Explain the credit crunch to me.

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mrandrewv
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Explain the credit crunch to me.

Postby mrandrewv » Fri Oct 10, 2008 8:14 am UTC

Lo.

As has been said many times before: I don't know shit about economics. So please explain the causes of the current financial crisis to me.

My imperfect understanding is that banks gave home loans (mortgages) to people who they knew couldn't afford them, drove them into bankruptcy while they desperately tried to keep up with the payments (cause no one wants to lose their home) then when they inevitably defaulted the bank repossessed their home, and sold it to someone else who also couldn't afford it.

This cycle continued until they ran out of victims and they were left with alot of homes and no one to buy them, and alot of loans that people couldn't repay.

This left them, the ganks, oops, I mean banks, with no money themselves which they need to lend to other people and with no lending going on the market can't function, the US market collapsed and took the world markets with it.

No one knows how to fix this other than to place tighter regulations on this (and if you're smart, all other) markets, kinda like what was done with the stock market after the last greed-driven catastrophe (the great depresion part I).

The blame can be placed at the feet of:
1) The idiots who ran the banks that gave out these unethical loans.
2) The Republican party for fighting for looser regulations in the business sector in general.
3) The Democratic party for fighting against tighter regulations on the mortgage market specifically.
(Points 2 and 3 are from Factcheck.org)

And I hope economica responds to this thread. I find that I learn more from his posts on economics than anyone else's :)

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Re: Explain the credit crunch to me.

Postby Malice » Fri Oct 10, 2008 8:41 am UTC

mrandrewv wrote:Lo.

As has been said many times before: I don't know shit about economics. So please explain the causes of the current financial crisis to me.


As I understand it (imperfectly)...

Banks were like, "Hey, how can we get more money out of this whole loan thing? You know what market we haven't tapped yet? The group of people who can't afford to pay us back."

So they started tricking people into taking out loans those people couldn't afford. The banks couldn't hide that some of these loans were bad, though, so they started reselling them to other people--most importantly, they sold them in packages. If you have 90 good mortgages and 10 bad ones, you can sell 90 (which, because they're good, will have let's say a 100% return on investment each) and be stuck with 10 bad ones (because they'll have a zero percent return on investment each); or you can group them together into a big package of 100 mortages, which has a 90% return on investment.

Those packages were bought by mutual funds, who said, "Hey, 90% is pretty good," and since they didn't know what went into the original bad loans, they didn't realize they were being shafted. (Alternate possibility: they did realize, and didn't care, because they were passing the shafting onto the next person in line...)

So then the people who paid into those mutual funds were essentially subsidizing the bad loans of the banks indirectly, and subsidizing the bad judgment of the mutual funds directly.

The credit crunch came because this got worse and worse, until the mutual funds were saying, "Hey, 40% return on investment is still pretty good", and all of a sudden everybody in the industry gets scared, almost simultaneously. They go, "Wait a second, 40%? You've gotta be shitting me. I'm not investing in your little mutual fund." Which meant the fund couldn't buy the mortgages, which meant the banks couldn't sell them, which meant the banks were stuck with the shitty loans they took on the in the first place. The banks had too much useless non-assets--loans that weren't gonna get paid off, and loans that now weren't gonna get sold--and not enough actual cash. Without cash, they couldn't make any new loans (which is the same thing as saying they couldn't extend more credit, therefore the phrase "credit crunch"), and without new loans, they couldn't make any more cash, so they started imploding.

Everybody's panicking, firms that have been around for decades start failing, and the stock market starts taking huge dips. The government comes in and says, "Shit, what'd I do? I only looked away for a minute." While it's true that deregulation had been building towards this for years, the piece of work that actually endangered the entire economy was removing a certain specific rule, less than a year before this financial crisis. This rule, put in place after the Great Depression, forced the pieces of the economy to remain separate--I think it was based on what kind of financial entities could hold what kind of property, and anyway the point is that if that rule was still in place, a sector of the economy might have failed, but it wouldn't have taken everything else with it.

That is my understanding, and I admit that there are parts of it I'm not sure about, either. Anybody else have a better explanation?
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Re: Explain the credit crunch to me.

Postby Mzyxptlk » Fri Oct 10, 2008 8:45 am UTC

mrandrewv wrote:The blame can be placed at the feet of:
1) The idiots who ran the banks that gave out these unethical loans.
2) The Republican party for fighting for looser regulations in the business sector in general.
3) The Democratic party for fighting against tighter regulations on the mortgage market specifically.
(Points 2 and 3 are from Factcheck.org)

This probably isn't a very popular sentiment, but:
4) The fools who took on loans they can't afford.
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Re: Explain the credit crunch to me.

Postby Marquee Moon » Fri Oct 10, 2008 8:56 am UTC

Here's an excellent explanation. It's a radio episode and it's 60 minutes long, but I still highly recommend listening to it. It was originally posted in one of the other credit crisis threads by someone else.

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Re: Explain the credit crunch to me.

Postby Mzyxptlk » Fri Oct 10, 2008 9:18 am UTC

Marquee Moon wrote:Here's an excellent explanation. It's a radio episode and it's 60 minutes long, but I still highly recommend listening to it. It was originally posted in one of the other credit crisis threads by someone else.

Personally, I prefer this explanation. :)
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Re: Explain the credit crunch to me.

Postby Malice » Fri Oct 10, 2008 9:41 am UTC

Marquee Moon wrote:Here's an excellent explanation. It's a radio episode and it's 60 minutes long, but I still highly recommend listening to it. It was originally posted in one of the other credit crisis threads by someone else.


I don't suppose you'd care to summarize? I have no problem listening to something like that if it's interesting, and I will probably check it out this weekend. But the point of the thread is to offer succinct explanations that make sense to laymen.
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Re: Explain the credit crunch to me.

Postby ian » Fri Oct 10, 2008 9:43 am UTC

Does anyone know a good introductory book about Global economics/markets/finance? Something suitable for say a year 1 uni student, but not too text booky?

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Re: Explain the credit crunch to me.

