Really, what the general public has got to be asking after the financial news of the last week is “wha’ hoppen?” — accompanied by grogginess, head shaking, and animated birds circling their heads, chirping.
It started ten days ago, with a series of events that had the result of “freezing” the credit market. What that means is that banks and other financial institutions stopped lending one another money and people started moving away from money markets and similar kinds of accounts — the savings accounts of really big companies — and moving their money into Treasury bills. They were so frantic to get out that, for a short while, Treasury bills were down to zero yield. This is pretty much the definition of fear on Wall Street: they were so worried about losing money that they were willing to lose money.
If this goes on, here’s what could happen.
We depend on credit lines more than most people realize. Credit lines dry up: businesses that depend on them grind to a stop. That means: grocery stores start to empty — they depend on short-term credit to buy food for the shelves; paychecks bounce, or aren’t delivered at all — many companies, especially very big and very small ones, use short-term credit to pay payroll against receivables. People will be out of work.
When something similar happened in 2000 in Argentina, within a few months Argentina had 25 percent unemployment and middle-class people were reduced to recycling cardboard and picking rags in order to get money to eat. We’re talking Great Depression here: bread lines and soup kitchens.
Now, that hasn’t happened yet. Faced with the possibility of a new Depression, Ben Bernanke, chairman of the Federal Reserve, and Hank Paulson, secretary of the Treasury, got their attention wonderfully focused; the last weeks have been spent laying out a plan and attempting to sell it.
Before we talk about that, though, let’s talk about what did happen.
Basically, it was a run on the bank, like happened at IndyMac a few months ago, like the one in It’s a Wonderful Life. People started asking big financial firms for cash, until they ran out of cash; because the markets weren’t working and credit wasn’t available, the big financial firms didn’t have it. This frightens people, and markets don’t like fear.
So how did it happen?
The history of this really starts back in the ’70s. For various apparently good reasons, Congress in its wisdom decided that banks and lenders should sell mortgages they would not have ordinarily done. Sometimes, the reason they didn’t sell the mortgages was very possibly racial prejudice; sometimes it was the bank’s observation that some neighborhoods seemed to do better than others (so called redlining); and sometimes it was for reasons of creditworthiness and income. In any case, the Community Reinvestment Act passed in 1977 during the Carter administration and was revised in 1995 during the Clinton administration. Whatever the desirable qualities of these laws, the net effect was to make home mortgages, over all, more risky.
As Wikipedia correctly says (as of September 25, 2008, at least):
Part of the increase in home loans was due to increased efficiency and the genesis of lenders, like Countrywide, that do not mitigate loan risk with savings deposits as do traditional banks using the new subprime authorization. This is known as the secondary market for mortgage loans. The revisions allowed the securitization of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997 by Bear Stearns. The number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent.
The 1995 revision of the Act allows lenders other than banks to get into the business of offering home mortgages, and allows both banks and these other lenders to offer these subprime mortgages while securitizing them. “Securitizing” means the loans were collected into a financial instrument like a bond and sold on an open market. These collections of securitized loans are called mortgage-backed securities, usually abbreviated as “MBS.”
Why would you do that? The answer is that it was an attempt to reduce the risk: a single mortgage could fail or not, but a lot of mortgages collected together should always be worth as much, or nearly as much, as the face value of the bond. If a few mortgages failed, it didn’t matter to the bond, because the face value included an allowance for some failures.
Still, some people felt the risk was too high, so another “innovative financial instrument” was invented, called the credit default swap, or “CDS.” In a CDS, I insure my MBS by finding another company, like AIG, to effectively write me an insurance policy: if certain things happen to my MBS that make it have less value, AIG promises to pay me the full value of my MBS in cash, swapping it for the MBS itself. (A “credit default swap” works like this: since I believe in the good credit of the issuer, I’ll let you pay me a small fee, with the promise that if the issuer defaults, I’ll swap the full amount in cash for the security. In other words, if something bad happens to the bond, I’ll buy it back from you, paying cash for it.)
