Rug Burn Junky on 4/10/2008 at 00:38

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I've been meaning to pipe up way sooner than this, but there are any number of things which have taken up my time, most of which, ironically, are actually very relevant/affected by this mess in a very visceral way. I live and breathe this stuff, and more so in the past year. More on THAT in a moment.

The other thing that's sort of kept me from writing anything is the fact that, sorry, but so many of you are so unsophisticated in this stuff that I'm afraid most of what I'll write will go over your heads, or I'll have to spend so much time explaining shit that the thought of doing that much work makes me stop in my tracks before I start. OR worse, I have to defend myself against people who wield their ignorance like a club.

First of all, please disabuse yourself of the notion that what's happening on the "Dow" is really the "Market." It's not, it's merely an indicator, and right now, not even close to the most important one. The Dow is only about equities - stocks - and very few of them (~30) at that. A one day fluctuation in any direction in equities is trivial (OK, I watched the 400 point drop after the "bailout" failed the first time in real time, and that *was* scary, because it was instantaneous). Hell, it's not even the only "Market," debt, commodities, derivatives; all of these are traded separately. It's kinda like saying "The Red Sox and Cubs are in the playoffs, so "Sports" are doing well." It's only a subset, and only sub-subset at that.

There is so much more going on right now, and most of it is on the debt side. More than that, it's not even in debt securities (bonds), but in interbank lending - the repo and commercial paper market in short term debts. The real indicator to watch is the difference between LIBOR (the amount of interest banks charge to each other) and the Treasury Rate (which is seen as the safest investment out there, the "Risk-Free Rate"). If everybody and their brother is buying T-Bills, because that's the only thing they think is safe*, and nobody wants to lend to each other except at exorbitant interest rates, these get really far apart. That's a bad, bad sign.

*Treasuries right now earn so little interest that they are below the cost of inflation. So every dollar you invest today is worth some asinine figure like 96 cents down the road. May as well burn 4% of your money.

OK, let's start at the beginning. I'm going to simplify as much of this as I can, but I can get into more detail if you fuckers need it. I'm also going to run through a lot of information that you can get elsewhere if you simply look at it. I highly recommend reading Paul Krugman's "Conscience of a Liberal" blog on the NYTimes website. He's been on top of this all along. Other financial bloggers have had some good pieces on it - not all of whom agree, but most of whom raise good points - including Felix Salmon, and Seeking Alpha.

The Great Depression. Banks speculated. Banks borrowed money to speculate. Speculations lost money, Banks owed large fractions or money on multiples of what they had and had to post collateral. Customers panicked before they could recover, making a bad situation worse - a "bank run". Glass-Steagall act is passed, separating the investment banks (the parts that speculate) from the depositary banks (parts that just take deposits, and lend the money). All of the basic securities laws that govern the markets were created in the ensuing decade (the Securities Act of '33, the Exchange Act of '34, The Trust Indenture Act of '39, the INvestment Company/ADviser Acts of '40). The FDIC is created, backstopping those deposits so silly customers won't herd into banks on rumors and pull out all of their money precisely when the banks are most vulnerable. This is the big bang of modern wall street as we know it.

To get a complete picture, you really should read up on Michael Milken and junk bonds (Predator's Ball), Salomon Brothers and mortgage trading (Liar's Poker) and Long Term Capital Management and the last time that Wall Street nearly went under (When Genius Failed). You may want to look into the 1987 crash as well (caused by the same Nobel prize winning economists that were part and parcel of LTCM). When you know the history of Wall Street, and can follow all the threads, it's really easy to see how what's happening now is the end result of events that started 10, 20, even 80 years ago.

OK, so, the "Bailout" is entirely misunderstood. And for that, the background you really, really need goes back roughly a year and a half. In the Spring of 2007, the Financial Accounting Standards Board, FASB, instituted new rules: "Mark to market" accounting. What this means is that banks that hold securities had to value them on their bbooks not at the amount they paid for them, or the amount they were likely to earn, but at the amount they could get for them if they sold them right this very moment. This had a chilling effect almost immediately. Deals died on the vine, because every bank was suddenly scared to be the first out the door. You see, if there's a highly illiquid market, nobody's willing to pay much for these things. So if you have a bond, that's going to pay you a dollar down the road, but nobody wants to buy because they're afraid that it'll pay much, much less, then you have to mark it on your books at 60, 50, 40 or 20 cents.

The problem is that if you have to value your assets much cheaper, it affects how much money you can lend/borrow, and you have to start selling assets to correct this.

When everybody is selling assets at once, the price goes down further. Because there's no demand, and now there's a glut of supply.

Price goes down. It's a spiral that's hard to stop.

It's irrelevant if this is what they're "really" worth, you have to value them as low as what people are paying for them. And when there's a glut in the market, and people don't KNOW what they're worth, you're going to have to slash prices. This is what brought down Bear Stearns and Lehman Brothers. Their investments weren't "bad" per se, but they weren't able to hold the positions without raising money, and other people who were loaning them money stopped out of fear that they would go under, making a bad situation much, much worse.

