Decoding the Wall Street - Main Street shorthand

(note - changed title to clarify what the post was about and added link to NYT article on raising of debt limits. Also added a link to a This American Life follow-up story and a note about credit default swaps).


Has anyone else noticed that the public discourse has fixated on the meme "Wall Street Versus Main Street" (and, as Saturday Night Live pointed out, looks like Martin Luther King Drive and Cesar Chavez Way are on their own once again).

What does this mean? Does anyone else find it odd that there seems to be no effort to explain specifically what is wrong and why there is such a sense of urgency here? Others have compared it to the post-9/11 Patriot Act, the Enron reaction, Operation Iraqi Freedom, the Hurricane Katrina response, etc.

In this case, I don't understand what the sense of urgency is. The path to this point has been well-documented by many others but I'll put it in here so I can try to guess where we're headed (I'd recommend the This American Life show "The Giant Pool of Money" and Another Frightening Show About The Economy for a very accessible story describing some of this):

1. In 1999 Congress repealed a law preventing banks from issuing both loans and investments. At the same time, there was a general push to encourage home ownership, especially low-income home ownership, to encourage people who had formerly been on welfare to set down permanent roots and get invested in a community.

2.  Because of low interest rates and rising home prices, mortgage writing became a very competitive market and many companies jumped in to take advantage of both laxer lending rules and strong interest in refinancing. This resulted in many smaller lenders cropping up, who would originate mortgages/refinances and then sell them at a profit to larger entities.

3. Since the payment to the agents was typically a commission based on the value of the loan, the incentive was to sell as much debt as possible to as many people as possible. In order to accomplish this new forms of mortgage were developed for those who couldn't qualify for a traditional fixed-rate loan like adjustable rate mortgages, interest-only mortgages, etc.

4. This led to many loans where the buyer's ability to repay was either not considered or openly fabricated, sometimes by agent manipulation and sometimes with the active participation of the borrower.

5. The mortgages were combined into investment vehicles called Collateralized Debt Obligations or CDOs, which were traded as a class of investment called derivatives.  The equivalent would be taking 10 IOUs for $100 and claming you have $1000 in assets. Since the derivaties were backed by mortgages which were collaterized by real estate which was continually rising in value, the CDOs were seen as no-lose; if the borrower couldn't pay, the property could be sold for more than the value of the loan.

6. However, since the CDOs were obligations instead of hard assets, some bought insuurance from companies like AIG and Bear Stearns against the value of the CDO. The insurance was a financial item called a "credit default swap", which is a term used by Wall Street to offer insurance without the funding requirements for insurance.

Agents that didn't even own the CDO (like hedge funds) were able to buy and sell credit default swaps without actually owning the asset they were selling the swap on.  The thinking was that the insuring company made a fortune in premium payments, and they bought a credit default swap to cover the losses if the CDO failed.

Think about that - the financial institutions were selling insurance and buying insurance from each other on the same pool of investments. Everything was fine as long as home prices rose, CDOs kept being issued and credit default swaps were available.

7. The CDOs were used as investments by everyone from Wall Street firms to a Norwegian teachers' association - since interest rates were low these CDOs offered a better return than anything else out there at the time. The tracking and management of the CDOs was extremely lax, due to both the high number of mortgages, the complex nature of the CDOs and a permissive regulatory environment encouraged by a SEC ideologically opposed to government regulation of the markets.

As the amount of debt climbed, the banks appealed to the SEC for permission to raise their ratio of debt to assets, which was granted in January 2004. This allowed the banks to become even more leveraged (take on more debt).

8. Eventually the housing market topped out, and when prices started to fall homeowners began to be trapped in their mortgages - they had been refinancing out of each mortgage based on appreciating home price but when prices fell they couldn't, because the property was worth less than the loan they already had out. At this time the ARM mortgage interest rates began to reset upward and some of the other exotic mortgages began to become more expensive. This also further depressed home prices because of increasing foreclosure sales and the perception of a buyers' market.

9. Eventually default rates began to rise, a little and then a lot. With so many defaults and the possibility of many more, the value of the CDOs began to fall, or at least become more doubtful. Since the Wall Street firms and Fannie Mae and Freddie Mac used those mortgages as assets, their balance sheets began to worsen and worsen.

This was because they had borrowed money using those CDOs as collateral and two things happened -

 a) The value of the CDOs dropped and lowered the asset value of the firms;

 b) The credit default swaps started kicking in and requiring payments on the insurance they had been selling to other institutions, which they didn't have enough cash to cover.

The effect was that the firms' debt-to-asset ratio got to the point where regulations kicked in and forced them to recapitalize (get more assets to raise the ratio). That's what killed Lehman Brothers - their position was so bad that they couldn't raise any financing and eventually went bankrupt.

Since the institutions had been selling CDOs and the related swaps to each other, once one of them failed the failures cascaded throughout the system. This is what scared Paulson and Bernanke so much - they saw all of the Wall Street firms getting their asset base wiped out.


10. As those balance sheets got worse, other financial institutions and eventually consumers either stopped lending to them or started retrieving any funds held by them.

At the same time the insurers, who were responsible for the CDOs they insured, began to be affected by increasing losses. This led to the prospect of large payouts and affected their health. That's why the government loaned AIG $85 billion; the insurance policies it had written for the CDOs could have bankrupted the company and caused it to default on its other policies, which would have snowballed into a major crisis.

Washington Mutual, having built its expansion on mortgage lending, was seized by bank regulators and sold to JP Morgan before it went bankrupt.


11. Last week a secondary effect began - since the banks are not sure how much debt other banks are responsible for because the value of the CDOs is indeterminate right now, they slowed their rate of overnight/commercial paper loans.


