Well, it's official. The President of the United States wants us to be very afraid of an economic crisis we might not recover from. Afraid enough, in fact, to support the passage of the biggest chunk of new government spending in history.
I'll forgive you for suspecting that Obama is blowing smoke up your nether regions. After all, no one has more to lose than he does from the poor economic conditions. At least if we enact a massive stimulus bill and things don't get any better, he'll tell you (without proof) that things would have been even worse otherwise.
But we've had recessions and economic slowdowns before. Lots of them. What makes this one so big and special that the President himself is warning that he might be unable to fix it?
The economic crisis is rooted in a financial crisis that began in 2007, which metastasized into a banking crisis in 2008. The immediate source of the crises is the collapse of the housing bubble.
For a lot of reasons, not just the few that you keep hearing about, the value of housing became inflated beyond all reason, not just in the US, but also in Britain, Ireland, Spain, and a few other places. When that unsustainable bubble started collapsing sometime in 2006, all the people who had lent money to homeowners for mortgages, began to suffer.
When the value of houses declines, it gets increasingly difficult for homeowners to keep paying their mortgages. Some of them will miss payments, and a small number will default altogether. If you've lent your money to the homeowner so she can take out a mortgage, you're now holding an asset that (because of the higher default risk) is far less valuable than it was when you made the loan.
I'll forgive you for suspecting that Obama is blowing smoke up your nether regions. After all, no one has more to lose than he does from the poor economic conditions. At least if we enact a massive stimulus bill and things don't get any better, he'll tell you (without proof) that things would have been even worse otherwise.
But we've had recessions and economic slowdowns before. Lots of them. What makes this one so big and special that the President himself is warning that he might be unable to fix it?
The economic crisis is rooted in a financial crisis that began in 2007, which metastasized into a banking crisis in 2008. The immediate source of the crises is the collapse of the housing bubble.
For a lot of reasons, not just the few that you keep hearing about, the value of housing became inflated beyond all reason, not just in the US, but also in Britain, Ireland, Spain, and a few other places. When that unsustainable bubble started collapsing sometime in 2006, all the people who had lent money to homeowners for mortgages, began to suffer.
When the value of houses declines, it gets increasingly difficult for homeowners to keep paying their mortgages. Some of them will miss payments, and a small number will default altogether. If you've lent your money to the homeowner so she can take out a mortgage, you're now holding an asset that (because of the higher default risk) is far less valuable than it was when you made the loan.
Now consider the fact that mortgages are no longer isolated assets, originated and serviced by a local bank. These days, mortgages are gathered together into pools, packaged into mortgage-backed securities, and sold on to investors all around the world.
The innovation of the MBS solved a very important problem, by making it possible for investors (who ordinarily would buy government or corporate bonds) to provide the money for people to buy homes. (You may remember that expanding homeownership rates has been a stated priority not only for Republican Presidents but also for Democratic ones from FDR to Johnson to Carter to Clinton.)
But you get a problem when so many mortgages are sliced, diced, and repackaged into things that look like bonds. You can't distinguish which specific mortgages are at risk of default, so that increases the default risk across a huge range of mortgage-backed securities.
That means the people who invested in the securities are experiencing huge paper losses. It's quite typical for an MBS purchased for 100 cents on the dollar to be marketable today only for 15 or 20 cents.
Well, ordinarily people who buy bonds (and bond-like things such as MBS) intend to hold them to maturity, collecting twice-annual interest payments, and getting their principal back when the bond matures. So even if you face an inability to sell an MBS for anything approaching par, you'd think that's not really a problem, right?
Well, it is a problem. Many of the people (like investment banks and hedge funds) bought MBS using borrowed money. In extreme cases, you could put up four cents, borrow 96 cents, and buy an MBS for a dollar. You'd make money on the spread between the relatively high yield of the MBS, and the interest you pay to borrow the 96 cents.
That string runs out when the current market value of the MBS falls. And it doesn't need to fall very far at all before your lenders tell you they want a much larger security deposit ("margin"). And then if short-term interest rates rise (which they have, very sharply), then you're losing money all the way around. You'll either have to liquidate at a huge loss and go out of business, or else deleverage (eliminate the borrowing and finance the MBS with "real money").