Postby Rysto » Fri Oct 10, 2008 2:08 pm UTC

Every time I think that I understand the issue I learn about a new wrinkle. But here's a quick summary of my understanding of the issue:

1) Mortgages in the US were being securitized. Just like you can buy shares in companies, banks were selling shares in mortgages(I can't remember what the real name for the shares are).
2) Financial "derivatives" based on these mortgage shares were introduced. Kind of like a mutual fund in mortgage shares: the creator of the derivative bought shares in a whole bunch of different mortgages and packaged them together, and then sold shares in the package of shares.
3) More complicated derivatives based on the derivatives were created. People bought shares in different derivatives, packaged them together and sold shares in the package.
4) So on and so forth, with ever more complex derivatives. The most important thing to understand here is that these derivatives are complicated. So complicated it would take months, or longer, to take one of those packages and work out which mortgages, and how large a share of each mortgage, are owned by the derivative.
5) The housing bubble blows up. Huge numbers of people -- way more than were expected by those buying mortgage-backed derivatives -- default on their loans. Houses are foreclosed on but are worth less than the loan. Thanks to the way that the mortgage securities were structured some of the shares in those mortgages are now completely worthless.

So now we have a situation where there are shares in these mortgage securities that are completely worthless, and nobody knows who owns them. Anybody who owns asset-backed commercial paper(ABCP) might own worthless shares. So now we have all this money tied up in ABCP, and nobody's going to buy any ABCP unless they know that it isn't backed by worthless shares, and it will take months to figure out if just one of these derivatives are worthless. So ABCP is completely illiquid -- the people who own ABCP can't get any money at all for it. The financial world is just frozen until this gets figured out.

The goal of the Paulson bailout is to buy $700 billion in ABCP, and then the government will unwind the whole thing and figure out what ultimately backs the loans, and once that's figured out sell it all again and hopefully recoup their money. Buying up ABCP makes the financial markets liquid again, which should unfreeze things.

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Re: Explain the credit crunch to me.

Postby PhilSandifer » Fri Oct 10, 2008 2:21 pm UTC

OK. So the mortgage backed securities thing has been explained pretty well in the thread, so I won't go over that again. But the credit crisis's relationship to it hasn't.

So there's a thing called the commercial paper market. What that is is a market of short term loans to businesses so they can do things like large equipment purchases, floating payroll, etc. This market is one of the safest financial markets around. It's where businesses park short term money for small but reliable profits. And it's what businesses need to survive - without it, tons of businesses, from small local ones to huge multinational corporations.

In mid-September, the commercial paper market seized up. What happened was that Lehman Brothers - a big investment bank - failed and went bankrupt. And that caused sufficient damage that the commercial paper market "broke the buck" and stopped being profitable. People were losing money in the commercial paper market - which was supposed to be an ultra-safe investment.

And so people fled the market en masse, buying the other super-safe investment, US Treasury bonds. The available amount of money in the commercial paper market dried up, and interest rates on it shot up. And that's the credit crisis.

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Re: Explain the credit crunch to me.

Postby segmentation fault » Fri Oct 10, 2008 3:00 pm UTC

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Re: Explain the credit crunch to me.

Postby Plasma Man » Fri Oct 10, 2008 3:38 pm UTC

Just a note on the sub-prime mortgage lending that helped get this panic underway.

Banks gave out mortgages at a lower rate of interest than was standard. The standard rate is referred to as the prime rate, hence these are sub-prime mortgages or sub-prime lending.
These were fixed-term deals, so you'd be able to have them for a couple of years, then you'd have to go onto one at or above the prime interest rate.
When these deals ran out, it turned out that a lot of the people who had these mortgages couldn't keep up the payments on this higher rate. Banks and investment companies panic, because they've got quite a lot of money invested in these kinds of deals. Now, here's where it gets a bit more complicated. Banks like to maintain a particular ratio of assets to debts. These bad deals mean that bank x is not going to get a return on some of the money they've loaned, so their profits (which are assets) go down, and they're not going to get back some of the money they lent. They almost certainly borrowed money to lend it as mortgages, so these bad mortgages that aren't going to be repaid increase their debt. The bank now wants to keep more assets for itself, so it's less inclined to loan money to people and it's also less inclined to loan money to other banks, because it knows that they're probably struggling as well. This kind of inter-bank, inter-company loaning is what helps keep the day to day business running effectively (borrow in the short term to loan money that's going to get you a medium-long term profit).
The end result of this is that anyone who needs to borrow money to do anything is in trouble, because there is now less loaned money to lubricate the system, plus banks are now wary of lending money. So they probably don't want to lend money to you, and even if they did, they might not be able to borrow enough in the short term to loan it to you in the longer term. This is where the big government bail out comes in. By putting more money into the market, they hope to give banks more confidence and to get them loaning to each other (and ultimately to people and businesses) again.
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Re: Explain the credit crunch to me.

Postby PhilSandifer » Fri Oct 10, 2008 5:03 pm UTC

Plasma Man wrote:Just a note on the sub-prime mortgage lending that helped get this panic underway.

Banks gave out mortgages at a lower rate of interest than was standard. The standard rate is referred to as the prime rate, hence these are sub-prime mortgages or sub-prime lending.
These were fixed-term deals, so you'd be able to have them for a couple of years, then you'd have to go onto one at or above the prime interest rate.
When these deals ran out, it turned out that a lot of the people who had these mortgages couldn't keep up the payments on this higher rate. Banks and investment companies panic, because they've got quite a lot of money invested in these kinds of deals. Now, here's where it gets a bit more complicated. Banks like to maintain a particular ratio of assets to debts. These bad deals mean that bank x is not going to get a return on some of the money they've loaned, so their profits (which are assets) go down, and they're not going to get back some of the money they lent. They almost certainly borrowed money to lend it as mortgages, so these bad mortgages that aren't going to be repaid increase their debt. The bank now wants to keep more assets for itself, so it's less inclined to loan money to people and it's also less inclined to loan money to other banks, because it knows that they're probably struggling as well. This kind of inter-bank, inter-company loaning is what helps keep the day to day business running effectively (borrow in the short term to loan money that's going to get you a medium-long term profit).
The end result of this is that anyone who needs to borrow money to do anything is in trouble, because there is now less loaned money to lubricate the system, plus banks are now wary of lending money. So they probably don't want to lend money to you, and even if they did, they might not be able to borrow enough in the short term to loan it to you in the longer term. This is where the big government bail out comes in. By putting more money into the market, they hope to give banks more confidence and to get them loaning to each other (and ultimately to people and businesses) again.