So now we’ve got three of the four big dominoes: higher-risk mortgage loans, mortgage-backed securities built from those loans to reduce the risk of holding these higher-risk mortgages, and credit default swaps to insure the holders of the MBSs.
Now we get to the fourth and final domino: between late 2000 and 2002, major failures of companies like Enron and WorldCom led Congress to pass the Sarbanes-Oxley Act. Part of the Act was to force companies to use “fair value accounting” — to carry certain securities at what they were currently worth, instead of book value. In November 2007, the Financial Accounting Standards Board codified this with FAS 157, which effectively imposed an accounting rule called “mark-to-market accounting.” Enron and WorldCom had exploited older accounting rules to give an artificially high value to some securities they owned; that let them continue to show good results even as the dot-com boom busted. With mark-to-market, you couldn’t do that: a company had to value any securities it held at their current market value, whatever it was.
Now we have all the dominoes lined up. Here’s what happened: eventually, for various reasons, the housing market stopped going up. House values stopped growing and in fact started decreasing. At the same time, interest rates started to go up as the Federal Reserve Bank thought inflation was becoming a danger. So people who had bought these special subprime mortgages saw their variable interest rates go up, and with them the house payments; at the same time, their houses were worth less. It got to be hard to refinance them and people started losing their houses to foreclosure. As default rates went up, the assumptions about the value of the MBSs didn’t make sense any more, so they started to lose value. One day, someone decided to sell their MBSs, even if they took a loss, because they were too risky.
At that moment, everyone who held an MBS had to revalue it at the lower value.
Then someone else decided to get out of MBSs; it happened again. At this point, the credit rating agencies noticed that the companies who held these MBSs were losing paper value because of mark-to-market, and reduced the companies’ credit ratings.
Reducing the credit rating is one of the events that can trigger a CDS: companies that held CDSs started demanding their cash, swapping them for the securities themselves as the contract required. The companies that issued the CDSs wanted to raise more cash and tried to sell the MBSs; this pushed the price down more, causing more markdowns, more CDS claims, and more sales, until suddenly companies like AIG had immense demands for cash, against their new ownership of a bunch of mortgage-backed securities they couldn’t sell. (They were “illiquid.”) At this point we’ve got, in effect, the classic “run on the bank” I discussed in my recent article on IndyMac.
That pretty well gets us to Wednesday, September 17. The Fed reacted, at first, in the usual way it responds to a run on a bank (although AIG wasn’t strictly a bank), by taking it over and opening the Federal Reserve vaults to provide cash. (That’s why it’s the Federal Reserve Bank; ever wonder?)
The only thing was, now no one really knew who was still solvent and who else had immense problems because of CDSs they held — CDSs aren’t regulated or traded on a normal market. Banks wouldn’t loan money to one another; then the banks started pulling money out of money markets, which serve much the same function that your savings account does for you. But those are themselves backed with something besides cash —
Let’s take a short side trip here: there’s always a trade-off in any loan or bond: the harder it is to get to your money, like a longer-term certificate of deposit, the more the bond will pay; the more risk on a loan, the more the interest rate. So a “money market” account pays out more or less like cash in a savings account; money markets make a profit by putting most of that money into Treasury bills that don’t pay off for months or years.
— are themselves backed with something besides cash. Now there’s a second run on the bank, as if the Bailey Building and Loan’s problems caused a run on Mr. Potter’s bank. People start trying to cash in their money markets; the prices of Treasury bonds drop and suddenly there’s no cash left.
At that point, banks are no longer lending cash to one another and banks don’t have any more cash to lend. The credit market is “locked up.”
That’s how we got to the night of the 18th.
Bernanke, being a profound student of the Great Depression, must have been having his own visions of bread lines and soup kitchens at that point, and for good reason: remember, it had actually happened in Argentina only a few years ago.
Something had to be done. But what?