Why is this important to people who don't work in finance?

Commercial paper is what big corporations use to meet short-term cash needs (if, say, Delta Airlines has to rebuild a hangar or pay for reinforced doors on its planes). It's essentially a very short-term loan at a very low interest rate banks make to each other and to large companies.

Without commercial paper and credit, businesses won't be able to meet operating expenses or will worry about meeting operating expenses, which leads to the same thing - less spending, either not hiring or reducing workforce, which means the businesses spend their assets, which further reduces the bank's assets, and the situation accelerates - less confidence, less spending, less confidence, less spending.

The other big user of commercial paper is money market accounts - commercial paper is how many banks put their money market accounts to work. Since borrowing was slowing down, interest rates dropped, and hit a critical benchmark last week. With money market yields dropping, consumers get nervous and stop spending, which causes a further contraction in the economy.

I hope you see where that's headed.


What will happen with a bailout?

The Secretary of the Treasury wants a grant from Congress to buy up those CDOs so they will be assigned a value and removed from the books of the surviving Wall Street firms to clarify their balance sheets. He wants to be able to do this in an independent, reactive mode to respond to market conditions and choose which securities/obligations to buy. The $700 billion amount is a top-end figure which is estimated to cover all of the at-risk securities.


What's the gain of a bailout?

By purchasing the debt Paulson hopes to assign a value to it, and remove it (and its associated uncertainty) from the balance sheets of the Wall Street firms currently holding it. This should allow the resumption of normal credit flow between the banks. Also, since most people do pay their mortgages the US will eventually get some kind of a return on the CDOs.


What's the risk of a bailout?

There are several -

1) The bailout may not work. There are other forces at work here as well. It also may turn out there is a lot more debt out there, or the environment is risky and banks stay with their current positions. There has just not been enough time to determine what the problem is here - Bernake and Paulson think they know, but it may turn out there are more factors are at work which this bailout does not address. It's like helping out a relative with a failing business; there's no way to determine where the bottom is and once you get involved it can be impossible to walk away.

2) Lack of confidence in government's ability to intervene: When a hero comes to the rescue you gotta have faith in the hero. There's been a general failure of American political leadership here, plus here's a secret; there's an election in 30 days. A new President, whether McCain or Obama, may want the option of replacing the Cabinet including Paulson. A new person will bring a different personality and level of competence to the job. It may be that the new SOT might want to go in a different direction.

3) Inflationary pressure -  the government does not have $700 billion or whatever amount they try to work with just sitting around in a vault. To raise that kind of money they have to sell bonds, and with foreign investors watching the same CNN and Bloomberg shows we do we might have to offer them a more attractive interest rate.

Eventually, making more dollars will dilute the value of a individual dollar, with inflation a a result. Unmanaged (and let's face it, not exactly a success story there to this point)  this can lead to inflation forcing existing debt to be serviced with more and more debt - opening new credit cards for cash advances to pay your old cards.

Eventually the creditors (T-bill owners) will start cashing in those bonds and since the USA does not have enough money to cover all the obligations (our national debt) we would go into default.

Google "Argentina 2003" for a vision of how that might look. For extra credit, Google "Weimar Republic" and "Business Plot". But we're not that foolish...right?


What's the risk of no bailout?

Credit markets seize up and no loans are made. Some free-marketers might say that some institutions will surely lend money, but unless most of the credit market is replaced, there will not be enough credit to go around.

Investors and businesses lose confidence and stop borrowing, and start drawing on assets.

With interest rates tanking since no one wants to lend money, the banks get into a liquidity crisis where they don't have enough money to cover their obligations, like our 401Ks and savings accounts.

Banks default and the FDIC kicks in, only the FDIC is like the interstate or a cell phone system - it was never designed for everyone to use it at the same time. FDIC defaults. Now it's a full-blown panic and since we're not blessed with an FDR to inspire the country, no countermeasures are available except an even bigger bailout and with serious liquidity issues in the government...again, Google "liquidity trap" or "nationalization" for a vision of that.


Questions:

Rather than discuss the how-did-we-get-here (which I hope someone does at some point) I'd just like to see these questions answered before we write that blank check:

* Why is Secretary Paulson the sole agent of the bailout? He may get a congressional panel, but that's unlikely to be a meaningful check and balance on his authority. Isn't he leaving office in 120 days? Why aren't the candidates more concerned about this? Either they inherit Paulson (McCain may be OK with this) or they inherit his policy and try to find someone to implement it.

* Why purchase the securities? The crisis is a crisis of confidence - is there a way to reassure the markets with a declaration instead of an immediate expenditure?

*  Why not simply underwrite the securites for a defined amount and then value them instead of buying them outright? It reduces uncertainty and fear without putting Washington in the consignment market. Otherwise, what's the plan for discharging that debt? Are we going to hang on to them until every last mortgage is paid?

* Commercial paper is not the only capital route for businesses - many also have lines of credit available. Is this really a meltdown scenario if overnight loans stop for a week or two?

* This bailout is like the Forest Service's policy of stopping all fires immediately - that policy led to gigantic wildfires which could not be controlled.  Has that been considered? Is it time for a wildfire now to prevent a future inferno?

* What about the anti-trust implications of having JPMC and BOA be the sole big players in the major investment bank market? Could we at least discuss this?

I don't know the right answers, but I think we need to spend a little more time on the questions. I am also not entirely comfortable with a lame-duck administration obligating us to a debt that is greater than the Iraq/Afghanistan Wars, the tax cut, economic stimulus and Medicaid programs combined.