Worthless and Weak

You may be asking yourself what my position and or thoughts are on the whole financial crisis. Up in till now I've been so busy dealing with it at work that I haven't had much time to write about it. Until now that is.

I do have a couple of caveats and disclosure.

First, I don't really know what the hell is going on. So if my arguments seem convincing, it may in fact mean that you know even less. (Also, I'm kinda guessing at some of the specifics here, so if you see something I write contradicted somewhere else, believe them)

I'm coming out in favor of the $700 billion bailout. (I'm not in %100 agreement with it, but in general, I think its probably the smart thing to do).

So here's the theory:

Banks are in a tough spot. They got there by leveraging. Leveraging is simply borrowing money to make investments. I've heard reports that Freddie and Fannie were leveraged at about 100x. (that is, for every dollar of their own money (equity) they invested, they invested $99 of somebody else's money (debt)).

This, if you think about it, is really the sole function of a bank. To borrow one person's money, and to lend it to somebody else. So I'm not certain that the whole point is that banks were too leveraged.

When even a fraction of that debt goes bad, you can lose everything. (a 1% default rate would wipe out all of the company's equity in the above example).

Of course, banks charge interest, so say they charge 6% interest on their loans, and pay 3% on their debt, they can have up to 3% of the loans default and still make money.

You can leverage yourself in the stock market as well. (this is what Hedge funds tend to do) by using borrowed money to buy stocks. The problem with this is that nobody trusts people who buy stocks, and therefore will "call" your loans if your portfolio value changes by much, thereby forcing you to either give them more cash (and if you have cash on hand, you're not really leveraged) or sell your bets at a loss to cover the loans. In this manner, if a fund is sufficiently leveraged, a bad hour can wipe them out. And eventually, you'll have a bad hour, so natural selection means that we won't see too many ultra-highly leveraged hedge funds at one time. You don't tend to get the same sort of natural selection in banks, as debt markets can remain very stable for a long period of time. You can have a bad year in banking, you don't typically have bad days in banking. (ok, we're having bad afternoons this week, but it was primarily due to the fact that the subprime market is having a bad year, more on that later)(as a bit of an aside, two of the previous biggest failures as a result of leveraging illustrate this. LTCM was highly leveraged, but dealt primarily with debt (obscure things such as Norwegian Morgtages. Barrings bank was destroyed by a rogue trader who leveraged by about 8 to 1, invested in equities, and had a bad hour, destroying the 250 year old bank).

So the problem we've had a sector that has had a bad year. This sector was called collateralized debt obligations (CDOs) sector. A bank will make loans to home-buyers (called mortgages, of course). They accept as collateral the house that is being bought. (thus, if you stop paying your mortgage, the bank will seize and sell your house). What these banks started to do is to bundle these mortgages and then sell them as bonds. The advantage to these bonds was that so long as housing prices went up, there was virtually no risk to these bonds, because in a default, you could simply sell the house and make up the entirety of the mortgage payment.

When housing prices go down, of course, there is the opposite problem. If the price of a house goes down to the point where it is worth less than the remaining value of the mortgage, one is in some respects better off defaulting on the mortgage.

That's what happened about a year ago. Housing prices started to fall, at the same time defaults started to go up. This is compounded by mortgages which were offered with little or no down payment. This led to the failure of Bear Stearns, they had too much money in CDOs.

It hit Lehman recently, bankrupting them. Now, the fear is twofold. First, that the crisis can easily spread from bank to bank. AIG had insured Lehman Bonds, when Lehman went bankrupt, it took AIG with it (I have no idea how AIG got into a situation where the failure of one bank would bankrupt it, although there is probably a lot more to it than that). The other problem is that everybody goes to the safest asset when one bank fails, meaning that they all try to withdraw their money at once. This is known as a "run," and it is a very bad thing.

One of the problems that we have right now is that everybody wants to sell, and nobody wants to buy. That is, in normal situations, if a bank is in trouble of making its next payment, it can sell long term assets, even at a slight discount, and survive the day. But in this environment, nobody is buying. Let's say there is a bond with a face value of $100 (what the bank originally bought it at). The bank who holds it think that it has an intrinsic value of $50 (say, they think that there is a 50% chance they will get the full $100 at the maturity of the bond). However, they need cash now, so they want to sell it. But the market is selling it for much less, say $25. Now, ordinarily, another firm would see the 50 dollar bond selling for 25 dollars, buy the bond, hold it till maturity, and make some easy money. But every bank is in selling mode right now, very few can afford to buy for much more than the market price. The reason they can't is because if they pay more than $25 for the asset, then their immediate balance sheet declines (They add an asset of $25 while adding a debit of north of $25, and make themselves more illiquid to boot). So you've got a situation where everybody wants to sell and nobody wants to buy, and its not a stable equilibrium either. If nobody ends up being able to sell, then most banks may not have enough cash on hand and therefore go into default, causing other banks to fail, etc. If the bank can sell enough bonds to pay their current debts, they can possibly make it through, to a point where they will be able to become a buyer, and thus bringing the market price to the "intrinsic value."

The idea behind the bailout (you knew I was going to get to it eventually!) is to have one big buyer of these securities, allowing the banks to get cash on hand now. The beauty of it is that if the Fed is buying $50 bonds at $25 a head, then they're gonna end up making nearly a half trillion dollars FOR the taxpayer, at the same time, giving the banking sector enough liquidity to get their house in order, thus saving the economy from a gigantic credit crunch.

Of course, there's no guarantee that the fed will either end up saving the economy or keep from losing any money at all. My thoughts are that, if things are really much better than they seem, the Fed will make a killing buying debt. If things are much worse, we're screwed anyway, and if they're about the same as we think, I believe the Fed will still end up ahead, and the benefits given to the economy will be much greater than the cost.

Labels: Financial Crisis of September 2008