For a number of reasons, this poorly explains the situation - most notably, it ignores the role that securitization of the mortgages into CDOs led banks to badly misjudge the risk of their investments, and to put a lot of money into what turned out to be very, very bad investments. Which is much more the relevant issue than the borrowing money to lend money issue.

These CDOs are an explanation unto themselves, but they're absolutely vital to understanding the subprime crisis - which is, in most regards, a separate issue from the credit crunch. The former caused the latter, but they are not the same.

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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Fri Oct 10, 2008 7:35 pm UTC

It started with Jimmy Carter, who was outraged that people were being turned away from loans which they did not qualify for. Assuming Race etc. were factors, he passed legislation such as the Community Reinvestment Act and others, which required banks to ignore factors such as undesirable location and that welfare and unemployment payments be counted as income when evaluating a loan. Later, Clinton would expand these protections of un-qualified borrowers.

the Banks decided to do two things in response:
1. They invented ways to get around these requirements, such as sub-prime loans which 'disadvantaged' borrowers could be approved for, but which over time would become the same sort of loans that these people would have gotten before borrower protection legislation (in many cases even worse loans than these people would normally have been approved for)
2. they securitized Mortgages. This insulated lending banks from the results of approving loans to unqualified borrowers and as the practice grew, enabled them to make even worse sub-prime loans.

Debt became more valuable to a loan bank than a mortgage that would be paid in full, They could give out a loan at a subprime lending rate, package it as a 'debt-backed security' and sell it to an investment bank.

And the investment banks Accepted these securities and even paid full price for them, they didn't have the tools or experience to look too deeply at these securities, and until then, securities backed by loan debt could be evaluated easily by the interest rate, the lower the better, and these subprime 5 and 6 percent interest loans looked fantastic, investment banks were all too eager to suck them right up, giving loan banks plenty of incentive to keep giving these loans out and selling them off as low-interest loan securities.
Of course, when the interest rates on these subprime loans started to balloon, the investment banks were left holding the bag, having paid the full cost of low-interest loan securities for loan securities that were only worth half to a quarter as much.

Mises.org has been doing a lot of good articles on the credit crunch etc. recently, anyone interested in further reading should it out.

EDIT: At the same time all of this was going on, Automatic Credit Evaluation software allowed banks to quickly and easily approve loans and made things like online loan application/approval possible. this made it easier than ever to apply for and be approved for loans. so at a time when it was advantageous for banks to give out crappy loans, they were giving out record numbers of them, it's even possible these ACE programs were being 'twerked' to give out disproportionate numbers of subprime adjustable rate mortgages, and so when things came crashing down, there were also many more mortgages on the market than anyone expected, the sheer number of forclosed homes blew out the housing market, with so many houses on the market, prices collapsed and loans that were already worth less than they were being sold for as securities, were still worth more than the houses they were based on.
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Re: Explain the credit crunch to me.

Postby Yakk » Fri Oct 10, 2008 8:18 pm UTC

Asset
Customer
Lender
Bundler
Investor
Insurance

The Customer borrows money for an Asset. Sometimes this causes the Asset to be made.

The Lender lends the Customer the Asset. Traditionally, the Lender kept the loan on their books -- so they had to be careful about who they loaned to, or the company went under. Except recently, specialization kicks in.

Now, the Lender sells the Loans to a Bundler. The Bundler bundles the Loans into securities. A big pile of loans are clumped together, and then divided into tranches. Suppose it is divided into 5 tranches of equal share.

The "top" tranch gets paid first -- so long as 1/5th of the Loans in the Bundle are paying, it gets it's income.
The "bottom" tranch gets paid last -- if even 1/5th of the Loans aren't paying, then it gets nothing.
The middle tranches get paid ... well, in the appropriate order.

The trick here is that a "top tranch" loan is pretty damn secure, even when backed with really bad loans -- it requires an 80% default rate among the backing loans to impact your repayment. Each lower tranch is a bit less secure.

The Bundlers sell these tranches to Investors of various stripes. Now, some of these Investors want high-yield, high-risk investments -- they buy the crappy tranches. Others want decent-yield, low-risk investments. For these folks even the higher quality tranches are not good enough.

So they buy Insurance on their investments -- in the event that the investment fails to perform, their insurer pays them the money that the investment didn't.

Bonus.

So now the investor has a really really secure investment. Heck, it is so secure, you could by the middle or even 4th tranch and still have an AAA rated security. I mean, it would take an average price drop and a huge amount of morgage failure and the insurance company would have to fail.

Now, as it happens, I'm a bank who invested in a AAA rated security this way. I have to keep a certain percentage of my assets in cold, hard cash, in order to satisfy reserve requirements, and keep my own AAA rating. What more, if I lose my AAA rating, there are punative contracts that basically make me go bankrupt.

And fuck, an insurance company, who over-insured some bad morgages, just said that they are insolvent. And they are insuring some of my securities.

Now some of my nice AAA decent yield investments ... aren't being secured any more. And what is worse, some of my rivals AAA securities aren't secured. And some of my rivals are also insuring other of my AAA investments. And I'm securing some of theirs. Crap.

And, I don't know who is securing what, so I don't know if a company is about to go insolvent. And I don't know when I'll get people demanding I pay up for the insurance I offered other people, so I need cash, now. And my assets -- even though they are still paying their interest -- are not cash. People want cash right now to stay solvent. So people want cash more than my assets. So my assets just got cheaper.

And I have to keep a reserve ratio, or I can get a credit downgrade. I need more cash.

But so do all of my rivals.

Oh, Fuck.
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Re: Explain the credit crunch to me.

Postby ThomasS » Fri Oct 10, 2008 8:23 pm UTC

Regarding the origins of the crisis, a real error was in the statistics of the rating agencies, and the reliance of many many banks and institutions on those ratings.

If you have 1000 mortgages in the pool, and if the odds of one going bad is something like 10% and if the recovery when you foreclose is at least 50%, then a 5% loss is likely, and a 10% loss is rather unlikely. So set it up so that 20% of the bonds lose money first and are junk and 80% only lose money if the junk is gone. Obviously that 80% are investment grade. I mean, how could the best bonds possibly get hit? I mean, simple statistics shows that the odds of the investment grade paper taking a loss is minuscule. Absolutely minuscule.

