With the failure of Bear Stearns bank earlier this year, the failure of Fanny Mae and Freddie Mac five weeks ago, the forced sale of Merrill Lynch to Bank of America, the failure of Lehman Brothers, the bailout of AIG, America’s largest insurance conglomerate, the failure and forced sale of Washington Mutual and Wachovia, the largest savings and loan and the fourth largest bank, we are witnessing a massive failure of both our investment and credit markets. Someone asked me, ‘Well what does this mean?” That is a good question. I will try to explain what it means. First, you must understand the role of investment banks like Bear Stearns, Merrill Lynch, and Lehman Brothers. Those companies provide much of the liquidity for the U.S. economy. How do they do this?
Lets start with your paycheck. Paychecks come from companies that must use short term and long term loans to operate. Even companies that have a lot of cash will not always use that cash for daily operations but will park the cash in short-term instruments and borrow against a line of credit. Businesses that have a cyclical cash flow, such as retailers (buying goods for the Christmas season as an example), or others absolutely need to borrow cash to meet daily operations and to meet payroll. These short-term purchases, whether for fuel for airliners or paper for their office, are financed with credit arrangements, commercial paper and overnight loans through banks. It is not enough to say that businesses just ought not to “go into debt” and should just use cash. All international shipments of goods require credit to move those goods from manufacturers to markets. As an example, a retailer will place an order for 10,000 red sweaters with a Chinese clothing manufacturer. That Chinese manufacturer will insist on seeing a letter of credit to cover some or all of the cost of that purchase. The retailer cannot ship and would be insane to ship actual cash (whether in greenbacks or a check or wire transfer) to Chine before the job was completed. Also, the shipping company will not release the finished product at the dock until it sees a letter of credit. In international transactions everyone along the line insists that some financial institution guarantee that payment will be made. Domestic transactions can also use the same instruments. However, there are some additional nuances. Lets take the example of a printer. A printer gets an order for 10,000 brochures. That printer may either require partial payment up front, a letter of credit, proof of credit-worthiness. The printer may subcontract parts of the job to other companies who will in turn rely on the credit-worthiness of the printer. If along the line any of the companies in this chain have a problem with their credit, the music stops and everyone is left without a chair. So, even if Mainstreet is solvent, if its banks have problems with their cash position then businesses will experience an inability to make payrolls or to pay for their payables.
What about longer term purchases such as machinery, equipment, real estate, and infrastructure? These are all purchased with loans that are backed by their bank who in turn may obtain the actual “cash” from their own accounts, from other banks in the form of intra-bank loans, or investment banks who gather the funds from individual, corporate, and institutional investors. Most people do not put their investments in CDs, where it is easily available for banks to loan out to customers. Americans have trillions of dollars invested in retirement accounts, investment accounts, and pensions. Not all of that money is actually invested in stocks. Much of it is invested in bonds, treasuries, and in stocks of companies that use that equity to loan out to other companies in the form of investments. So, the investment “money” of Americans is not actually “sitting in an account.” That money was moved “out” of that account the second it landed and was put to work in the credit market. It was used to buy treasuries, short term notes, long-term notes, and many other sorts of investment vehicles, matching the type of investments that the account is advertised to hold. A “money market” account in fact involves loaning out your investment monies to banks and companies for short-term loans. The money isn’t actually in the account anymore. It has been loaned to other institutions. If you really want to get technical, your money never existed in the first place. Did you ever see it? Unless you are the type to hide your money in a mattress, you have never actually “seen” any of your investments. In one real sense, money is actually a promise to pay. We match those promises against other promises and thereby keep the wheels of commerce flowing. Although this is a topic for another day, it is mind-boggling to realize exactly what money is made (or not made) of.
The current situation involves the companies that handle both the short term and long term credit instruments. If those institutions have solvency issues, then both the short-term and long-term credit markets are in jeopardy. If investment banks become unstable, commercial banks (such as the bank that your checking account is with) will not be able to get access to lines of credit. That will in turn put pressure on those institutions’s ability to be profitable. In addition, the recent surge in bank failures indicates that as banks restate their balance sheets to reflect losses in the real estate boom and other securities placed with investment banks, many more commercial banks will face trouble.
So, to retrace the problem going backwards, both commercial banks and investment banks are interdependent when it comes to moving cash to businesses that need that cash. How did the current crisis impair that ability?
