Politics and Technology.

Thursday, September 25, 2008

Thoughts on the current financial crisis

Here is the content of an email I sent out to some friends explaining the current financial crisis in the US:

"Bailout" is certainly the wrong name for this.

Picture this: you, me, and Frank are playing 5 card stud, no peek, jacks or a better split the pot. Anyone who rolls a 2 of clubs immediately has to fold and loses their ante and bets. The ante is high, say, the title to your car. Are you going to play? A rational person probably would not, even though you have a poor chance of being dealt a 2 of clubs.

That's the game we're playing. No one knows who has a rotten hand, and that is keeping everyone from playing.

So, with that game in mind, pricture this: you're the CFO of a small bank and you are sitting on $1 million dollars. You can't keep that in your safe, so you have to invest it somewhere. You shop around and find an investment that is likely to yield 1% or two better than a Treasury bond and is given a high rating by S&P and Moody's. It is backed, in part or in whole, by mortgages. You buy it, not just because it seems safe, but you were encouraged by the fact everyone was buying them. You did your job: maximizing contemporaneous shareholder value (biggest share price now).

Meanwhile, some circus monkeys in an investment firm somewhere weren't entirely truthful in creating an investment vehicle that was based on a pool of mortgages. When working with the rating agencies to gauge the overall risk, they kinda hid the truth behind the mortgages they were bundling. The guys working the ratings agencies are folks who didn't do well enough in business school to go to work for an investment bank, so they ended up working for essentially (apologies to my co-workers) newspapers (S&P and Moody's) and are not the sharpest pencils in the box. They even allowed themselves to be "wined and dined" by the firms while working on the ratings, because at $50,000 a year, a stay in a nice hotel with a lobster dinner is a nice change of scenery. Between mouthfuls of lobster, they gave their thumbs up.

These investment vehicles were then divided up and resold in packages with other investments by some other unwitting but enterprising young business school guy working at a different investment firm, which were in turn chopped up again by some other guy and resold with other entirely different assets. So now there is this investment vehicle that might be backed in part by someone who will not make his mortgage, but for the most part, the investment is probably backed by entirely other things that have nothing to do with home mortgages.

You bought this investment from the $1 million dollars you had before. Now, there's no way for you to know just what portion of that $1 million dollars you will see evaporate because someone can't pay their mortgage. It could be, literally, $1, or it could be the whole $1 million. You just don't know and you can't know as it would probably take $1 million dollars to figure it out. If you and everyone else who bought these things pooled together, you all would lose maybe 2% (I'm making this number up, but it is much less than 15%) of your overall investment due to deliquent mortgages. It's really nothing over all, but no one knows for sure how much of that 2% they own themselves.

No one is going to buy it from you because no one can put a finger on its worth. Worse still, you can't use it as collateral for a loan from a bigger bank because no one will take it. In January you could use it as the basis for $10 million in loans to small business. Thanks to the recent "mark to market" account rule, you now can't use that investment vehicle anymore and you've essentially had to remove $10 million dollars from the economy. That $10 million dollars is no longer available to the corner cabinet shop to borrow to make this month's payroll while they're waiting on their customers to pay for the cabinets they've ordered.

Now, the government is coming along saying they're willing to buy this investment from you based upon an auction. It'll probably mean you will have to sell your $1 million investment for something like $500,000. $500,000 is better than $0, and it allows you to get back in the business of using at least $500,000 for collateral or loaning out $5 million dollars to that cabinet shop to make payroll.

Should you lose your promised compensation package because you unloaded this to the government? That's unfair, in my opinion. In fact, it creates what is called an agency problem. If I'm that CFO, I might think twice about participating, and I might tell my boss that we're better off waiting for this whole thing to blow over as we'll likely to get more than $500,000 for it. Meanwhile, that cabinet maker has to close down because he can't make payroll.

In my opinion, yes, the guys that made the crappy bundles in the first place and the rating agencies bear most of the blame. The thing about the ratings agencies is that they are free and independent and there are only two of them. The whole world relies on them so you can't beat them up just yet and you can't do it so publicly. God, the horror that would entail if they had to stop doing ratings suddenly!

As far as nailing the guys who did the bundling, that market is so complicated and intertwined, the guilty will all be dead before we figure out who did what. I remember a year or two ago specialists had to be brought in to meet with the Fed to explain how these bundles worked. It went even above THEIR heads!

Yes, this is directly related to Fannie and Freddie [Mac]. They are the largest holders of these investments. The more "illiquid" these papers became, the more pressure they had to come up with other assets for collateral, until they had no other assets available to use.

The systemic risk is based on the fact no one knows who has what exposure so no one is willing to part with their cash. Investment banks who trade with each other thousands of times a day, using blind faith, are eyeing each other suspiciously. Banks are told they need to come up with more collateral than they ever thought they would need. In the end, it is the small business guy who can't get a loan to operate. Our economy is based on the short-term use of cash. I borrow today, loan tomorrow, and we all get to do things like make payroll, buy office equipment, build inventory, etc. off of this practice. That's the lifeblood of business and it is quickly drying up.

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