THE GAME IS UP/ FINANCIAL MELTDOWN

THE ECONOMIST (2007) 8/18 P. 63-66

It appears that we are heading for an international financial meltdown. At least it appears that the United States is in trouble. How did this happen?

SECURITIZATION- In the past, banks gathered bad debt as part of business. Over the years, a new way of organizing capital was invented. In the old days, generally one bank went under as the other trading banks survived. Now bad debt is spread in small pieces to all the banks in a region. So no one goes under….until now.

SUBPRIME LOANS- During the real estate bubble, sub prime loans were granted to folks who were not as likely to pay back their debt. They are called MARGINALS.

MARGINALS- Are folks down on their luck and an ARM is given to them to sign.

They may pay very little at first and all that money goes to interest. When the ARM goes up, they can’t afford the house and they bail out. The bank gets the house back along with the interest as nothing was put down on the principal. Sub prime loans were very good for lending institutions as more and more people bought houses.

ARMS- ARMS are adjusted rate mortgages. The first few years you pay just a small amount and then it quickly escalates to a huge house payment as the interest increases. Thus, the marginals have to bail out.

DISPERSED RISK & DISPERSED MISTRUST- At first this system mentioned in SECURITIZATION helped all the banks. They covered for each other and no one bank was ready to go under. However, as time went on, some banks BUNDLED their sub primes into  CDO’s (Collateral Debt Obligations.) The lending institutions would roll up or bundled all this debt and sell it to a larger lending institution. The bigger bank would buy say 1.5 million dollars of debt for 1 million dollars. Thus, if the economy continued to prosper the bank could make $500,000 (gross.)

SUB PRIMES- go bad. This easy money goes down as people bail out. Banks that bought bundles of sub primes, were not holding onto contracts or mortgages that weren’t worth anything.

OVERBUNDLING –At first bundling or CDO’s could then be bundled with even more sub prime bundles and on paper the big banks got richer faster. So bundles of really bad debt was increased to bigger and bigger bundles and sold to even bigger financial institutions. Now we have a problem. How liquid or good are the bundles? They could be just a bundle of papers (mortgages) that are not worth much. To make matters worse, in 2008 more ARMS are going to transfer from small interest to big interest and that means more foreclosures or stress loans.

RATING AGENCIES – Standing on the sidelines are rating agencies and they don’t like what they see and they increase their involvement in ranking in clanches or strata of how good or bad the risky bundles are. This slows down the trading and lack of scrutiny that has gone into bundles before. So big bundles with risky and non-risky loans are rated.

Banks fear that the rating will mean that larger banks will no longer ROLLOVER.

ROLLOVER- When a banks rolls over that means in continues to take funny money and continue to use it as part of further transactions. If securities or bundles of sub primes are forced to reveal how bad they are, the banks begin to MISTRUST each other and the paper that had a great deal of value on Monday is relatively worthless on Tuesday, so it is dumped into any buyer that will purchase it. Rapidly, much of the market goes bad.

HEDGE FUNDS- To complicate matters hedge funds enter the picture. What is a hedge fund? It is an insurance of sorts that one pays another institution so that if times go bad, the banks have paid an amount of money overtime as insurance against going under or going out of business. In the old days, there were elderly and wise individuals that knew the market and would pick stable stocks and bonds that were much less affected by the market. They knew that the business cycle is constant. That means the market goes up and then goes down. Their job is to try to weather the storm and to flatten the business cycle. However, a small change in bundling and sub primes become systemic or impacts the entire market to varying degrees. Today, hedge funds are based on ever changing math models that are probably multiple regression models with beta weights indicating growth for the hedge fund investment. These computer models and my guess at what they are doing have made the market more risky not less…so far. Hedge funds can lose huge amounts of money or they can make incredible amounts. If things go real bad, taxpayers have to pay for their mistakes.

DEREGULATION- How did all this get started? The great deregulation movement of

 The Reagan years promised that if regulators or government would get out of the way, the whole country would prosper and get richer faster. However some financial institutions are more regulated than others. Deregulation is still very controversial today.

So where are we? Bundles of worthless paper became bigger bundles and were traded here and in the new global economy. Further, the U.S. dollar keeps losing value as the Bush administration keeps borrowing from other countries. At the moment our cheap dollar helps sell our exports. However, there comes a tipping point when the dollar isn’t worth much and other countries sell their dollars and there is a run on the dollar. As the American dollar goes bad, it can make other countries lose too, because they bought so many dollars.

It all ends up that in dribs and drabs, we discover more bad news on the door step. We need to change policies, but what to do? Where to now St. Peter?

This has been an attempt to describe the possible financial meltdown that appears to be happening at the moment as described by THE ECONOMIST and this author.