The brokers explained this to the rating agencies. Surely the fact that the brokers pay the rating agencies couldn't possibly have affected their judgment about the accuracy of such analysis.

Besides the statistical problems, the deals are involved, but not quite as involved as some have suggested. I once sat down with a prospectus and reversed out a (non-CDO) deal in a day or so. It did have a fairly nasty "not quite a sticky z" tranche in it.(This is why we needed to reverse it). Also the senior sub structure is fairly boilerplate. Similarly, if you take a CDO and pick 10 of the subs which make it up, analyze each of them, and realize that all ten of those that you picked are worth maybe 10 cents on the dollar, you start to realize that the CDO maybe shouldn't be rated investment grade. There does start to be a skilled labor problem when you own or need to buy dozens or hundreds of bonds though, and rating agencies are supposed to solve this by doing this work for you.

On the other end, you have immigrants and other people with a poor grasp of interest rates and a strong desire to own a house. Brokers were paid a commission to sell them mortgages for homes they might not be able to afford after the rate reset in 1-3 years, but hey, at that point they will be able to refinance. Now, when you refinance the mortgage broker gets another fat commission, but surely that wouldn't affect their selling habits.

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Re: Explain the credit crunch to me.

Postby PhilSandifer » Fri Oct 10, 2008 10:28 pm UTC

ThomasS wrote:Regarding the origins of the crisis, a real error was in the statistics of the rating agencies, and the reliance of many many banks and institutions on those ratings.

If you have 1000 mortgages in the pool, and if the odds of one going bad is something like 10% and if the recovery when you foreclose is at least 50%, then a 5% loss is likely, and a 10% loss is rather unlikely. So set it up so that 20% of the bonds lose money first and are junk and 80% only lose money if the junk is gone. Obviously that 80% are investment grade. I mean, how could the best bonds possibly get hit? I mean, simple statistics shows that the odds of the investment grade paper taking a loss is minuscule. Absolutely minuscule.


This isn't really what went wrong with the model. What went wrong with the ratings model was that the loss rate was mis-estimated because they were assuming continual increases in housing prices. And as long as the house appreciates in value, a seller who is behind on the mortgage can just sell the house, pocket the appreciation in value, and move on tens of thousands of dollars richer. So the risk of someone falling behind on their mortgage was considered small, because for the most part if that happened the owner would have every incentive to just sell the house and pocket a profit instead of foreclosing. As a result, all mortgages were good investments! Magic! (You're absolutely right about the conflict of interest here)

The problem is that housing prices stopped rising, so that easy escape vanished. People were now stuck in houses that were worth less than the value of their mortgage, and getting behind on the mortgage. And so foreclosures were happening at a wildly higher rate than the model predicted, and the securities turned to junk.

But the central problem was the assumption that housing prices would always rise.

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Re: Explain the credit crunch to me.

Postby qinwamascot » Sat Oct 11, 2008 1:55 am UTC

I'd watch this to try to understand it more (and it's highly comedic). It's basically that the people were making assumptions like that the housing prices would always increase. This is objectively idiotic but historically there was evidence of this. When money stopped coming in from the mortgages because of sub prime lending, investors realized that the mortgages they were holding on to basically had no value, and the markets collapsed because of this.
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Re: Explain the credit crunch to me.

Postby mrandrewv » Sun Oct 12, 2008 6:39 pm UTC

................................................

So basically Terry Pratchett was right all along: modern economics is a stage magic.

The money will always be there, as long as no one ever CHECKS to make sure the money is there ;)

Anyway I think I understand it alot better now. It seems that my understanding was right, but only told a small part of the story.

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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Sun Oct 12, 2008 9:25 pm UTC

I don't think any modern economist has ever said that economics is anything other than stage magic.
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Re: Explain the credit crunch to me.

Postby qinwamascot » Sun Oct 12, 2008 11:55 pm UTC

EdgarJPublius wrote:I don't think any modern economist has ever said that economics is anything other than stage magic.


I think most would agree with you that modern economics is all about show and not grounded at all. My Macro professor certainly would.
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Re: Explain the credit crunch to me.

Postby VannA » Mon Oct 13, 2008 3:55 am UTC

Why do you think Prachett wrote "Making Money"?

In any case, Yakk has highlighted why this is 'stage magic' is necessary, along with the other people explaning the short-term loans/capital market.
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Re: Explain the credit crunch to me.

Postby Yakk » Mon Oct 13, 2008 3:35 pm UTC

Another way of looking at it.

What is cash? Cash is an agreement that you will be ... compensated ... for whatever you just sold/gave up/did by some third party. If it wasn't some abstract third party that was doing the compensation... then you'd call that debt. A promise of later 'repayment'.

Cash is debt, in a very fundamental way.

In the current system, cash is created by debt. Every (nearly) dollar out there is the product of somebody somewhere promising "I'll do something for someone else". When you make this promise to a bank, you get a loan from the bank. Your loan debt is the amount you promised you'd do for someone else (and it grows over time if you don't fullfill it), and the cash is the promises from _other people_ that you get to call in.

Some people are promise-rich -- they hold a large number of promises from other people (cash) to do things for them.

Some people are promise-neutral -- they owe about as many promises as they are owed.

And some people are currently in the red -- they have promised to produce things for other people in the future more than they have promises.

Now, holding onto a promise without having it do anything is pretty silly, especially when you can find people who will buy your immediate promises and give you a few more in the future. A classic method of doing this is to buy a bond -- a promise that, in the future, you will get more promises than you have right now. In exchange, the seller gets promises to use _right now_ on whatever they want.

This is all buying and selling of promises -- but eventually, you take your promise-cash, and find somebody who can produce something you want (say, you need an office building built). You give that person the promises in exchange for their building the office building.

Each person that produces actual wealth looks around for people who have promises to exchange for the actual wealth they are creating, because strait barter is really crufty. Now, somebody whose promises are credible can simply go to a bank (the arbitrator of credibility), say "I want some promises to buy that actual wealth _right now_", and promise to pay somebody back for that privilege at some later time. This is known as getting a loan from the bank.