We often peg the beginning of the Great Depression to the crash of the stock market in 1929. But actually, life did not change for everyday people until the banks failed in 1933. It took some time, but eventually people figured out that their deposits had been invested in speculative securities and that the banks had lost much of their deposits. There was no internet back then and everyone and his brother owned a bank. Regulations were few and there was little disclosure. Inevitably, once confidence was shaken, people started to go to their banks and ask for their cash. Of course, as I stated above, money is not actually held in banks. This inability to open the vault and produce cash led to panic and runs on the banks that caused them to fail since they did not have money to pay back their depositors. If every American went right now to their local bank and demanded their money, it would take about five minutes to empty out the vault. Most small suburban branch banks have as little as $5,000 on any given day. They really operate as any other retailer with a “drawer” of cash sufficient to make change and to dole out minor withdrawals. If you want your “cash” then just ask yourself. Did you actually deposit “cash” with the bank when you put that money into your account? Unless you own a cab company or pizza joint, probably not. So don’t be surprised that there isn’t any cash in the bank.
After these bank failures, two laws were passed in 1933 to set up the FDIC and to prohibit commercial banks from putting depositors’ money in stocks and other securities. Those laws were known collectively as Glass-Steagall. This stringent regulation of the commercial banks resulted in a lengthy period of financial stability punctuated by the S&L debacle of the mid-1980s which occurred after S&L regulations were relaxed.
The regulatory environment of banks changed in 1999 when as part of the deregulation craze sweeping still sweeping Washington, Senators Gramm, Leach, and Biley sponsored a bill which was signed into law by President Clinton, to repeal those controls. The bankers were not satisfied with knocking down the walls between Wall Street and mainstreet banks. So, the next year they lobbied for the passage of the Commodity Futures Modernization Act of 2000. This bill had bipartisan support and was passed and signed by Clinton. The bill deregulated banks by legalizing single stock futures and allowed banks to offer futures contracts without any regulations. As an aside, this bill also contained a provision known as the “Enron Loophole,” which exempted over the counter energy trading on electronic energy trading markets. We all know what happened with that. That Enron Loophole was finally closed by Congress which had to override a Bush veto to get the job done.
The net effect of these deregulation efforts was that banks could now package multiple mortgages into investment vehicles and create “mortgage-backed securities” or “MBSs.” The investment bankers even divorced the actual mortgage itself from the cash flow derived from payments by homeowners on those mortgages. So, one entity might hold bare title to the mortgages and another would pay money for a share of the cash flow from interest payments. Some investment securities retained a security interest in the underlying mortgage and others were totally unsecured. Here are some simple examples. You could just buy 2% of the interest payments made on 500 underlying sub prime mortgages. Even the interest payments were chopped up into time periods. This would be a totally unsecured investment. By dividing the interest payments from the underlying mortgage, the investor could demand a higher return from the broker packaging these investment vehicles. On the other hand, an investor who wanted to retain the right to foreclose on the house would get a lower amount of interest. But it could get much more complicated. An investor could, say, buy the right to receive just the interest payments made from 2010 to 2011 on those same 2% of the pool of 500 sub prime mortgages. This is essentially a “futures” contract as no money is owed now. What the investment is worth depends entirely on the ability of the borrowers to make their payments, the interest rate (both current and anticipated), and the level of risk inherent in the group of mortgages. And it did not stop there. Those individual securitized investments could be combined, sliced, and repackaged in a billion different ways. Some of these investments were combined into packages that became “derivatives.” Derivatives, in turn, are the bread and butter of the hedge funds. The value of these derivatives was dependent on the value of the underlying MBSs in the derivative investment. The bottom line: the investors lost any quick and easy means of determining whether the individual mortgagors could actually make payments on their mortgages. The growth of the derivatives and “hedge funds” followed the largest lobbying effort in American history. Hedge fund owners and managers spend more money on lobbyists than any other lobbying group.
The originating bank or mortgage originator was thrilled to have received a fee for having originated the loan. Freed from the controls imposed by the post-depression laws, the investment banks dove into these speculative investments. They were happy to repackage the underlying loans into Mortgage Backed Securities and derivatives. These investments were moved into the international markets as well. What made them even more attractive is that many of the repackaged mortgage loans (those that were secured) were guaranteed by Fannie Mae and Freddie Mac. Of course many of these derivatives are unsecured. While much finger-pointing has been going on with respect to Fannie and Freddie, the push to make mortgages more available was not something that would have crashed the entire credit markets were it not for the deregulation that allowed those sub-prime mortgages to be repackaged and sold.
