Executive Summary
The blame for the current economic crises spans not only both political parties, but also the “non-partisan” government organizations that are supposed to be responsible for monitoring and regulating the macro financial environment. These include both the Federal Reserve (The Fed), the Treasury Department, and the Securities and Exchange Commission (SEC). Their mismanagement of monetary policy at the highest level of government for almost two decades combined with irresponsible fiscal policy on the part of the congress and president is what created the environment for the failure of the system. The abuse of the system through total disregard of sound money management practice (ie. greed) by the banks, brokerages and investment houses within that environment has brought us to the brink of financial collapse on a scale much larger than that seen in the 20th century depression.
DiscussionThe easiest way to describe the problem is through a comparison with an earlier financial crisis. In 1971 President Nixon nullified the 1944 Bretton Woods treaty that had pegged gold at $35/ounce and effectively made the dollar the currency of the world. Removing the dollar from the gold standard meant that the dollar's value had to float, based on the confidence of other countries in the ability of the US to pay it's debts.
Now that there was no gold to back up the dollar, the value of the dollar plummeted (remember “devaluation” from the news in the 70's). More dollars were needed now to cover the US debt. How could this be fixed? The Fed turned on the printing presses and started printing more money. So, now there were more dollars and the debts could be paid.
However, money is subject to the same supply and demand rules as any other commodity. The more money printed, the larger the supply. If supply increases then value decreases. This over-supply of dollars led to runaway inflation. To counter it, a wage and price freeze was implemented. This accomplished nothing except to create more inflation as the supply of dollars continued to increase but the demand dropped due to the freeze. The combination of inflation combined with a slowing economy led to what was dubbed “stagflation”. Jobs were disappearing and GDP was dropping. Yet prices were increasing. This continued until the Carter administration.
It was Paul Volker, as Fed Chairman, who finally got things under control. Previously, the Fed tried to “fix” things by ratcheting up interest rates (as high as 13.5%). Volker abandoned this approach and instead began limiting the growth of the money supply. The unit “M3” was monitored, the amount of dollars in circulation world-wide. By lowering the supply, the value of the dollar increased and eventually stabilized. This left the country in a recession (he removed the inflation part of stagflation) but that also stabilized as the system equalized over the next few years. Volker's money management is a prime ingredient for the growth during the Reagan years.
Today we have the same problem as in the 1970's. When Allan Greenspan became Fed Chairman, he went back to old way of managing the central bank – jerk around with interest rates. However, he also realized that the economy could be stimulated by continuously increasing the money supply while artificially keeping interest rates low. Easy credit to the banks meant easy credit for consumers. The overall result was an economy that was supported primarily through consumer spending. The more credit, the more spending. The more spending, the more demand for dollars. The more demand for dollars, the more money is printed.
So, first the economic boom was maintained through consumer debt (ie. credit cards). Consumers were encouraged to spend all the money they didn't have to buy things they didn't need. Then, since credit was still easy for the banks, this approach was applied to mortgages. At first the good rates were given only to those that had the means to repay the loan. But then greed kicked in.
Now consumers who couldn't actually afford houses were given mortgages anyway through sub-prime loans. The reasoning was such that easy mortgages lead to an increase in demand for housing. So, housing prices increase. As property values increase, sub-prime loans could be refinanced, thus allowing the borrowers to continue to underpay on the loan. As long as property values continued to increase the borrower could always be re-qualified for a new sub-prime loan and the payments would keep coming.
In the meantime, qualified borrowers were encouraged to keep spending through easy access to home equity. Again, as long as property values continued to increase, the equity existed on paper and could be borrowed against.
While consumers were building debt at a rate never before seen in the history of the world, the US Executive and Legislative branches also went on a spending spree. Balanced budgets became irrelevant. Again, as long as spending continued, the economy, as measured by GDP, also grew. The US budgets became excessively bloated with entitlements and pork. Why not? All the government needed to do was have the Fed print more money.