Having said that they need to collect X excess promises to pay off the loan (and then interest, if they take a long time), they now have X promises to give you for your wealth right now. What is backing those promises? Eventually, the promises of the person you bought from, and the bank which issued the loan.

After all, what happens when the bank loans promises to someone who doesn't repay the bank? The bank has to repay those promises! Thank is what bankruptcy is, or defaulting on a loan. You could have chosen to make a deal directly with your customer, where they say "I'll owe you the value of the office building", but then you wouldn't have the bank-backing on the promises.

The wonder of the loan and cash system is that this is abstracted. You get cold, hard cash (or the electronic equivalent). There is no trace saying "these are promises generated by person Y, then backed by bank X, then backed by investors W and Z". Instead, the bank issues debt, and if it goes 'bad' they have to write it off of their books and make an equal amount of promises disappear. That disappearing act is the bank paying for the promises that the defaulting borrower isn't paying off! (or, it is finance-teleported to the actual outstanding promise notes that the bank issued when it made the loan) No tracking down of which specific unit of cash the bank is backing needs be done -- by erasing it's own cash, it justifies an equal amount of cash owned by somebody, somewhere.

Now, guess what happens if the bank doesn't pay out on the promises they have outstanding -- ie, enough people go bankrupt, and the bank owes more in promises to other people than the bank has in promises? In some cases, the government is left picking up the tab (FDIC in the USA). In other cases, the last person to say "I want my money back" from the bank picks up the tab.

This triggers runs on banks, and nobody wants to be on the hock for Bank promises. So when a bank is seemingly in trouble, nobody wants to lend the bank their promises. A bank can never seem to be in trouble until it is too late. This ... sucks, because in dangerous times, you start expecting banks to lie.

What is scary right now is with interconnected promises between banks (different kinds of promises!), and a misvaluation of a bunch of securities (aka, the banks/finance companies payed out dividends/salary that they couldn't actually afford to in the past), there is a fear that a large number of banks are insolvent.

So what the hell do you do with promises you hold, but don't have a use for right now? Banks are supposed to be the ones who broker "promise now for promise later". In many cases, you buy up US government debt, which is backed by the collective promises of the entire USA.

So you have a massive downward pressure on the price of US bonds. Debt, right now, is dirt cheap for the US government.

You could also turn your US promises into non-US promises... but somebody still holds those promises!

Backing up a sec, let's look at what happens when a Bank really goes under.

You have a Bank with reserves of 1 billion dollars, and outstanding loans of 10 billion dollars, and deposits of 5 billion dollars.

All of a sudden, every loan goes bad. Every one of them stops paying any money, and there is no expectation that any of them can pay in the future.

The Bank probably has insurance against that -- but the insurance companies are also under water.

The depositors demand their money: but the Bank only has 1 billion dollars in cash. It pays the first people to ask, and the remaining 4 billion dollars ... well, the bank says, "I don't got no more promises".

It does have 10 billion dollars in loans which have defaulted. And 4 billion dollars in deposits.

Even if the deposits are all erased -- the money goes poof -- the economy still doesn't balance.

Every asset the bank owns is sold -- buildings, it's very name, etc -- and another 4 billion dollars is raised. It pays off it's depositors. (It expected to be able to make more, but ... the price on what it owned dropped sharply!)

Now it has 10 billion dollars in loans which have defaulted. That 10 billion dollars is ... well, worthless debt. 10 billion extra promises where just added to the world economy.

Who pays those? Either the government generates debt to pay it, or you have more promises out there than people who agreed to repay them.

The bank might instead sell off it's assets. It then has 5 billion dollars in deposits, 5 billion dollars in cash, and 10 billion dollars in loans. It erases 5 billion dollars in cash, bringing it down to 5 billion dollars in deposits and 5 billion dollars in loans. It then says "yo deposit people -- you are on the hock. Sucks to be you.", and the bank folds with balanced books.

Now, I think, no excess promises where created.

...

Note that the above is not the view of an insider to the banking system, but rather the view of someone who has some tangential education making (I hope) half-decent guesses.

The idea that cash as promissory notes is, however, fundamentally sound.
One of the painful things about our time is that those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt and indecision - BR

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Re: Explain the credit crunch to me.

Postby SpiderMonkey » Mon Oct 13, 2008 4:04 pm UTC

The cause of the credit crunch is, clearly, insufficient attention being paid to the speakers pet ideology.

It is one of these events which denies simple explanation, and thus many people are inclined to cobble together a few events which happen to coincide in time and have a connection to the credit crunch and try and link to them into what is essentially a conspiracy theory about how a broad lesson in favour of the speakers worldview can be learned by all. Like the 'free market' or not (I am not a great fan) - its a too complex a system to be completely explained in soundbites.

So don't listen to them. If the stock market were as simple as such people make out, the person who can so clearly see the lines of cause and effect that determine where the Dow closes would be on a yacht spanking a playboy bunny, not chatting on some Internet forum to the likes of you.

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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Mon Oct 13, 2008 7:52 pm UTC

Why? Does his yacht not have an internet connection?
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Re: Explain the credit crunch to me.

Postby SpiderMonkey » Tue Oct 14, 2008 1:07 pm UTC

EdgarJPublius wrote:Why? Does his yacht not have an internet connection?


I'm sure it does, but who would want to use it?

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Re: Explain the credit crunch to me.

Postby Ixtellor » Tue Oct 14, 2008 1:20 pm UTC

I am pressed for time, and read a few good answers, but let me add this very important factor.

As long as housing prices were going up rapidly, it was irrelevant who you gave a homeloan too.
A minimum wage worker could buy a $300,000 home in California. Make 1 or 2 payments, then start defaulting (You get 3 months usually), then 5-6 month from the time of purchase sell the home for $325,000 or MORE.
Thus the bank wins because of the fees and 100% interest payments that it received for 2 months = pure profit, and still have the entire note paid off after the home is sold.
The poor person wins, because the sell price might still result in a small profit in addition to having a credit report that shows the successful buying and selling of a home.

If you move slightly up the socio-economic scale to the lower middle class, the profits for both the bank and the buyer are greatly increased as they can live 'house poor' for 6 months too a year, then sell the home at a whopping increase. So the bank gets several months of pure interest on a million $ loan, in addition to all the fees, and the buyer walks away with a very large check and improved credit.