So, let's fast forward a little bit. Bear Stearns. Investment banks today are dependant upon borrowing huge sums of money. They do so on a short term basis, in many ways (the Repo desk at a bank is the center of the universe to some extent). Bear was sitting on a huge pile of mortgages, and, even worse, they were sitting on swap agreements which exposed them to a lot more risk. As long as they could borrow capital, they're fine. But that's not the way things work in the real world. Wall Street is a herd animal, and once the whispers started. You had the modern version of a Bank Run. All of the counterparties on Bear's deals wanted Bear to post collateral or else, and they got cut off from their lifeblood - borrowed money. Their deals were in danger of tanking. Had this happened, it would have set off a chain reaction - other banks that were dependant on BEar's backing for their deals would no longer be hedged in their positions, and the same would likely have happened to them.

So the government brokered a deal, took on some of the risk, but pawned Bear off on JPMorgan. Crisis averted for the short term, but the laissez fairies in the market place all groaned that it was a mistake. "Wah, that's not the free market, let them fail, what's the worst that could happen? It'll be good for the system." Which, quite frankly, is retarded ideological dogma. But I'll get to that in a second as well.

Fast forward again. As soon as Bear went down, the whispers started about Lehman. It was a self fulfilling prophesy. Rumors start, lenders tighten up, it gets harder for them to operate, rumors gain traction, lenders freeze up more, it gets harder and then BAM, they're in the same position as Bear. Having studied the Bear deal, and afraid of the "wah it's socialism" whining, Paulsen let Lehman go under. Big mistake.*

*Little detour about Hank Paulson. I'm not a huge fan, but it could be worse. Backstory - in 1998, a currency crisis swept the globe. credit spreads widened considerably. A hedge fund that was playing arbitrage with the credit spread - Long Term Capital Management, run by some of the best traders on wall street, guys who dominated the market in the 80's in a way that was like Shaq playing against a high school team - nearly went under after losing billions of dollars, and being on the hook for billions more. Goldman Sachs, the last of the major investment banks to go public, was about to finally putout their IPO. The CEO at the time, a man you may know as John Corzine, helped the Fed engineer a huge buyout by all of the investment banks, probably saving our economy. Ironically, BEar Stearns was the one bank that didn't help. Unfortunately, Goldman's other partners were pissed that it tanked their IPO, which cost them each millions individually. Soon thereafter, Paulsen led a coup against Corzine.

OK, so, the Lehman bankruptcy. Yeah, the Dow effects were unremarkable. The LIBOR Spread? Fucking ridiculous. The credit markets seized up. It was financial armageddon. Really.

I've mentioned this in the past, but it bears repeating. Our economy runs through the deals that happen on Wall Street. If they're not doing deals it's bad for everyone. It seems like "Ha Ha, let those fuckers who ruined the economy burn" is just desserts, but it is cutting off your nose to spite your face.

You see, a lot of the money that you use everyday is enabled by this system. Mortgages, Credit cards, student loans, small business loans. But instead of the old days, when it was loaned out by banks, only on the basis of deposits, it's funneled and structured in ways that, in theory, spread the risk. For the most part, it does. IT could use some tightening up. What we're seeing now is what happens when that money comes from big investors, hedge funds and the like, instead of small bank accounts.

Ironically, the banks that are best able to handle this are the hybrids. This is a repeat of the '29 crash, but caused in part by the reforms that corrected it. You see, a few years ago, Glass Steagall was repealed, enabling the depositary banks to buy up investment banks. Now the depositary banks are highly regulated, so they can't operate as riskily. They have flexible Investment Bank arms, but also billions in deposits (subject to their stringent capital requirements) to stabilize their bottom line. Deutsche Bank, CitiBank and UBS made just as many bad bets on mortgages - they aren't going under because they have stability precisely BECAUSE they're banks. They're better able to weather the storm.

So that brings us, finally, to the Paulsen Plan.

It's not perfect. Really. But at this point, it's a start. The parts that were negotiated into it - the government getting equity in return, the oversight, etc. - go a long way. Like I said, I'm not a Paulsen fan, but he's not a heckuva-job-Brownie Bush appointee.

One of the things that really fucks it up is that everyone sees it as a "bailout" and starts whining. It's not the windfall that everyone thinks it is.

Here, simply, is how it will work. Remember how I told you that people were paying 20 cents on the dollar for these assets? That's a bargain. You pay 20 cents, then the MBS pay back 80, and you come out ahead.

But that doesn't help the banks - because that leaves them in the same position - devalued assets they no longer have. They take the full brunt of the loss.