Now, during the Clinton years, there was a “successful” effort to balance the budget. Government spending was kept within budgeted limits specified by taxable income. It made for spectacular headlines (and is still used as an example of “good” government budgeting). However, government trade policies were put in place resulting in a huge transfer of wealth to foreign nations. Free trade, open borders, and trade agreements were created that brought foreign goods into the country, generally much less expensive than local equivalents. The theory was that as long as commerce continued it would fuel the economy. Spending was spending – it didn't matter who was spending. The result? Huge trade deficits with billions of US dollars going out of the country. The budget was balanced at the expense of widening trade spreads detrimental to the US. And President Bush has compounded the problem by running up the largest deficit in history
And of course the printing presses just kept on printing those dollars. How much was printed? We don't know. By 2006 the number was so high that the Fed simply stopped counting. M3 was/is no longer tracked. Oh, also in 2006 Allan Greenspan retired and turned the Fed over to Ben Bernanke, who continued the same monetary policy as his predecessor.
Summarizing to this point: The supply of US dollars is so high that it is no longer tracked. Interest rates have been kept artificially low so that consumers have incentives to spend on TV's, iPods and houses they can't afford. The government is generally running a deficit, meaning they too are running on credit (weekly bond auctions are held to raise the money to finance the debt).
Now the banks wanted to mitigate some of their risk of holding all of the mortgages. Instead of simply holding and servicing the loans, they were packaged up and sold to brokerages and investment banks as collateralized notes or “Collateralized Debt Obligations” (CDO). These were again repackaged and resold to investors, marketed generally as safe investments.
The entire system created here can only function as long as spending continues. More spending = more demand. More demand = higher value. Higher value = more credit. More credit = More spending. And those printing presses keep right on going.
But, as soon as the spending slows or stops the system begins to unwind. Less spending = less demand. Less demand = lower prices = lower values. Lower values = lower credit. Lower credit means that the sub-prime mortgage holders can't refinance. Oops. Sub-prime rates reset upwards and those unqualified buyers can't pay. They default.
So the bank forecloses and takes the property. On a small scale this isn't a problem. However, the high volume of sub-prime loans that were given all defaulted simultaneously. Housing supply goes up because of all the foreclosures. Property values go down. Values go down = decrease in CDO value.
Decreasing CDO's on their own may not have been a problem. However, the way they were accounted for on the investment house books had them valued at full value. Now that value has disappeared. This leads to dramatic losses by the investment houses and the investors that were sold the CDO packages.
Now there are huge losses on the investment house books. The CDO's and the properties used as collateral are quickly losing value. As the investment houses experience losses they have to raise cash in order to pay their obligations. However, their books are filled with bad debt and no assets so nobody will lend them the money.
First Fannie May and Freddie Mac experienced this. Their entire business was mortgages and CDO's. And for reasons outside the scope of this paper they were carrying trillions more than they should have been. First the Fed allowed them to borrow money directly at almost no interest. However, it soon became apparent that mortgage and CDO value held by these institutions was almost worthless. With no capital, neither institution could do business. In the end, the Fed and the Treasury took them over.
And as a slap in the face to the American public, they guaranteed that these worthless investments would be covered by the good faith and credit of the US government. In other words, those holding the Fannie and Freddie debt, which now was worthless, would be paid anyway. This covered those holding this paper – primarily foreign governments. However, investors in these institutions were out of luck. Their investments were worthless.
They had nationalized the profits (taken whatever value was left and paid it out to other countries) and socialized the debt (the US taxpayer is now responsible for all the bad mortgages and CDOs – about $7.8 trillion.
Other institutions who had investments in this paper were also screwed. First Bear Stearns ran into trouble. The Fed, SEC, and Treasury jumped in and got JP Morgan to take them over by guaranteeing their debt (more for the taxpayer). Today Lehman and Merrill went over the edge. The Fed refused to help. By the end of the week we will probably lose Washington Mutual and AIG.
Anyone who says we're on the road to recovery is a moron. This CDO garbage has been used not only for sub-prime mortgages, but also standard, jumbo, and commercial mortgages too. With property values continuing to drop, this paper too will become worthless.
And so it goes.
Not to be overly pessimistic, but it is very possible that we could experience a complete collapse of the US monetary system. If foreign governments lose confidence in the US investment paper they're holding, they may begin dumping it at bargain basement prices. This will cause demand for the dollar to drop precipitously resulting in the dollar losing value against all other world currencies and causing inflation at a rate seen previously only in banana republics.
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Sources:
Publications from Agora Financial Company.
Wikipedia
I feel better having written this. I know its a simplification of the situation but at least I've explained to myself. I'm sure I'll have additions and corrections to this. Of course, I may not bother since I'm probably the only one reading it anyway :-)
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