In essence, everyone went into the deal knowing the buyer could not afford the home. But it didn't matter, because rising home values would solve all the problems.

The financial meltdown began the very day that homevalues started to level off. Which put all these Adjustable RAte, piggyback, 2/28's, and other mortgage schemes, into total chaos.


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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Tue Oct 14, 2008 9:10 pm UTC

SpiderMonkey wrote:
EdgarJPublius wrote:Why? Does his yacht not have an internet connection?


I'm sure it does, but who would want to use it?


Who wouldn't?
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Re: Explain the credit crunch to me.

Postby SJ Zero » Wed Oct 15, 2008 9:26 pm UTC

These are all pretty extreme walls of text.

Here's my simplification:

1. Some banks gave loans to people that couldn't afford it.
2. Those banks managed to make short-term profits on those loans.
3. An entire industry called "house flipping" arose around taking out loans you couldn't afford, adding a grand or two of parts and labour, and making tens of thousands of dollars of profit from idiots who took out loans they could afford even less.
4. Banks trusted these loans people couldn't afford and mixed them in with the loans people COULD afford.
5. The housing market finally died a screaming death because the final people were left holding the bag, and couldn't afford to pay back the loans they couldn't afford.
6. Suddenly the loans people couldn't afford were losing banks millions of dollars. The loans were going to collections, the banks got the houses back, but the banks weren't able to sell the property for as much as the loans were for, so they lost tens or hundreds of thousands of dollars on each single loan.
7. Suddenly, banks were afraid to lend money to ANYONE, not just people who couldn't afford it.
8. The government came in and gave a trillion dollars to the banks to bribe them into making credit easy to get again.

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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Thu Oct 16, 2008 3:21 am UTC

SJ Zero wrote:These are all pretty extreme walls of text.

Here's my simplification:

1. Some banks gave loans to people that couldn't afford it, because the government told them they had to.
2. Those banks managed to make short-term profits on those loans, because otherwise they would have collapsed immediately.
3. An entire industry called "house flipping" arose around taking out loans you couldn't afford, adding a grand or two of parts and labour, and making tens of thousands of dollars of profit from idiots who took out loans they could afford even less.
4. Banks mixedthese loans people couldn't afford in with the loans people COULD afford, so they could make money and not collapse immediately
5. Suddenly the loans people couldn't afford were losing banks millions of dollars. The loans were going to collections, the banks got the houses back, but the banks weren't able to sell the property for as much as the loans were for, so they lost tens or hundreds of thousands of dollars on each single loan.
6. The housing market finally died a screaming death because there were so many foreclosed homes on the market prices couldn't be maintained
7. Suddenly, banks didn't have any money to lend to ANYONE, not just people who couldn't afford it.
8. The government came in and gave a trillion dollars to the banks to buy all the worthless loans they made the banks give out in the first place.

Fix'd in italics

EDIT:
I hate it when people (not necessarily you SJ zero) try to make this out to be the fault of 'The Free Market' when the whole reason banks were giving out debt-backed securities was to keep them afloat after the government told them they had to give loans to unqualified people. the free market is the reason we didn't have this collapse 20 years ago. Granted, that probably would have been better for everyone involved since it would have happened before Automatic Credit Evaluation software hit the market and their would have been far fewer subprime loans, the housing market wouldn't have collapsed as much as it did because there would have been far fewer foreclosed houses on the market to drive prices down.

That's another thing that I hate, when people talking about the credit crunch are like 'and then the housing market collapsed' the housing market collapsed because of the credit crunch, not because the housing market was built on fairy tales, people tend to forget that real estate is just as controlled by supply and demand as any other market. Normally though, supply of real-estate generally decreases (there is only so much land to go around) During the credit crunch though, with thousands and tens of thousands of homes being foreclosed and getting put back on the market, suddenly supply dramatically increased.
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Re: Explain the credit crunch to me.

Postby Yakk » Thu Oct 16, 2008 5:39 am UTC

EdgarJPublius wrote:That's another thing that I hate, when people talking about the credit crunch are like 'and then the housing market collapsed' the housing market collapsed because of the credit crunch, not because the housing market was built on fairy tales, people tend to forget that real estate is just as controlled by supply and demand as any other market. Normally though, supply of real-estate generally decreases (there is only so much land to go around) During the credit crunch though, with thousands and tens of thousands of homes being foreclosed and getting put back on the market, suddenly supply dramatically increased.
So, a house is a means to produce the good called "shelter", for the most part.

An alternative way to get a nearly equivalent shelter good is .. renting a comparable house.

During the bubble (and it was a bubble), the price of owning and renting diverged. Rent prices barely moved, while house prices (and mortgage payments on the house, even after low interest rates) skyrocketed.

This is a sign that something strange and drastic is about to happen. Either (A) rent prices have to go through the roof, or (B) house prices have to collapse.

The housing bubble was built on fairy tales. A large portion of it relied on an exponentially growing rate of housing price to fund paying for itself, while the fundamental good (the shelter) that the house produced wasn't increasing in value exponentially. It was a classic bigger idiot bubble (Buying this house only makes sense if somebody else pays 10% more for nearly the exact same house).

Earlier part quoted:
I hate it when people (not necessarily you SJ zero) try to make this out to be the fault of 'The Free Market' when the whole reason banks were giving out debt-backed securities was to keep them afloat after the government told them they had to give loans to unqualified people. the free market is the reason we didn't have this collapse 20 years ago. Granted, that probably would have been better for everyone involved since it would have happened before Automatic Credit Evaluation software hit the market and their would have been far fewer subprime loans, the housing market wouldn't have collapsed as much as it did because there would have been far fewer foreclosed houses on the market to drive prices down.

http://www.newamerica.net/blog/asset-bu ... -mess-3210
One of the painful things about our time is that those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt and indecision - BR

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Re: Explain the credit crunch to me.

Postby phlip » Thu Oct 16, 2008 6:34 am UTC

I want to say thank you to everyone in this thread... my job is pretty close to the mortgage industry (I write software for mortage brokers), but while I understood the coarser concepts of the crash, a lot of the details had escaped me (being outside the US, and thus feeling all the effects second-hand anyway, didn't help).

