Economic Crisis for Dummies

Frustrated TraderI think I’m a reasonably good manager in at least one respect: I try to shield my team from the horrors of what exists outside of our limited domain. I don’t rehash every argument I’ve had, or tell them every silly quip that has been said by my superiors; I try to create an atmosphere that is conducive to creativity.

However I’m beginning to wonder if some members of my team are almost too insulated: I got asked yesterday, “What is all this?” This being the economic crisis, the credit crunch and the subsequent fallout resulting from it.

I could sympathise; the present crisis is not easily understood. In fact, I’m not sure I understand all of it: what I do know sounds thoroughly crazy, but given that unlike fiction, reality doesn’t have to be realistic, perhaps it’s true. I attempted an explanation for his benefit and that of my team.

I asked him if he’d ever heard of a company called Yes! Car Credit; this is a British firm that sells cars to people with bad credit histories. He said yes. Fine, I told him, have you ever seen the interest rates they charge on their car loans?

He hadn’t. The interest rates, I explained, are much higher than they would be for a “standard” borrower. It’s a premium you get charged for being a bigger risk: Yes! Car Credit makes their money this way, by being a lender of last resort and socking it to those who have nowhere else to turn.

Similarly, subprime mortgages were attractive to investors because of this higher rate of return. If houses kept rising in value, these were not as risky as usual, because even if there were some “deadbeats”, the houses would still be valuable asset, and could be sold on at a profit.

This problem was made worse by the present banking culture; investment bankers are incentivised to get high rates of return on their money in the short term. Subprime mortgages offered these high returns, quickly. The bankers, eyeing big bonuses, Saville Row suits and Aston Martins, said “Yes, more of that please”.

“But,” my colleague said, “the people taking out the mortgages didn’t have any money!”

Right. A lot of people got into a financial hole and the only way to keep above water for some was to borrow against the perceived (rising) value of their homes. There was an insane situation, repeated throughout the United States, in which people were taking out loans just to pay their mortgages.

Government made the problem worse because they didn’t tell the banks to cut it out; indeed, in America, Fannie Mae and Freddie Mac provided guarantees for the issuance of these subprime mortgages. So long as the market kept rising, the day of judgement was kept at bay.

This is not to say the banks were oblivious to risk. The way they handled it was by issuing “derivatives”, which packaged the subprime debt into other securities which were sold on to other banks throughout the world. Banks, again, liked them because they offered a higher rate of return than more conservative investments.

I then had to lower the boom on my colleague: I said, “What if I told you that all banking is a con trick?”

“Say what?”

When one looks at their bank account, they assume that the nice figure on the ATM or computer screen is somehow stored in the bank’s vault. It’s not; for banking to make a profit, they loan the money out or invest it. Thus the money in your account is actually not there; all they have on hand is a fraction of total deposits, and a hope that you’ll believe the money is secure.

My colleague visibly paled. I continued: so let’s move on to recent times. Bought any petrol recently, I asked. He replied in the affirmative and complained about how expensive it was. I said, because of the constraints on the supply of oil, food and other commodities, prices have been rising quickly. This made subprime mortgages even less affordable for those who had them. Add to that the measures that central banks took in order to stamp down price increases, namely, by raising the main interest rate at which banks operate, those mortgages became even less affordable. Subprime deals began to collapse like a house of cards; in the United States, some people went so far as to evacuate their houses and hand their keys over to the banks without bothering to go through repossession. House prices have plummetted as a result: according to the Guardian, you can buy a two bedroom house in Detroit for £800. My colleague said, “Cheap holiday home!” I think he hadn’t heard the “Detroit” bit. However, the price is an indicator: subprime mortgages stopped meaning anything other than losses.

My colleague then wondered why it’s our bad luck; surely the banks should just tough it out and suck up the losses. I replied that in an ideal world, that’s precisely what would happen. The problem is that the derivatives bundled in these bad assets in so many wrappers and spread them so far and wide that the banks actually don’t know what their assets are worth any more. Furthermore, they don’t trust each other’s assets to be worth anything.

“Is that important?” he asked. Yes, it is: a lot of banks lend to each other to cover temporary shortfalls. They’re now treating each other like subprime borrowers, raising interest rates, and thus discouraging the consistent flow of credit. Furthermore, some institutions are regarded as being too risky lend to: Lehman Brothers failed because no one wanted to loan them any money, in spite of the fact that much of their business was profitable. This problem is made more complicated because the banks obviously mistrust each other even without a credit crisis and won’t get around a table to discuss the problem: new disclosure rules, for example, could show who is toxic and who isn’t. However, those who are toxic don’t want to show that they are until the very last minute.

Because of this mistrust and lack of lending, all credit is drying up: it’s not just affecting the flow of money between banks, it’s also affecting the amount of money banks have to lend. Individual savers are more inclined to stampede to get their money out: because of the con-trick at the heart of banking, a lot of banks can’t withstand that at the moment. They have to maintain higher reserves from now on in order to weather the storm. This means there is less to loan to businesses and individuals. Economic activity, as a result, is slowing down, if not shutting off.

My colleague asked how the bailout would fit in. The idea, I replied, is that the government would buy these toxic assets and thus flush the system out of what’s creating the mistrust. However, there is another way around it: make the subprime assets into good ones. This can be done through revision of the terms of these mortgages (i.e., at a lower interest rate) and also by giving cash to homeowners. This has the added benefit of making fewer people homeless. However, unlike buying toxic securities, there is no prospect of the government actually making a direct profit out of it: they are trying to get these assets at a bargain price, with the hope of making money after the situation improves, and thus minimising the cost of the bailout. But that’s just a hope; and it won’t reduce the number of tent cities of repossessed people that are springing up.

My colleague then asked the killer question: “How long is this mess going to last?”

I had to tell him the truth: I don’t know. If the banks can somehow manage to get rid of the toxic assets, and if the “bailout” is done in such a way that confidence returns, the worst may be over by the end of 2009. I did remind him that the worst performing business of all time is predicting the apocalypse: so far they’ve been wrong every single time. Somehow, we muddle through war, chaos, and economic catastrophe: even the Black Death didn’t finish off humanity. However, it could very well be that we are like Japan, which sleepwalked through a deep recession for over ten years. In any case, the era that we are coming into is a more modest one, a less reckless one, one in which we can and should be more aware of how things actually work. It may not make anyone happier, but at least, it should make us safer.

My colleague asked what he, personally, could do.

“Keep your head down,” I replied, “and if you’re religious…pray.”

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