What if you're an ordinary bank that takes deposits, rather than an investment bank? Now, if you own a portfolio of MBS (and nearly all banks did, because what's the point of a bank if not to make mortgage loans?), you have to mark it to market on a frequent basis, to satisfy regulators that you have enough capital to withstand any losses. (I won't get into the shenanigans that big firms like Citigroup and Merrill Lynch got into, to keep these portfolios off their balance sheets and away from regulatory scrutiny. They can't get away with that any more, anyway.)
So now we're close to answering the original question: why is this crisis so big? Because the losses from mortgages affect nearly every bank and financial institution in the world. And they may add up to two trillion dollars or more before we're done with it all. Some people go way out on a ledge and predict eventual losses of three, four or even five trillion dollars.
The whole US economy is $14 trillion a year. The whole US mortgage market is $12 trillion. Total assets held by the very largest US banks are in the range of 1.5 to 2 trillion each. Now do you see the scale of the problem? If someone knocks $25 a week off your pay, you won't notice. If they take away a third or a half of it, you WILL notice.
And this is the critical thing about the problem, that no one wants to talk about, especially not in Washington: when you have losses that big, you will NECESSARILY suffer for a certain period of time. That's incompressible, no matter what policymakers or Obama do.
Think about it this way: if you collect your paycheck and stop at the racetrack on the way home and lose half of it, what will happen? You're going to eat a lot of macaroni and cheese until your next check comes.
That's what's happening to the US economy. The losses are far too large to simply bail out with taxpayer money. And this is the disconnect that many economists and policymakers are refusing to face.
Do you remember IndyMac, the large California bank that failed last summer? It was a fairly big hit to the assets of the FDIC, which handles bank failures, but not something anyone else would have noticed. In effect, deposit insurance spreads the risk of bank failures around so they don't threaten the system. That works perfectly well. An IndyMac-sized failure threatens no one.
But now we have a situation where almost every single bank in the world is facing a significant capital loss. The instinct of policymakers is to socialize, or bail out, those losses.
What could be done to socialize the losses? Well, we're talking about guaranteeing ("ring-fencing") any losses on the MBS portfolios held by banks. You can also buy the assets out into a "bad bank" and finance them to maturity by selling Treasury debt. Both approaches are forms of the same thing, with different technical characteristics.
At the end of the day, you have a lot of distressed mortgages that simply must be held to maturity, by someone. And it's going to tie up trillions of dollars in capital to do that, for the duration of the mortgages. That's trillions of dollars in capital that will not be available for economic growth. And that's the genesis of the global economic crisis.
Socializing the losses is the rationale underlying the stimulus package that Obama is trying to sell us. It's also the rationale for Congress and the FDIC's desire to force Fannie Mae and Freddie Mac (now fully nationalized entities) to simply absorb the losses on all the distressed mortgages out there. If you can find deep enough pockets, you can make losses disappear. And the taxpayers have the deepest pockets of all.
Except this time, we're talking about trillions of dollars in losses. Not even the taxpayers, with a $14 trillion economy to work with, can make that lump disappear without a lot of pain.
There's no magic bullet, not even for a magical man like Barack Obama. Even under the very best-case scenario, a lot of people are going to be eating macaroni and cheese for at least the next several years to come.
How long? Well, how long does a typical MBS take to mature? Five to seven years. If the average remaining duration of the aggregate MBS portfolio out there on bank balance sheets is now about three to five years (MBS issuance decelerated rapidly in 2006 and real interest rates are now very high due to deflation), then that's your answer.
Three to five years.
The innovation of the MBS solved a very important problem, by making it possible for investors (who ordinarily would buy government or corporate bonds) to provide the money for people to buy homes. (You may remember that expanding homeownership rates has been a stated priority not only for Republican Presidents but also for Democratic ones from FDR to Johnson to Carter to Clinton.)
But you get a problem when so many mortgages are sliced, diced, and repackaged into things that look like bonds. You can't distinguish which specific mortgages are at risk of default, so that increases the default risk across a huge range of mortgage-backed securities.
That means the people who invested in the securities are experiencing huge paper losses. It's quite typical for an MBS purchased for 100 cents on the dollar to be marketable today only for 15 or 20 cents.
Well, ordinarily people who buy bonds (and bond-like things such as MBS) intend to hold them to maturity, collecting twice-annual interest payments, and getting their principal back when the bond matures. So even if you face an inability to sell an MBS for anything approaching par, you'd think that's not really a problem, right?