But thanks to this thread, I think I've got a much better grasp on what's going on now. And I'll definitely be checking out all these links when I get home.

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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Thu Oct 16, 2008 6:55 am UTC

Yakk wrote:
EdgarJPublius wrote:That's another thing that I hate, when people talking about the credit crunch are like 'and then the housing market collapsed' the housing market collapsed because of the credit crunch, not because the housing market was built on fairy tales, people tend to forget that real estate is just as controlled by supply and demand as any other market. Normally though, supply of real-estate generally decreases (there is only so much land to go around) During the credit crunch though, with thousands and tens of thousands of homes being foreclosed and getting put back on the market, suddenly supply dramatically increased.
So, a house is a means to produce the good called "shelter", for the most part.

An alternative way to get a nearly equivalent shelter good is .. renting a comparable house.

During the bubble (and it was a bubble), the price of owning and renting diverged. Rent prices barely moved, while house prices (and mortgage payments on the house, even after low interest rates) skyrocketed.

This is a sign that something strange and drastic is about to happen. Either (A) rent prices have to go through the roof, or (B) house prices have to collapse.

The housing bubble was built on fairy tales. A large portion of it relied on an exponentially growing rate of housing price to fund paying for itself, while the fundamental good (the shelter) that the house produced wasn't increasing in value exponentially. It was a classic bigger idiot bubble (Buying this house only makes sense if somebody else pays 10% more for nearly the exact same house).


The Bubble was built on the decreased availability of housing as Automated Credit Evaluation and Sub-Prime loans allowed record numbers of people to buy homes, drying up the market and driving prices up.
With more people able to buy houses, why would rental prices go anywhere? Fewer people wanted to rent more available units, if anything, rental prices would have begun to go down if the housing bubble hadn't collapsed.


Yakk wrote:Earlier part quoted:
I hate it when people (not necessarily you SJ zero) try to make this out to be the fault of 'The Free Market' when the whole reason banks were giving out debt-backed securities was to keep them afloat after the government told them they had to give loans to unqualified people. the free market is the reason we didn't have this collapse 20 years ago. Granted, that probably would have been better for everyone involved since it would have happened before Automatic Credit Evaluation software hit the market and their would have been far fewer subprime loans, the housing market wouldn't have collapsed as much as it did because there would have been far fewer foreclosed houses on the market to drive prices down.

http://www.newamerica.net/blog/asset-bu ... -mess-3210

Not a direct refutation of yours, but a decent look at what happened in light of CRA: http://mises.org/story/2963
Personally, I don't think CRA was as directly, or completely responsible as DiLorenzo does, but it was a catalyst (among others) for an increase in poor loan practices.
Without CRA and related pressures to make subprime loans profitable over longer periods of time, the sub prime market would have collapsed before ACE made it possible to approve ridiculous numbers of subprime loans, the housing bubble would have occurred years earlier and been much smaller, and when it burst, the effects would have been minimal..
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Re: Explain the credit crunch to me.

Postby Yakk » Thu Oct 16, 2008 2:02 pm UTC

EdgarJPublius wrote:The Bubble was built on the decreased availability of housing as Automated Credit Evaluation and Sub-Prime loans allowed record numbers of people to buy homes, drying up the market and driving prices up.

Making it possible to buy something doesn't mean people buy it. Without the decision to buy, there would be no bubble.
With more people able to buy houses, why would rental prices go anywhere? Fewer people wanted to rent more available units, if anything, rental prices would have begun to go down if the housing bubble hadn't collapsed.

Did I say rental prices would go up?

I said that either rental prices would go up, or prices would come tumbling down.

As demonstrated by the current market, there was an alternative to rental prices going up.

Many things utterly unrelated to the housing boom could have driven rental prices up -- hell, it could still happen. If the USA creates inflation via a loose credit policy that applies to nearly everything except housing prices, the price of rent could easily increase to the point where housing prices aren't ridiculous.

The reason I used the term bubble is because it was a speculative bubble. At some point, someone has to say "it is worth buying this house at the terms presented", and someone else has to say "it is worth selling this house at the terms presented". If housing prices where on a firm foundation -- if the houses produced a shelter good that was cheaper than buying rent -- then you could have had a ramp-up in housing prices such as we saw without a crash at the end (or a change in the price of rent).

Saying that something is "a speculative bubble" before it crashes requires more than "the demand outpaced supply". You can have steep cost growth without it.

However, there are very few mechanisms out there to directly short housing prices, shorting is extremely dangerous thanks to the unlimited downside problem, and predicting when a bubble pops is difficult even if you think there is a bubble.

Yakk wrote:http://www.newamerica.net/blog/asset-building/2008/no-larry-cra-didn-t-cause-sub-prime-mess-3210

Not a direct refutation of yours, but a decent look at what happened in light of CRA: http://mises.org/story/2963
Personally, I don't think CRA was as directly, or completely responsible as DiLorenzo does, but it was a catalyst (among others) for an increase in poor loan practices.
Without CRA and related pressures to make subprime loans profitable over longer periods of time, the sub prime market would have collapsed before ACE made it possible to approve ridiculous numbers of subprime loans, the housing bubble would have occurred years earlier and been much smaller, and when it burst, the effects would have been minimal..

Mate, with the growth of NINJA loans, you can't blame automated credit evaluation. (No Income, No Job, no Assets).

You can make subprime loans nominally profitable (even if it isn't worth the opportunity costs) -- hell, you can have a healthy banking sector even if it loses some money on subprime loans (this does require that it make up the money elsewhere).

But at some point, you had people stating that large numbers of securities where AAA-level when they where shouldn't have been.
You had people creating liar loans for customers, cashing them in, and then walking away with the money.
You had people buying liar loans and letting others cash them in, often personally cashing in the sale.
You had a huge non-transparent market of securities develop outside of any infrastructure.

None of these are required by the existence of subprime loans.

What you did have is a ridiculous amount of credit, desperate to find someone who is willing to accept it, and desperate for higher return.
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Re: Explain the credit crunch to me.

