Friday, February 20, 2009

comments on: The Crisis of Credit Visualized (a video)

I watched an entertaining and fabulously animated video, derived from link to a Digg story via tweet from Kevin Rose.

The Kevin Rose/Twitter/Digg effect are, as of this writing, overloading the original site and the Vimeo mirror of the video, so you can catch it on YouTube:


While oversimplified, the video's explanation is better than your drive-by news has given, but not perfect. However, the graphics and presentation are sooo slick, I couldn't resist sharing!

The video either doesn't or under represents the role government played via promotion of loose-lending by various homeownership programs (Community Reinvestment Act), via applying funding to pressure groups like ACORN to agitate bank lending, and via the Federal Reserve (the base of the inverted monetary pyramid, and chief engine of magic money creation).

The video properly characterizes the idea of leverage used to magnify the returns of mortgage originators and investors in the securitized products.

(Incidently, MBS refers to pure mortgage backed securities, depicted in the video as CDOs. While MBS are a form of CDO, CDOs can and did include other types of debt, like consumer loans and automobile loans. The video mischaracterizes the risk of the CDOs issued to investors. While it's true that different risk pools existed, frequently, some prime mortgage debt would be mixed into a batch of CDOs containing mostly junk consumer debt or low-quality subprime mortgages, so as to garner a AAA rating from Moody's or S&P. This was an exploitation of lax standards of the ratings agencies, and their cloudy debt-type requirements. This is why these securities are now called toxic. It is now very difficult to separate the quality and worthy debt from the junk debt in any given traunch of CDOs, making them all the harder to value on the open market.)

The situation goes bust because it was credit expansion which supplied the $ to underwrite the mortgages. Up to $40 would be magically created from each $1 from an investor or investing institution. 39 of the $s were not real, they were bank magic. Even some of the $1 coming into the banks weren't real, they were Fed magic. Prices go up so long as the _rate_ of this magic money creation remains fixed.

The process of securitizing mortgage debt for resale to individual and institutional investors was a signal of the end-game.

See, the banks ran out of reserves, having levered 30:1 or 40:1 (the prev. limit of about 10:1 to 15:1 having been extended by Congress at the request of Hank Paulson, when he was Goldman Sachs' CEO, before he became Treasury Sec'y!), and needed more investment. Investors buy the CDOs, and the banks could take the proceeds and underwrite new mortgages up to 40x again.

Eventually the supply of dollars at the bottom of this inverted pyramid of inflation dries up and is fully invested. There are no new dollars to buy the next round of packaged mortgage CDOs. Thus the rate of money creation slows, bringing about the bust. Magical "paper" dollars evaporate and start to change back into the tiny pile of original real dollars, with the effect of falling home values (the inflated high values weren't real), bankruptcies, and investment portfolio loss.

That's fractional-reserve banking at work, and a boom-bust _always_ occurs with this system. Perversely, free-market forces act as a check on this leverage, keeping it small by magnifying the risks of bankruptcy by banks magically creating money. Banks don't want to be bankrupt (and it's this fear that helped _contract_ the magic money supply!).

Our gov't is embarked on its plan to try (in vain) to keep unsound banks solvent by puffing them with magic Fed $s (via Fed interest rate reductions and "quantitative easing"). The idea is to keep the highest levels of the inverted pyramid from contracting any more by injecting money into lower levels.

This money comes from TARP and other programs. And it came to those programs via our taxes or (more properly) via foreign investment and outright "printing" via Fed FOMC purchases.

You can think of that foreign investment as like a 2nd tier of CDO selling. Our gov't is absorbing the mortgage debt, and repacking it into gov't debt "CDOs" to sell to China.

As the 1st tier was an end-game signal for Wall St., unless we reverse course this 2nd tier signals the end-game for gov't!

The proper course is for government not to be involved, because this is the only way we will vanish away all the magic dollars on paper, and come back to actual dollars. The banks don't want to lend today because they understand this, that to do any more lending would cause them future bankruptcy, and that to secure solvency in the face of their existing bad debts means hoarding onto deposits and seizing any chance of selling the bad assets to someone else (though I disagree with any plan for the gov't to buy them, as this socializes the risk, and creates future moral hazard).

Allowing failures to occur will make for a very sharp, but also very short depression, like 6-18 months, as all depressions were prior to the Great one.

Our fear of the pain, and for purely political reasons, our government's fear of allowing us to feel that pain, is prompting the present bailout and stimulus effort.

The best-case outcome for our gov't intervention is a delaying action as the _rate_ of magic money creation is temporarily stabilized (or worse, reflated) and prevented from further contraction. This can be perpetuated only to the extent that we can continue to get ever more tax and foreign funding.

When we use up that credit, gov't will be forced to tax to crazy levels (unpopular, ultimately riotous), or monetize the debt ("print" the needed dollars to repay). Given the quantity of debt outstanding and forecast future debt, this monetizing would cause the money supply to become truly monstrous, meaning Zimbabwe-type inflation (an indirect sort of tax).

Bottom line as I've said in this blog elsewhere, is that we got here via a government-subsidy of business risk, leading to excessive risk taking which wouldn't have happened in a free and unfettered market. By a now decades long government culture of preventing failures, we've interrupted the free-market feedback mechanism that limits risk and contains leverage. The longer we continue this trajectory, the more we trade smaller amounts of present pain (peversely, even pleasure in the case of reflation), for greater amounts of future pain. By dialing back government involvement, we reconnect the risk-mechanism, experience more pain now, but are rewarded with a future of honest prosperity, rather than looming and protracted depression.

For more, read on:

  • Jaguar Inflation - credit expansion illuminated entertainingly
  • The Bailout Reader - for more on the mechanics of the crisis and our efforts to overcome it
    (also contains excellent gateway articles into the Austrian theory of business cycles)

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