October 01, 2008
Understanding Current Econ Problems..
This essay strikes me a as cogent (though incomplete) explanation of what is going on with the economic crisis of the current time... From the blog Understanding Tax
Full text of article in the extended entry.
The Financial Crisis: What Went Wrong? by Ted Seto (Loyola Law School Los Angeles)
The ongoing turmoil in the financial markets has diverted me from my usual tax academic pursuits, including this blog, for which I apologize. This post explores the causes of that turmoil. My next post will explore solutions currently under consideration, including aspects of the so-called “$700 billion bailout.”
The current financial crisis has many causes, some long-term and structural. I focus here, however, on three immediate aspects of the crisis: the trigger, how problems generated by that trigger spread through the markets, and how this produced the liquidity freeze that persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).
The Trigger: Teaser-Rate Mortgages
The media talks about “sub prime mortgages” – by which it means mortgage loans to borrowers with less than stellar credit. The real problem, however, was the advent and widespread use of teaser-rate mortgages in both the prime and sub prime markets. A teaser-rate mortgage allows a borrower to make relatively small payments for several years. At some point, the rate jumps dramatically, and the borrower faces much higher monthly payment obligations.
Not surprisingly, borrowers loved this innovation. Teaser-rate loans allowed folks who otherwise could never have afforded to own a home to buy one, at least until the rate reset. But it wasn’t just sub prime borrowers who liked teasers. Teasers sold like hotcakes; loan originators made correspondingly fabulous profits.
(Some have tried to blame teaser-rates on the Community Reinvestment Act of 1977, which encouraged lending to minorities and lower income Americans. But that act only applied to commercial banks. A majority of this crisis’s teaser-rate loans were made by unregulated originators not subject to the act. More fundamentally, there is no evidence the present crisis started in 1977. Teaser-rate mortgages first became widespread after Mr. Bush took office in 2001.)
In any event, it’s not hard to predict what happens when rates reset. All of a sudden, buyers who have been paying $1,000 per month face monthly payments of $4,000. Many, perhaps most, go into default.
The possibility that this would become a major problem became apparent as early as 2005. (I actually wrote that fall predicting the current crash.) Mortgage economists began publishing reset schedules – schedules of how many billions or trillions of dollars of mortgages would reset and when. In effect, those tables offered a rough schedule of how many mortgages would go into default and when.
As defaults increased in number, lenders ended up holding large amounts of foreclosed property. When they tried to convert the property into cash, they put downward pressure on housing prices. And this, in turn, made financing and refinancing more difficult and further defaults more likely – even of non-teaser loans. (A perfect vicious cycle, and we’re not remotely near the end of it. In parts of the country, more half the homes offered for sale are now foreclosures. Banks are desperate to get those homes off their balance sheets and are dumping them much faster than the market can absorb them.)
The Spread: Securitization and Debt Chains
But why did Lehman Brothers and AIG go under? After all, they don’t make mortgage loans. I turn next to how the problem spread.
Assume that A borrows from B to buy a home, giving a mortgage on the home to secure her debt. B then borrows from C, using A’s mortgage as security. C in turn borrows from D, using B’s obligation as security. And so on.
Now assume that A’s mortgage goes bad. What happens to B, C, and D? Answer: all the loans up the chain go bad as well.
And this isn’t all. If the loan is secured (as mortgages and many other links in debt chains are), the lender is typically less interested in the creditworthiness of the borrower. The lender relies primarily on the collateral, not the borrower, for assurance of repayment.
As a result, each financial intermediary can be thinly capitalized. So a company with $10.1 billion in assets and $10 billion in debt may have a small amount of net equity. Indeed, the more thinly capitalized a company, the higher the return it can make on its capital.
Unfortunately, what this means is that when A’s mortgage goes bad, it’s not just the loans up the chain that go bad – financial intermediaries in the chain often go bust as well. A thinly capitalized intermediary cannot absorb many losses. And that is why teaser-rate mortgage defaults triggered and are still triggering defaults and failures across the entire financial sector. Almost everyone was in the debt-chain business and extended themselves to the max to take advantage of the extraordinary profit opportunities of that business.
I’ve explained the transmission mechanism in terms of debt because readers have an intuitive understanding of how debt works. In fact, however, many of the most important links in the chain were not technically “debt.” Some were shares in “mortgage pools”; some, “derivatives”; some, “credit default swaps.” What they all had in common was that each transferred some risk of default up the chain to someone else. Wall Street sometimes calls links in such debt chains “toxic waste,” because today no one wants them.
