“Stupidity and incompetence”

A couple of weeks ago I said I was preparing a post on the financial apocalypse. Yes, it really did take this long, mainly because I've been gathering material from other people to help explain what the buggeration's going on. While I now understand it on an instinctive level – much like an animal following the urine scent of another in heat – even though I've following this shitstorm for about a year I still can't explain it in my own words. It's that complicated. And which is why I think it's causing so much fear and confusion. Nobody knows what's happening so people either don't know whether they should be worried or are blindly panicking. So welcome, readers, to Bagelmouse's attempt to explain the economy…

Let's start off with John Bird and John Fortune from last weekend with one of the clearest explanations I've seen of the investment vehicles (SIVs, CDOs) that have caused all the trouble, over-extension of credit and banking greed.

You'll notice that they also mention credit default swaps (CDSs) without explaining what they are, only that they're baaad. I am now going to liberally quote from a Time article published in March.

"Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default… The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.

"Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded – or swapped – from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults."

In other words, it's like me offering you fire insurance for your house. You pay me premiums every month and I sit back, knowing
that the chances of your house burning down are incredibly slim. And in
a normal situation I'd be right. But what I don't know is that you've
got a conviction for arson; it's only a matter of time before you take
a match to the curtains. And when you do, you come to me for the cash
to rebuild your home. Only I don't have the money. So I go bankrupt and
you still don't get your money.

"…The situation is exacerbated by the heavy trading volume of the
instruments, the secrecy surrounding the trades, and – most importantly – the lack of regulation in this insurance contract business. 'An
original CDS can go through 15 or 20 trades,' said Harvey Miller, senior partner at Weil, Gotshal & Manges. 'So when a
default occurs, the so-called insured party or hedged party doesn't
know who's responsible for making up the default and if that end player
has the resources to cure the default.'"

Except that it's not as simple as me selling you insurance. You actually bought house insurance from someone else, but the policy got sold on and on and on and by the time it gets to me you have no idea who I am or whether I have the funds to pay you. (If you know the policy is with me at all.) And you start to get jittery, because you don't know if you'll get your money back when your home is ashes.

Scale that up to financial institutions and the amounts involved are colossal. Instead of insuring your house, they were insuring vast numbers of CDOs and SIVs, which the Long Johns just explained are about as safe as our arsonist. Because no regulator was making sure that whoever bought the CDSs  had enough capital to pay out if necessary, once the subprime mortgage holders started defaulting, and the CDOs and SIVs started collapsing, everyone lost money.

So large financial institutions are losing pots of cash and going bankrupt and laying off staff left right and centre. But it gets worse. Time again:

"A meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis. If bond insurance disappears or becomes too costly, lenders will become even more cautious about making loans, and this could impact everyone from mortgage-seekers to municipalities that need money to fix roads and build schools."

Yay! The CDS meltdown is making the liquidity crisis even worse! It's not enough that banks are reluctant to lend to each other because they don't know if they'll see their money again, but the insurance they used to take out to protect against such losses has also become useless!

An excellent summation of the crisis, bringing us more or less up to date, comes from John Lanchester (not an economist) in the London Review of Books (via Adam at Crockatt & Powell). Now you understand securitisation (CDOs, SIVs, CDSs), this will make more sense.

"The normal mechanism for assessing the value of these assets [securities] is the market: they are worth what someone is prepared to pay. At the moment, because no one is buying, no one has a clue what they're worth, if anything. Because of an accountancy practice called 'mark to market', requiring that assets be listed at their current values, this fact had to be reflected in the companies' balance sheets – so these balance sheets suddenly looked disastrous."

Which is why you're hearing about massive profit falls and writedowns.

"As a result, banks are reluctant to lend to each other, and the entire financial system has ground to a halt."

Banks used to have healthy balance sheets when their assets (the financial instruments) were considered to be worth something. Now they're considered to be worthless, banks look like they have no assets. If they have no assets, then they can't raise capital. They can't raise capital because it looks like they have no assets to secure the loans against. If they have nothing to secure a loan, nobody will lend to them. And since their assets have disappeared overnight they can't even raise money from the stock market because investors won't touch stocks belonging to a company with no assets. It's pure perception. What used to be worth trillions is now worth nothing, because opinion about them has changed.

