January 21, 2010

Help Me Understand: The Financial Crisis

One of the issues I have been trying very hard to understand is the financial crisis that has embraced America (and to a larger extent, the whole world). So, perhaps if I put my thoughts out there and garner feedback from whoever's listening, I (and hopefully you) can come to a better understanding of what's going on.

Now, I need to open by pointing out that I am a left-leaning liberal. I want to make this post as objective as possible, but because of this make-up of the humors in my body, I am more easily convinced of one line of reasoning than another. This is why I invite all points of view. Keep in mind that I am not here to pick a fight, so please don't try to start one with me. I freely admit I don't entirely know what I'm talking about.

I hope to continue what I write here into a series of self-indulgent dissertations, but my track record for staying dedicated to anything of the e-variety is not very good. Still, I am feeling more expressive of late - possibly due to the upping of my Zoloft prescription - and I may surprise even myself.

Here is what I've come to understand:

Although I am sure if I tried I could trace back the causes of this mess into the Precambrian era, I am just going to go back to the Great Depression. After the stock market crash of 1929 and the following Depression, the government decided that tighter regulations had to be placed on financial institutions. I can't recall all of the regulations, but one of note is the separation of commercial and investment banks.

Commercial banks are the first thing you picture when you hear the word "bank" - the edge of a body of water. Okay, maybe not the first thing. A commercial bank is your standard savings/checking/loaning bank. An investment bank is a bank that invests your money in stocks and stock-type things for (hopefully) wonderful gains and (possibly) crushing losses.

In 1999, this regulation was repealed, thereby allowing commercial banks to take part in stock/security trading. What this resulted in was banks finding they could make money by taking a mortgage garnered through commercial banking and "selling shares" of this mortgage to investors through investment banking. This is called a "mortgage backed security." The bank no longer owns the mortgage, and instead, it is divided up among the investors that invested money in it. These investors then also "sell shares" of their securities, dividing the mortgage up even more among even more people. By selling these mortgages to other people, banks are repaid for their loss (and then some) by the investors and the investors get to make all the money off the interest when the mortgage is paid. Now, I am surely oversimplifying this matter, but this is the best I can comprehend it.

Upon seeing the profits to be made off of securities, banks realize that more mortgages means more money. This is when banks start giving out mortgages to anyone that can fog a mirror. In fact, the more likely a person is going to default on a loan, the more money a bank can make off of it. The riskier the loan is, the higher its interest rate is. If the loan has a high interest rate, investors are going to pay more for it because it means more of a potential gain for them. So, not only does a bank get more money from a risky loan, but selling it, they no longer incur any of the risk.

Now, this may sound like kind of a cruddy deal for the investor, but the investor doesn't plan on hanging onto the loan, either. He's going to find some other sap to pawn it off on for even more money. No one is buying these loans to actually hold onto them, they're just purchasing them to sell them elsewhere.

So, because more loans means more money, and riskier loans means more money, banks are shoving these loans down people's throats. It doesn't matter if you don't need one. It doesn't matter if you don't want one. It doesn't even matter if you don't qualify for one. The banks just want you to sign that paper so they can sell at an inflated price to someone else, and they want you to sign it as quickly as possible because they know this isn't going to last forever.

Once people begin to default on these loans, people realize that these mortgages are worthless. All this money that was loaned out is now just gone, and all these financial institutions that held these securities lost everything. Well, they don't lose everything. They now get a house (once the foreclosure process is complete) that they don't need and don't know how to sell and couldn't sell anyway because no one has money to loan so somebody can buy the house. They also don't know how to upkeep it, nor do they care. The houses then get stripped, boarded up, rodent infested, and generally fall into disrepair, driving down neighboring property values. This means that the few mortgages that weren't defaulted on have greatly depreciated, and investors lose even more money.

Now, the banks can no longer conduct business because they just don't have the money, and if they fall, they can no longer lend money. Now, this is where it gets a little muddy for me. From what I understand, institutions such as Wal-Mart and Home Depot purchase their stock and pay their employees and other incidentals through a short-term loan provided to them by a bank. Once they bring in the money from selling their goods, they pay off the loan with that money and keep the profits. This is done because, although a business may make millions in a year, the flow of that money does not conveniently trickle in at the same time bills are due and checks are cashed. So, to make sure everything necessary for the operation of the business gets paid in a regular in timely fashion, banks lend them the money they would make anyways ahead of time.

Unfortunately, with no money to lend and the banks possibly shutting down, businesses, although they may have enough in assets to afford their operating budget, have little actual cash in hand and no time for liquidation of their assets. Employees need to get paid on Friday, and if you don't have the money, consumers won't have the money necessary to spend on goods and services. If goods and services aren't selling, businesses can't recoup their losses and pay their employees. So, essentially, no one in the country has any money. What would've happened at this point creates enough possible scenarios to keep post-apocalyptic sci-fi writers busy for a long while.

What we did do was bail out the banks, or, give them enough money so they could start lending again. Despite how much I dislike it, I do see why this was necessary in order to keep some semblance of normalcy. Lots of businesses did wind up going under anyways, as did quite a lot of banks. Plus, there has been lots of criticism because essentially the banks were handed the money with little strings attached, not to mention that the banks are only loaning exactly enough to keep the system moving and are still keeping disgusting profits for themselves.

What bothers me most is that they can do this all they want. I suppose this is why I'm more left leaning, because, although I don't want a gigantic big brother government, I would prefer a government that is more powerful than the banks and billionaires that bring about this kind of financial ruin. Our government is so weak that all it could do was throw money at the banks and beg them to fix it. Now that they're using the money for big bonuses, all we can do is reprimand them. Any action we have threatened to take on them (fees, taxes, etc.) they said they would just pawn off on their consumers, and we can't do anything about it.

I don't know a solution to this because I don't even know if I understand it all correctly. But, I have always been under the impression that the reason for a democracy was to give equal power to all people, and with the deregulation, we all lose that power and control. I realize I'm going off on a bit of a leftist rant now, so I'll slow it down and see what you all have to say.

Again, I'm not trying to convince anyone of anything, I'm just trying to understand it. Am I wrong? Am I mistaken? Where am I mistaken?

Thank you for your time.

Bender: Christmas isn't about food.
Orphan: I'm ever so hungry.