AIG, for example, held about $500 billion in “notional exposure” on credit default swaps. In English, it was at risk to the tune of about $500 billion if mortgages down the chain went bad. When mortgages began to go bad in large numbers, the market realized that AIG might not be able to cover its obligations and began to sell AIG stock seriously short. Lenders stopped lending. End of story.
What made this more than just a corporate problem was that AIG was a domino at the head of many long chains of dominoes. If AIG had gone, some believed the world would have faced immediate economic collapse. So the US government bought an 80% stake in AIG in exchange for enough money to allow AIG to dissolve gracefully – over a couple of years – instead of imploding overnight.
The Crisis: Liquidity Freeze
None of this, however, would by itself have led a free-market US administration to propose a $700 billion general “bail-out.” Real estate is important, yes, but there are many parts of the economy not dependent on the market for home mortgages. What happened?
In ordinary times, most businesses borrow on a short term basis to fund payroll, inventory, and other operating needs. There are two principal sources of short-term money: banks and money-market funds. In the past several weeks, each of these has substantially reduced the amounts they are willing to lend. This is what’s called a liquidity or credit freeze.
Why did banks and money-market funds stop lending?
Let’s start with money-market funds. Investors put money into money-market funds when they want absolute safety and the ability to pull their money out at will. Put in a dollar, get out a dollar, whenever you want. In return, they accept a very low return. What happened was that The Reserve, the oldest and most highly regarded money-market fund sponsor, “broke a buck” – which means it paid back only 97 cents for every dollar investors put in.
The reason was simple: The Reserve had loaned short-term money to Lehman Brothers, a major participant in the debt chain business. Lehman Brothers went belly up, and The Reserve’s short-term loans to Lehman became uncollectible. (Remember that the Treasury and the Federal Reserve Bank, having bailed out Bear Stearns, decided to let Lehman Brothers go bankrupt to teach the market a lesson. In retrospect, this was probably a mistake.)
As a result, investor confidence in money-market funds plummeted. Fortunately or unfortunately, investors always have a secure place to park money, Treasury bills – short term obligations issued by the U.S. government. When The Reserve broke a buck, everyone moved their money into Treasuries. Money-market funds dried up. And that was the end of one major source of business working capital.
Another major source is the banking system. Unfortunately, banks and other financial intermediaries became reluctant to loan to each other. As a result, money in one part of the banking system stopped flowing to where it was most needed.
Why did banks stop loaning money to each other? When lenders lend, they generally look at borrowers’ financial sheets to determine how creditworthy they are before giving out money. Unfortunately, most banks and other financial intermediaries have large amounts of toxic waste on their books.
In situations like this, accounting rules require companies to “mark assets to market.” If an asset with a face value of $100 appears to have a market value of $40, the company is supposed to record a loss of $60 immediately, even before the asset is sold, and to carry that asset on its books at a value of $40. So banks and other financial intermediaries began reporting enormous losses on the toxic waste they held, and their balance sheets crumbled. (The head of the Securities and Exchange Commission was pressured to waive this rule, but refused. It was for this reason that Sen. John McCain demanded that he be fired.)
But recognizing market losses isn’t the most serious problem. If a lender can be confident that the asset in question really has a value of $40, it may still conclude that the prospective borrower is likely to repay the loan – notwithstanding the reported loss. If no one knows how much the toxic waste is actually worth, however, lenders can’t assess the creditworthiness of any prospective borrower with significant amounts of toxic waste on its books. Almost all banks hold toxic waste. So banks stopped lending to other banks. (Waiving the mark-to-market rule would not have solved this problem; it would simply have hidden the accrued losses. Banks are sophisticated enough to worry when accounting rules do not correctly reflect what's going on in the market.)
But why is the unavailability of short-term money so bad?
Remember what businesses use short-term money for – to meet payroll and put inventory on their shelves. When businesses lose access to working capital, they stop operating, not because there is anything fundamentally wrong with their products or markets or business plans, but simply because they can’t get the cash they need on a daily basis.
You might think of short-term money as the lubricant that keeps the world’s economic engine turning over smoothly. If there’s no lubricant, the engine freezes. No paydays, no goods on the shelves. Seriously.
This was the possibility that persuaded Mr. Bush and Mr. Paulson to change course and support a general “bail-out.” And it remains a very real possibility.
The $700 Billion Bailout
I will discuss the details of possible solutions in my next post.
What is important to emphasize here is that current proposals are primarily intended to solve the liquidity freeze part of the problem – to prevent the world’s economic engine from seizing up.