This is a good point to bring in the notable financial theorist, Terry Pratchett. Because you might be sitting there thinking, 'yeah, but so what? I keep hearing about the liquidity freeze, but what has it got to do with me?' Recession, that's what it's got to do with you. A section of Making Money feels rather prescient – it's talking about the public's confidence in the banking system rather than the confidence of the banking sector in itself, but how it creates recession is largely the same.

Moist von Lipwig has taken over Ankh-Morpork's Royal Bank and has just met Hubert, creator of a machine that can predict economic cycles. Here, he explains how it works:

"Now, if we reduce public confidence in the banking system – watch that tube there – you will see here a flow of cash out of the banks and into Flask 28, currently designated the old Sock Under The Mattress. Even quite rich people don't want their money outside their control…"
Slosh! Valves opened somewhere, and water rushed along a new path.
"Now see how bank lending is emptying as the money drains into the Sock?" Gurgle! "Watch Reservoir 11, over there. That means business expansion is slowing… there it goes, there it goes…" Drip! "Now watch Bucket 34! It's tipping, it's tipping… there! The scale on the left of Flask 17 shows collapsing businesses, by the way. See Flask 9 beginning to fill? That's foreclosures. Job losses is Flask 7… and there goes the valve on Flask 28, as the socks are pulled out." Flush! "But what is there to buy? Over here we see that Flask 11 has also drained…" Drip.
Except for the occasional gurgle, the aquatic activity subsided.
"And we end up in a position where we can't move because we're standing on our own hands, as it were," said Hubert. "Jobs vanishing, people without savings suffering, wages low, farms going back to wilderness, rampaging trolls coming down from the mountains-"

Apart from the trolls, that's a recession. (What are we going to do when Terry Pratchett gets too ill to write?) If banks have no money they can't lend money: nobody can invest in their businesses, people can't buy stuff. All because of the greed of bankers. Or was it? John Lanchester again:

"Having fully indulged their greed on the way up, and created the risks, the bankers are now fully indulging their fear on the way down, and allowing the system to seize up. But it wasn't just the banks. One thing which has been lacking in public discourse about the crisis is someone to point out that we did this to ourselves, because we allowed our governments to do it, and because we were greedy and stupid. It's not just bankers who have been indulging in greed, short-termism and fantasy economics.

"In addition to our stretched mortgage borrowing, Britain has half of the total European credit-card debt. That is a horrible fact, and although it's nice to reserve the blame for banks who made lending too easy, the great British public is just as much to blame. We grew obsessed with the price of our houses, felt richer than we should, borrowed money we didn't have, spent it on tat, and now that the downturn has happened – as it was bound to do – we want someone else to blame. Well boo fucking hoo. Bankers are to blame, but we're to blame too. That's just as well, because we're the ones who are going to have to pay."

Read that last sentence again. The bankers aren't going to pay. Not the ones at the top, the ones who should have been overseeing this mess. They're getting massive pay-offs, the ones who still have jobs are still getting their bonuses. The rest of us, the ones on low and middle incomes, the small and medium sized businesses, are the ones who are going to suffer – people who took advantage of cheap credit most of all. Now that the banks are revealing themselves to be not so flash with the cash, clamping down on defaulters and stopping credit lines in their tracks, if you have debt – you're pretty much fucked. Sorry. But you can comfort yourself with the thought that the bankers haven't learned anything at all.

And they'll do it all again if we don't get some decent regulation in place, sharpish. Which we won't, because they'll threaten the government again.

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2 responses to ““Stupidity and incompetence”

  1. Amy November 10, 2008 at 8:13 pm

    Okay, I think I followed most of that. But I thought US sub-prime mortgages kicked the whole thing off? Or was that just part of the whole credit over-extension cock-uppery?

  2. Rachel November 11, 2008 at 1:53 pm

    Sub-prime? Oh, that’s so last year dahling. No, good point – it was all the sub-prime stuff that made up all these SIVs and CDOs, and the CDSs were insuring them. So when the sub-prime mortgages started defaulting they took the whole system down with them. And part of the credit over-extension. There are lots of different aspects of this mess so whatever you hear about, it’s almost guaranteed to be another effect of the same fundamental problem.

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