, huge losses are occurring, and people are doing everything they can to get their money out of hedge funds, etc, that holds the paper, but the buyers of said paper have no cash on hand to re-fund their investors. So they either go belly-up, or have to borrow the money from somebody. Also, such derivatives, or investment "insurance" start hitting the crapper. More squeals of pain!

5) Viola, the FED runs to the rescue, creating money out of thin air to make a market for such crap paper and derivatives--either by making it available for people to borrow, or buying the paper indirectly as funds sell every other asset they have, including US Treasuries, which is all the FED is supposed to be able to buy. The buying and selling of such crap paper ensues, even if the crap paper is discounted to pennies on the dollar, "order" is returned to the market, and catastrophe is averted or put off to another day. Some people lose, most get bailed out, and life goes on--the life of the non-productive gamblers and flim-flammers who inhabit the marketplace.

6) Of course, in the end, the bailing out of such reckless financial behavior will simply encourage more stupidity, until the whole thing collapses in a giant crack-up boom. And inflation will roar ahead as the money created out of thin air eventually makes its way into the real economy, where people actually do something productive for a living besides gamble with other people's money. Its just another form of privatizing profits and socializing losses. Once you understand that the role of the FEDERAL RESERVE is to contunually create money out of thin air for pumping up the business cycle, enriching bankers, and averting the financial ruin of gamblers, you've got the picture. Its neither Federal, nor does it have any reserves. It is a private corporation that is in fact a banking cartel--a perpetual monetary inflation machine granted a license to create money by the government in exchange for the promise to always buy government bonds to fund the wars and political vote-buying schemes of politicians, which has been exploited as well by the gamblers on Wall Street.

There, that should be simple enough for you.

Posted by: BIOH on August 18, 2007 10:58 PM

I'll give it a go. Basically, the Fed cut interest rates a lot between 2001 and 2003 to get the economy going after the dot com bubble collapse and 9/11. With the cost of loans so low, demand for buying homes shot up, but supply didn't (it takes a while for builders to, um, build). So prices began to rise.

Things were peachy for some time. Lenders, who make their money from origination commissions on loans, wanted to keep the party going. Since there is only a limited amount of prudent, creditworthy individuals, they offered finance to "subprime" borrowers (those with bad credit) and property flippers (by not asking them to prove income).

Prices kept on rising and builders kept on adding supply. When rates went up and prices became unaffordable even for marginal buyers, demand slowed. Thus, there was massive oversupply. Prices began to fall in late 2006.

People began to realize they couldn't make the payments and couldn't sell to pay back their mortgage. So they defaulted. The investors who bought their morgages, many with borrowed money, were hit by huge losses.

The problem is that no one knows who's holding the hot potato. If a fund blows up, investors lose. But if that fund can't pay back its creditors, and so on, then all hell breaks loose. So far, some funds have had problems, but have been rescued by their parent firms. However, no one knows what's lurking out there, so lenders are cutting exposure (i.e. not lending).

What the Fed is doing is assuring everyone that it's willing to help banks ride out the storm by lending them money and cutting rates. Will it work? I sure hope so, but many surprises await.

Posted by: Andres on August 20, 2007 7:01 PM

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