Postby EdgarJPublius » Thu Oct 16, 2008 7:10 pm UTC

Yakk wrote:
EdgarJPublius wrote:The Bubble was built on the decreased availability of housing as Automated Credit Evaluation and Sub-Prime loans allowed record numbers of people to buy homes, drying up the market and driving prices up.

Making it possible to buy something doesn't mean people buy it. Without the decision to buy, there would be no bubble.
With more people able to buy houses, why would rental prices go anywhere? Fewer people wanted to rent more available units, if anything, rental prices would have begun to go down if the housing bubble hadn't collapsed.

Did I say rental prices would go up?

I said that either rental prices would go up, or prices would come tumbling down.

As demonstrated by the current market, there was an alternative to rental prices going up.

Many things utterly unrelated to the housing boom could have driven rental prices up -- hell, it could still happen. If the USA creates inflation via a loose credit policy that applies to nearly everything except housing prices, the price of rent could easily increase to the point where housing prices aren't ridiculous.

The reason I used the term bubble is because it was a speculative bubble. At some point, someone has to say "it is worth buying this house at the terms presented", and someone else has to say "it is worth selling this house at the terms presented". If housing prices where on a firm foundation -- if the houses produced a shelter good that was cheaper than buying rent -- then you could have had a ramp-up in housing prices such as we saw without a crash at the end (or a change in the price of rent).

Saying that something is "a speculative bubble" before it crashes requires more than "the demand outpaced supply". You can have steep cost growth without it.

However, there are very few mechanisms out there to directly short housing prices, shorting is extremely dangerous thanks to the unlimited downside problem, and predicting when a bubble pops is difficult even if you think there is a bubble.


Americans like owning their shelter. fiscally it may make more sense to rent, but with the availability of loans so high, why not just skip a step and buy a home off the bat?
For that matter, why not buy a second home and flip it for a profit? the high availability of subprime loans is what made the housing bubble possible. When the loan market collapsed, so to did the housing market. The two were intrinsically and fundamentally related.
Yakk wrote:
Yakk wrote:http://www.newamerica.net/blog/asset-building/2008/no-larry-cra-didn-t-cause-sub-prime-mess-3210

Not a direct refutation of yours, but a decent look at what happened in light of CRA: http://mises.org/story/2963
Personally, I don't think CRA was as directly, or completely responsible as DiLorenzo does, but it was a catalyst (among others) for an increase in poor loan practices.
Without CRA and related pressures to make subprime loans profitable over longer periods of time, the sub prime market would have collapsed before ACE made it possible to approve ridiculous numbers of subprime loans, the housing bubble would have occurred years earlier and been much smaller, and when it burst, the effects would have been minimal..

Mate, with the growth of NINJA loans, you can't blame automated credit evaluation. (No Income, No Job, no Assets).

You can make subprime loans nominally profitable (even if it isn't worth the opportunity costs) -- hell, you can have a healthy banking sector even if it loses some money on subprime loans (this does require that it make up the money elsewhere).

But at some point, you had people stating that large numbers of securities where AAA-level when they where shouldn't have been.
You had people creating liar loans for customers, cashing them in, and then walking away with the money.
You had people buying liar loans and letting others cash them in, often personally cashing in the sale.
You had a huge non-transparent market of securities develop outside of any infrastructure.

None of these are required by the existence of subprime loans.

What you did have is a ridiculous amount of credit, desperate to find someone who is willing to accept it, and desperate for higher return.
[/quote]
I agree completely, CRA didn't create subprime loans and subprime loans didn't create the credit crunch.
CRA helped popularize NINJA loans, reduced the ability of banks to deny unqualified borrowers, and removed regulations that prevented some predatory lending practices in exchange for, of all things, increased lending to unqualified borrowers (I.E. predatory lending practices >.>)
Meanwhile, ACE made it easier and easier to get NINJA liar, and other subprime loans, prolonging and worsening the problem.

The current economic problems are really something of a perfect storm, numerous factors all came together at one time to cause the housing bubble, allow it to grow to sizes that should have been impossible, and then bust it right at the peak with massive credit failure
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Re: Explain the credit crunch to me.

Postby theferrymantune » Thu Oct 16, 2008 7:14 pm UTC

AMERICAN DREAM-DELUSION DEBT & DEATH
This explanation contains some dirty words and disturbing pictures. But it's refreshing perhaps. :P
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Re: Explain the credit crunch to me.

Postby Yakk » Thu Oct 16, 2008 7:46 pm UTC

Americans like owning their shelter. fiscally it may make more sense to rent, but with the availability of loans so high, why not just skip a step and buy a home off the bat?
Americans like owning homes when the homes increase in value exponentially.

Remove the expectation that the house price will go up, have the homes cost you 1.5 to 2 times as much as rent after taxes, and see what happens?
For that matter, why not buy a second home and flip it for a profit? the high availability of subprime loans is what made the housing bubble possible. When the loan market collapsed, so to did the housing market. The two were intrinsically and fundamentally related.

Because that relies on _the price of housing going up_, and barring a fundamental increase in the value of the produced shelter, a sustained increase in housing prices requires hyper-inflation.

And yes, a speculative bubble requires money to speculate on the bubble?

The current economic problems are really something of a perfect storm, numerous factors all came together at one time to cause the housing bubble, allow it to grow to sizes that should have been impossible, and then bust it right at the peak with massive credit failure


Except, of course, that such speculative bubbles are the norm, and not the exception.

There is an entire school of economic thought that blames the tendency for economies to cycle on exactly that thing -- that people get used to good times, and presume it will continue forever, increase their exposure to risk in order to generate really good returns (but the only risk is if the entire economy slows down, right?), and ... then the economy slows down, and everything collapses.

And, it turns out, you can demostrate how the people who get the dividends during the bubble can rig the game so that people who don't play the bubble pay more of the costs, and that the bubble players reap more of the rewards.

We need to fix the bubble/crash tendency, and make sure that playing a bubble fucks you over, so the bubble-players will have incentive not to cause a bubble. Otherwise, bubble/crash will continue, until society doesn't have the resources to pick up the after the crash.
One of the painful things about our time is that those who feel certainty are stupid, and those with any imagination and understanding are filled with doubt and indecision - BR

Last edited by JHVH on Fri Oct 23, 4004 BCE 6:17 pm, edited 6 times in total.


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