Mr. Paulson’s original proposal hoped to accomplish this in two ways. First, by buying up toxic waste at fair market value, Mr. Paulson could take toxic waste off financial intermediaries’ balance sheets. This would allow lenders to assess borrowers’ creditworthiness with greater confidence and, hopefully, get banks to start lending to each other again.
Equally importantly, however, Mr. Paulson requested authority to buy up that waste at whatever price he thought best. By buying toxic waste at higher prices than private buyers were willing to pay, he hoped to bolster the financial intermediaries’ balance sheets – to make them more creditworthy.
This aspect of the proposal was what made it a “bail-out.” And this was part of what led to its defeat in the House.
Note that Mr. Paulson’s proposal was not intended to solve the teaser-rate mortgage problem, either now or in the future. In the transactions that created the teaser-rate mortgages in the first place, both parties made bad decisions – the lender and the borrower. Mr. Paulson’s proposal was not intended to help either. One of its unavoidable side effects, however, was to relieve lenders of the consequences of their bad decisions, while leaving borrowers to suffer the consequences of theirs. This made it politically less palatable.
In addition, at least $500 billion more of teaser-rate mortgages are scheduled to reset over the next several years. In all likelihood, they too will go into default and become toxic waste. Nothing in Mr. Paulson’s original proposal was intended to do anything about this next $500 billion installment – or, indeed, to prevent lenders from making more teaser-rate mortgages in the future.
Similarly, Mr. Paulson’s proposal was not intended as a general Wall Street bail-out, although to some extent it would have had that effect. Note that the outstanding overhang of credit default swaps alone is estimated to be between $45 and $60 trillion – three to four times the size of our annual gross domestic product. The requested $700 billion, although the single biggest appropriation request in U.S. history, was miniscule when compared with the toxic waste problem as a whole. Mr. Paulson’s proposed solution was to cost just 1% of the size of the problem and was aimed only at a small part of that problem. (It is unnerving to realize that the U.S. government – the “beast” we have been starving for so long – may now lack the borrowing capacity to solve the problem as a whole. We need to get our financial house in order.)
All Mr. Paulson’s proposal aimed to do was to put lubricant back into the engine, to get short-term money flowing again to prevent our economic engine from freezing up. Now that the proposal has gone down to defeat, we can only hope that Mr. Paulson was wrong.
Posted by rakhier at 05:39 PM | Comments (0)
July 13, 2007
Indian Rupees to Razor Blades...
Funny modern story about how you can convert 1 Rupee coins into razor blades which sell for much more than one rupee.
This happened in the past, the Nguyen Lords bought Chinese and Japanese coins and then melted them down to make their cannons.
Posted by rakhier at 09:31 PM | Comments (0)
June 23, 2006
Cobb on the Real World vs. College...
Cobb is back. Mostly. Here is a great post from him about how college isn't like the real world...
- The thing that no student or graduate wants to hear, I'm about to say. Brains are a cheap commodity in the US. Universities are suppliers of moderately priced labor, just as Mexico is a supplier of cheap labor. There isn't a university on this planet which is as well organized and disciplined as a sharp corporation or a halfway decent army, and that's the thing you don't learn until you've spent a couple decades out in the world of work, where people aren't protected like students and faculty are. The beefs with Affirmative Action pale in significance to the ranches of conflict out here where people with tens of millions of dollars compete with people with hundreds of millions of dollars. But that's nothing you can learn while colleges are teaching what they teach. Perhaps the only people who actually do learn that from the brainy side of the equation are those guys who figure out how to build a better medical treatment in school and cash in by building a company around it.
So when it comes down to a black thing, getting into university is just the first step into the American middle class, and quite frankly it doesn't pay as well as learning construction. I wish somebody would have told me when I was in college that I could get 500k in revenue just making and selling plastic water tanks, like the neighbor of an associate of mine is doing. Oh, excuse me. 500k in revenue per month in a 5 person company. I would have avoided white collar, upscale corporate life like the plague.
The real hardball problem is that Affirmative Action's benefits and detractions don't amount to a hill of beans in the big old world. But there are still at least a couple million people who don't much care about the big old world and are just focused on the Affirmative Action world, where SAT scores, skin color and grade point averages make all the difference. I never thought Grutter and Hopwood were worthy of the Supreme Court, so I don't get my briefs in a bunch like our old pal at Discriminations. And I suspect that LaShawn Barber's lack of concern for the veneration so many blackfolks have for those two hallowed words is why she gets verbally dissed. I don't give much of a rat's any longer. Then again, living on the nice side of the six figure glass ceiling for a decade does give this black man a bit of perspective.