But you, as the government, can't pay 80, because nobody knows *for sure* that they'll pay that much. So there has to be a number in between. Give a little buffer. But pay little enough that there is still upside on the mortgages. That's why the "price discovery" you hear so much about is so important. So yeah, it's $700 Billion, but that's not the COST, that's the INVESTMENT price. If that $700B ends up worth 0, we'd have been fucked no matter what happened. Maybe they payoff and we get back $900B. Maybe the government loses its shirt and they only pay off $500B, in which case even the $200B is probably a savings over the damage that could be done if there's a serious run on the system. What's more, as I understand it, this is not a cash outlay. The banks trade in their mortgages, they get T-bills in return. These stay in a vault, and this shores up their capital base, and steadies them so that they don't go under. It's not as though the CEO's are just getting $100 bills to wipe their asses with.

The market is a herd, and if there's serious momentum in one direction, sometimes drastic measures have to be taken.

Now, were there other ways to handle this? Actually, yes. Saving Lehman may have been a start, it would not have reached crisis levels but for that.

More mortgage relief would have helped. All of the whining free marketeers did about not bailing out homeowners is short sighted and this is really an extension of that. The transaction costs of foreclosing on homes, leaving them vacant, driving down property values, forcing more foreclosures, etc. put pressure on the system. It craters whole deals, and that creates more problems than it solves. As I've said before, simply reworking the loans eases that pressure, and enables the banks to collect more than they would if they write them off as a loss and have to carry them on the books as an REO property.

Now, not that I'm enthralled with Paulsen (Bernanke is a bit better, and I'm glad he's involved) or even the bill that was hashed out by the Democrats, but the political theater of the past two weeks has been rather dismaying, and it's the sum total of the failure of the neocon movement put in stark relief.

On the one hand, you have Bush, who has cried wolf so many times that even when he finally stays in the background on something his administration has come up with, which is actually a viable plan, he's got so little credibility that it's almost doomed.

Then you have a group of congressman, both democrat and republican, who are well meaning, but politically vulnerable, and opposing the bill out of, well, what can only be described as ignorance. They aren't the worst.

Then there is that special subset, only existing on the republican side, that are STILL pumping ideology on this one. "Cut the capital gains tax." Really? No, I mean Really? REALLY?!?! ARe you that fucking stupid? That's your solution to everything... but let's just read what you're suggesting... it's capital GAINS tax... ummm, you realize that the problem is that the banks are getting stuck with shitloads of LOSSES? How does that help? That's like giving someone suntan lotion when they're drowning.

All in all, it's been very disheartening. And to see the government grind to a halt because of W's total lack of credibility and inability to lead is just one more nail in the coffin that makes me cry inside.

In any event, one of the reasons I'm so busy is that I'm in the middle of pondering a career switch. My applications for business school are due in the next month, and they're pretty brutal with the amount of work involved. Thing is, all the shit going down has substantially changed my career prospects on the other side. I have to rethink this if there ARE no major investment banks left (though I was aiming all along at a hedge fund anyway), but it's left me at a point where it's only worth it if the dice roll pays off and I get into Harvard, Stanford or Columbia or the like. Not that there's any pressure. And, of course, it's not as though I'm worried about getting that $150k in student loans I'll need. ;)

Undead Gamer on 4/10/2008 at 04:12

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Bailout was passed and guess who paying for it now YOU :tsktsk:

BEAR on 5/10/2008 at 00:48

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Thank you for explaining that. I can't claim to actually understand it all (I'm going to have to re-read it a few more times and look things up while I read it), it definitely makes me feel like I know more.

What I've realized in a lot of situations is that even if I feel like I have an opinion (probably best described as a gut reaction), I realize how little real information that opinion is based on. Thats why I've tried to resist weighing in on this subject because I know anything I could say would mostly be speculation and knee-jerk shit.

I find this to be the case with a lot of things, and we would probably all be better off if people just realized they didn't know enough really have an opinion (not that this seems to stop anyone).

I'm going to start reading through Krugman's blog. I'm not that interested in economics, but I hear so many dumbfucks talking about it (and politics) that I'm making it my business to understand things like that as well as I can so I can take people to task on it. I've always liked Krugman but its probably just because he's been on Colbert :D



How poignant. After the first post in this thread from someone who knows what they're talking about, comes the dumbest post in the whole place. I hope for your sake that the two posts were so close together you couldn't have seen it first, but more likely it was too long and you didn't read it.

Ghostly Apparition on 5/10/2008 at 01:49

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While your at it RBJ, Do you have an opinion on whether this bailout/rescue is going to work any better than the one Hoover tried in '31? Because that really didn't work. Like some of the others here though, I don't have enough understanding of this mess to really know.

Thief13x on 5/10/2008 at 04:27

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aww let me cwy a teaw fow you sweety

you're a sorry peice of shit excuse for an american citizen. If you're curious the average gunshop is 40 minutes away, why don't you buy a revolver and do us all a favor you emo peice of garbage (aim for the leg!)