Well, it is a problem. Many of the people (like investment banks and hedge funds) bought MBS using borrowed money. In extreme cases, you could put up four cents, borrow 96 cents, and buy an MBS for a dollar. You'd make money on the spread between the relatively high yield of the MBS, and the interest you pay to borrow the 96 cents.
That string runs out when the current market value of the MBS falls. And it doesn't need to fall very far at all before your lenders tell you they want a much larger security deposit ("margin"). And then if short-term interest rates rise (which they have, very sharply), then you're losing money all the way around. You'll either have to liquidate at a huge loss and go out of business, or else deleverage (eliminate the borrowing and finance the MBS with "real money").
What if you're an ordinary bank that takes deposits, rather than an investment bank? Now, if you own a portfolio of MBS (and nearly all banks did, because what's the point of a bank if not to make mortgage loans?), you have to mark it to market on a frequent basis, to satisfy regulators that you have enough capital to withstand any losses. (I won't get into the shenanigans that big firms like Citigroup and Merrill Lynch got into, to keep these portfolios off their balance sheets and away from regulatory scrutiny. They can't get away with that any more, anyway.)
So now we're close to answering the original question: why is this crisis so big? Because the losses from mortgages affect nearly every bank and financial institution in the world. And they may add up to two trillion dollars or more before we're done with it all. Some people go way out on a ledge and predict eventual losses of three, four or even five trillion dollars.
The whole US economy is $14 trillion a year. The whole US mortgage market is $12 trillion. Total assets held by the very largest US banks are in the range of 1.5 to 2 trillion each. Now do you see the scale of the problem? If someone knocks $25 a week off your pay, you won't notice. If they take away a third or a half of it, you WILL notice.
And this is the critical thing about the problem, that no one wants to talk about, especially not in Washington: when you have losses that big, you will NECESSARILY suffer for a certain period of time. That's incompressible, no matter what policymakers or Obama do.
Think about it this way: if you collect your paycheck and stop at the racetrack on the way home and lose half of it, what will happen? You're going to eat a lot of macaroni and cheese until your next check comes.
That's what's happening to the US economy. The losses are far too large to simply bail out with taxpayer money. And this is the disconnect that many economists and policymakers are refusing to face.
Do you remember IndyMac, the large California bank that failed last summer? It was a fairly big hit to the assets of the FDIC, which handles bank failures, but not something anyone else would have noticed. In effect, deposit insurance spreads the risk of bank failures around so they don't threaten the system. That works perfectly well. An IndyMac-sized failure threatens no one.
But now we have a situation where almost every single bank in the world is facing a significant capital loss. The instinct of policymakers is to socialize, or bail out, those losses.
What could be done to socialize the losses? Well, we're talking about guaranteeing ("ring-fencing") any losses on the MBS portfolios held by banks. You can also buy the assets out into a "bad bank" and finance them to maturity by selling Treasury debt. Both approaches are forms of the same thing, with different technical characteristics.
At the end of the day, you have a lot of distressed mortgages that simply must be held to maturity, by someone. And it's going to tie up trillions of dollars in capital to do that, for the duration of the mortgages. That's trillions of dollars in capital that will not be available for economic growth. And that's the genesis of the global economic crisis.
Socializing the losses is the rationale underlying the stimulus package that Obama is trying to sell us. It's also the rationale for Congress and the FDIC's desire to force Fannie Mae and Freddie Mac (now fully nationalized entities) to simply absorb the losses on all the distressed mortgages out there. If you can find deep enough pockets, you can make losses disappear. And the taxpayers have the deepest pockets of all.
Except this time, we're talking about trillions of dollars in losses. Not even the taxpayers, with a $14 trillion economy to work with, can make that lump disappear without a lot of pain.
There's no magic bullet, not even for a magical man like Barack Obama. Even under the very best-case scenario, a lot of people are going to be eating macaroni and cheese for at least the next several years to come.
How long? Well, how long does a typical MBS take to mature? Five to seven years. If the average remaining duration of the aggregate MBS portfolio out there on bank balance sheets is now about three to five years (MBS issuance decelerated rapidly in 2006 and real interest rates are now very high due to deflation), then that's your answer.
Three to five years.
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