Malcolm X was never impressed by Affirmative Action, and as loathe as I am to compare his vision to what we can see 40 years later, he's a good reference point for those still running the OS of Black Nationalism 1.0 on their brain pan. Malcolm could see right through the honeydripping for what it was. A job. A job you get because you symbolically represent 400 years of something irresistable to white liberal guilt. Yeah well, I suppose people get what they deserve.
Meanwhile, I'm perfectly content to see undergrads get whatever Affirmative Action the polity can stomach. Undergrads don't change much. They still get entry level jobs at big employers, and none of them have the brains, experience or guts to get much more. Fine. But I say make the graduates, specifically the professionally certified graduate programs get colorblind. The last thing we need are our experts racially codified.
Yea. He's right.
Posted by rakhier at 11:38 AM | Comments (0)
What would you do with 50 billion dollars?
I'm very sympathetic to Bjorn Lomborg. The Economist thinks well of him also. Here is another suggestion that some things are just not worth the money...
- Two years ago, a Danish environmentalist called Bjorn Lomborg had an idea. We all want to make the world a better place but, given finite resources, we should look for the most cost-effective ways of doing so. He persuaded a bunch of economists, including three Nobel laureates, to draw up a list of priorities. They found that efforts to fight malnutrition and disease would save many lives at modest expense, whereas fighting global warming would cost a colossal amount and yield distant and uncertain rewards.
That conclusion upset a lot of environmentalists. This week, another man who upsets a lot of people embraced it. John Bolton, America's ambassador to the United Nations, said that Mr Lomborg's "Copenhagen Consensus" (see articles) provided a useful way for the world body to get its priorities straight. Too often at the UN, said Mr Bolton, "everything is a priority". The secretary-general is charged with carrying out 9,000 mandates, he said, and when you have 9,000 priorities you have none.
So, over the weekend, Mr Bolton sat down with UN diplomats from seven other countries, including China and India but no Europeans, to rank 40 ways of tackling ten global crises. The problems addressed were climate change, communicable diseases, war, education, financial instability, governance, malnutrition, migration, clean water and trade barriers.
Given a notional $50 billion, how would the ambassadors spend it to make the world a better place? Their conclusions were strikingly similar to the Copenhagen Consensus. After hearing presentations from experts on each problem, they drew up a list of priorities. The top four were basic health care, better water and sanitation, more schools and better nutrition for children. Averting climate change came last.
This comment from Pejman Yousefzadeh: And what is my reaction? My reaction is that once again, Palmerston is vindicated. Nation-states have no permanent friends, nor have they permanent enemies. They only have permanent interests. This article neatly lays those interests--those priorities--out for the reader to see. How policymakers and would-be policymakers like Al Gore respond will, of course, attract a great deal of interest and attention.
Posted by rakhier at 10:34 AM | Comments (0)
November 28, 2005
How to Find Good Products...
The NYTimes had an article in which they praised the work of three people who posted extensive product tests online.
- Julie Streitelmeier reviews products on The-Gadgeteer.com
- Brett Jiu reviews products on Amazon.com (and no, I can't figure out how to find his reviews... sorry)
- Dmitriy Kozin reviews products on Epinions.com (I couldn't find him either... wierd)
Posted by rakhier at 04:26 PM | Comments (0)
The Scandinavian Model - Not A Success Story...
The Brussels Journal has a great essay in which they look at real peformance of the Scandinavian countries compared to Ireland. Its not a pretty picture for Sweden, Denmark, and Finland.
- Job Creation - essentially zero over a 20 year period.
- Sweden and Denmark droped 9 and 5 points respectively on the world prosperity rankings (Finland gained 1).
- By contrast Ireland has zoomed up the charts, employment has grown, wealth has grown and the Irish tax burden is comperable to the U.S.
Posted by rakhier at 03:53 PM | Comments (0)
August 29, 2005
Economic Prediction about the world in 2020 by Deutsche Bank
This essay is a summary of a report created by Deutsche Bank in which they speculate on the shape of the world's economy in 2020
- What will the world’s economy look like in 2020? ... by Jacques-Henri David, President of the Deutsche Bank Group in France.
I would like to add my contribution to this discussion, beginning with the results of a recent study by the Deutsche Bank Group, which analyzes the macroeconomic evolution of the major continents over the next fifteen years.
Combining the theories of growth and analyzing the evolution of development in the 34 principal countries in the world, this study apprehends the principal factors affecting growth and the trends at work today. It draws up a probability chart of the economic situation for the world in 2020, and the results of these projections are fascinating.