Without any effective regulation, the only thing holding back a mad rush to purchase these now mostly worthless securities was the fact that they had to be rated by the rating agencies. Standard and Poors, Moody’s and other agencies will slap a rating on an investment for a fee. Because this is a competitive market, there is an incentive for these unregulated companies to put a high rating on something even if it might not deserve it. So it is no real surprise that the ratings on these derivatives and other products were high. This last defense against financial ruin, one provided by the private markets, failed.
To summarize, the passage of the Commodity Futures Modernization Act of 2000 allowed banks to package mortgages into securities and derivatives that bore little relationship to the underlying mortgages themselves. The deregulation of the banks in turn allowed those securities to flow seamlessly from the originating banks to the investment banks, moving the risk from the originators to Wall Street. From Wall Street the derivatives and MBSs were quickly purchased by overseas investors, especially China, who need a place to park the dollars they get from America’s massive trade imbalance. In one sense, we send our dollars to China to buy big-screen TVs, and other luxury items and the Chinese take those same dollars and invest them in American investments, including Mortgage Backed Securities. Much of America’s money is not in fact in America. Much of it is overseas, or at least held by overseas investors and banks.
A more recent accounting rule imposed by the Securities and Exchange Commission requires publicly held companies to mark investments at their most recent market rate. Just as in 1933 investors realized that much of their investments were in companies that had put their investments into MBSs and derivatives. With mortgage defaults increasing with the bursting of the housing bubble, the value of those investments was called into question. Once investors lost confidence in the derivatives and MBSs — despite their solid ratings — the market for those investment securities vanished. Companies holding billions of dollars in those investments were forced to mark down their investments to the market price, which was essentially zero because the market had gone away. Suddenly, a huge number of assets on the asset side of the ledger sheet disappeared. This put the balance sheets of those companies in the red, causing them to become technically insolvent.
Who is to blame for this? I blame the bankers and investment houses and their lobbyists for pushing for banking deregulation. I blame Senator Gramm, chairman of the Senate Banking Committee for pushing the repeal through and getting rewarded thereafter by getting a job as Vice Chairman for UBS, a Swiss bank. I blame much of the Senate for voting for the repeal and I blame Clinton for cow-towing to the lobbyists and vetoing the bill. I blame both houses of Congress for allowing banks to create MBSs and derivatives free from any governmental oversight. I also blame Alan Greenspan for engineering ridiculously low interest rates during the last seven years in an effort to stimulate the economy so the Federal Government could pay for its massive spending increases in the face of tax cuts — which created a federal deficit now passing 400 billion dollars. It was this low-interest rate environment that triggered the rise in housing speculation. That, coupled with the repackaging of flaky mortgages as investment vehicles is the tinder in our current economic firepit. Interestingly, Gramm remains John McCain’s informal economic advisor even after having been fired for maintaining his ties as a lobbyist for his Swiss bank while poo-pooing the housing crisis. It is also interesting that Greenspan was considered by McCain to be his new economic advisor until a few weeks ago when even Greenspan criticized McCain’s proposed tax cut plan in the face of the massive federal deficit.
How big is the problem?
Some estimate that the total loss could total $5 trillion, which is more than half of all of the mortgaged residential real estate in America. That does seem excessive. If everyone who took out a ARM or sub-prime mortgage within the last few years got kicked out of their home then fifty million homeless would descend on Congress with pitchforks and torches. That is probably why there will have to be a politically-motivated solution. Just for information, all mortgage-backed securities total $6.1 trillion in the U.S. alone. This is half of America’s entire Gross Domestic Product, which is the national income of our entire economy. It is a big number.
By some estimates, if this credit crisis continues the next foot to drop will be the credit card companies and banks. Americans are already using credit cards to pay for basic needs as average income weighted for inflation has actually been dropping. This is continuing with the increase in their mortgage payments. If those same companies have trouble getting credit themselves, then they will not be able to lend any more money on existing credit card lines. The inability to pay credit card bills will also put strain on those same companies, creating a “perfect storm” that will force them to freeze accounts. Credit card debt is now up to about $700 billion dollars, so this is a significant part of the U.S. economy.
What can you do?
If you transfer retirement plans into a “money market” then it is still exposed as money markets invest in, you guessed it, commercial paper and short-term treasuries. If everyone dumps their stocks and tries to invest in money market investments, then there is a real risk that there won’t be enough of those instruments to actually absorb the money flowing out of the stock market. That cash could end up being held in commercial and investment bank accounts that are only partially FDIC-insured. If everyone went to the bank and demanded their cash, then, as I’ve noted above, there isn’t enough cash in the bank to make that happen. There isn’t enough. There are only $829 billion in coins and bills and most of those are in overseas banks. The money on deposit in banks and savings and loans is nearly ten times that number.