Taking a few deep breaths, there were some things that were clear. First of all, the mortgages that backed the MBSs were still mostly good: people were making mortgage payments to someone, and the ones that weren’t still were backed by the houses. The banks and the other companies that held MBSs weren’t broke but they were “house poor”: lots of assets, no cash. But lower-quality mortgages led to hard-to-value MBSs, which led to big redemptions on CDSs, which are what made the run on the bank, which is what happened to the low-income, “community reinvestment” house that Jimmy Carter built in 1977.
Hard-to-value MBSs are hard to sell; they’re illiquid. So Bernanke and Paulson thought, “We’ll buy these (expletive) MBSs.” They’ll buy them at a discount to what they think they are really worth, but for a good bit more than their current market values; then they’ll hold onto them, and sometime in the future they’ll resell them in an orderly fashion, trying to get as much as possible for them. In the meantime, everyone knows what they’re worth, because there’s a buyer, and everyone knows there’s cash back in the system.
It should work. In fact, it’s probably a good trade: there are about $2.2 trillion — $2,200 billion — of these subprime mortgages around, and we know Bernanke and Paulson propose to buy them for about $700 billion. The figures we roughed out talking about it at Tom Maguire’s Just One Minute suggest the subprimes may really be worth about $2 trillion, about 90 percent of the face value; Andy Kessler at the Wall Street Journal is a little more conservative and says 70 percent, but then he includes some other kinds of securities, so comes out with about the same bulk number, $2 trillion. And when you can buy $20 worth of something for $7, that’s a good deal anywhere.
Warren Buffet thinks so: he said he wished he had $700 billion so he could do it himself; he did put $5 billion into Goldman Sachs based on the plan.
In any case, what basically happened was that we got ourselves into this position by a bunch of decisions that seemed to make sense at the time and seemed to have good intentions; if we don’t do something, we’re talking about the bread lines crisis Bernanke feared and there isn’t a lot of time to spend on it.
So we have a bad crisis made better and a good deal for the government in fixing it. What’s not to like?
Well, enough, apparently. The Republicans don’t like spending that much money or appearing to spend that much money. The Democrats didn’t like having a spending bill passed without a cut off the top.
Then the actual bill language came out, with a Democrat-included scheme to skim the profits of any individual transaction and pass them to a Federal “trust fund” that has historically been used to pay off Democratic-associated groups — like ACORN, rather notorious already for its repeated involvement in election fraud. It included rules that would have forced unions into near control of some corporate boards. And it included a requirement for Congressional oversight that would have been entirely made up of Democratic members. (A handy comparison of the original plan, the Dodd plan, and the plan voted on Monday, can be found here at the DC Examiner.) It didn’t help that the bill language had been written largely by Chris Dodd and Barney Frank, who were largely responsible for the original problem.
This led to open revolt among House Republicans, who came up with their own scheme, including free-market insurance and accounting reforms, all of which would have been perfectly lovely a year ago — or in 2006, when McCain tried to push through a bill to prevent a Fannie and Freddie collapse. (And don’t be mistaken: the Democrats did their best to block it, but Republicans were at the trough too.)
Everyone fought back, and in the meantime more and more economists and pundits started to have their minds focused. It looked like it was going to pass, maybe, barely, when Nancy Pelosi couldn’t resist a final attempt to blame it all on Bush. Right before the vote.
It’s hard to think of anything better calculated to turn the Republicans away, and it’s hard not to wonder if that wasn’t the plan. After all, in the last Great Depression, it turned out all right for Democratic control of the House. Maybe she can be the next Sam Rayburn.
Of course, there have been a fair number of Republicans and conservatives speaking out against it, like Newt Gingrich, who originally said Republicans should demand a plan that merely meant completely rewriting the U.S. Tax Code and implementing all the programs he’d been unable to sell for the last five years.
Well, guess what? Now the Democrats have all the cover they need to add back the ACORN, and union control, and any pork they want, and pass it on a party-line vote.
Jim Manzi at National Review Online summarized it pretty neatly. Although he blames Republicans, I think the blame is on Congress in general: in an act of irresponsible folly, Congress has decided to run an experiment to see if a financial meltdown really will cause another Great Depression.
I guess we’re about to find out.