In 2020, the United States will remain the world superpower, with a total GNP of approximately $17 trillion to $18 trillion. Thanks to its dynamic demographics (1% annual population growth), a productivity and a competitiveness amongst the best in the world (currently second in the world and far out in front of Germany (13th) or France (26th) according to statistics from the World Economic Forum), and thanks also to its constant drive to create and innovate, and with flexibility due to the mobility of its labor force, the United States will maintain a clear advantage over China and India and will widen the gap with Europe. With average per capita salaries of approximately $55,000, the income of the average American in 2020 will be 1.5 to 2 times greater than that of a European; five times higher than that of a Chinese and nine times more than that of an Indian (approximately $6,000 per capita).
China will indisputably be the world’s second greatest economic power, with a GNP of some $14 trillion, or three times higher than today.
That of course assumes that beyond the inevitable short-term risks, no major social crisis interrupts the long-term dynamics: a progressive opening to the outside, an increase in domestic consumption, strong growth - in particular in foreign investment, and the rapid improvement in the qualifications of China’s working population (China already has the same number of engineers and technicians as the West, and more than any of the large European countries). Even more than today, China in 2020 will be the industrial workshop of the world.
Paradoxically, one of its handicaps will be an aging population, due to the delayed impact of its "one child policy." By 2020, the median age in China will be approximately 40 years, which will be higher than in the United States.
The world’s third greatest economic power will be India, but far behind the first two, with a GNP of about $7 trillion.
India should be the uncontested champion in terms of growth, due its demographics, its highly qualified labor force, the ease with which it can be integrated into the global economic system thanks to the wide use of English throughout its population, and thanks also to its mastery of communications technologies, especially the Internet. If China can be held out as the world’s future industrial workshop, India will undoubtedly be one of the great service societies.
In Europe, Germany, France, along with Italy and the United Kingdom, should lose ground in the world competition with a GNP per country of about $2 to 2.5 trillion.
While European countries will remain rich in terms of per capita income (about $32,500), their relative weight will decline with their demographics and weaker growth (on average, almost half as much as the United States). Countries like Spain or Ireland will experience a higher level of development than the European average, thanks to a wider opening of their economies to the outside, the dynamism of their investments, good population growth forecasts and effective immigration policies.
Ireland, for example, in 2020 will have the second highest GNP per capita in the world, just behind the U.S. The increased weight of these new stars on the European landscape will not, however, be sufficient to compensate for the retreat of its historic champions [Britain, France, Germany] who will feel the full weight of their society’s declining demographics [aging populations].
This report must not find us indifferent, and it suggests a certain number of remarks. It is also a call to action. There is, first of all, some good news: the resilience and performance of the United States. Indeed, a major concern about economic and financial conditions today are ballooning American deficits and fear that the monetary system will implode as the fall of the dollar accelerates, which would lead to a grave global crises.
Actually, because the United States will remain the world’s superpower for the next two decades, the dollar still has some beautiful days ahead of it, remaining the key international reserve currency, so American budget deficits should remain under control, can be financed, which should avert a major international crisis.
Another conclusion: the European countries must, without delay, reconstruct their political project to find the real dynamics of integration. Without that, individually, we will all be relegated to third class. We must do everything to reverse current tendencies by mobilizing our assets: our infrastructure, our capacity to undertake research and development, our "rules of law," the depth and effectiveness of our financial markets, and the importance of saving levels ... We must develop all of these elements to the maximum in order to compensate for our handicaps: stagnant demographics and a lack of flexibility in our social structures.
To take only one example in regard to future technologies: In France we have a perfect command of nuclear power. Nuclear power being the oil of tomorrow, it is a considerable advantage. Many other fields have the same logic: biotechnology, technologies of communication and knowledge, pharmacy, health, etc. We must completely mobilize ourselves to these issues, starting with the project of European integration.
Whatever the hazards of the now-broken process for approving the European Constitution, nothing prevents our governments from promoting practical projects, combining political goodwill and budgetary efficiency. In this way we can recapture the dynamism of the European political project that is now so lacking.
Finally, I dare say that to overcome Europe’s demographic shortcomings in the years to come, it will be necessary for us to lay down and implement a more finely-tuned immigration policy. In spite of the sensitivity of the subject, we shouldn’t underestimate the determinative role that the population structure will have in the future, in particular the average age and qualifications within society and on growth around the world. This is one of the great challenges that Europe must rise to.
I am not confident that China will continue its current growth for the next 15 years. My personal guess is that China is going to experience a period of substantial internal chaos sometime between now and then. I don't believe that the Chinese government will be able to maintain their grip on political power while giving the people economic power. Never-the-less, I think China will be close to the predicted economic level that this report suggests.
Posted by rakhier at 09:10 AM | Comments (0)