Can someone explain the financial crisis to me?

[Tenure]

Look, I understand it in a disperete way. There's a little bit on the CRA sitting over on this side of my brain, another bit on inflation of the money supply, another little bit tucked away somewhere on previous warnings of what the Federal Reserve would do, some cob-webs catching a few bits of lint of Freddie and Fannie's remains... it's all very disintegrated, and I don't have a very good understanding of what's going on.

I'm wondering if anyone has compiled a list of blogs/news articles that one could work through progressively to get a better understanding of what happened, why it happened, was it just to do with mortgages, what exactly is being done and what should be done?

I've found 'Crucible and Column', 'Rule of Reason' and 'Noodlefood' to be the big three for me, in sifting out the important details, but even that leaves it still to complex and disorganised, because I have to go sifting through a ton of articles, remebering a bit here and there, trying to piece it together.

I believe part of my confusion also stems from a lack of understanding of how markets work. Kendall, for example, has a brilliant grip on how businesses work, why bankruptcy and liquidation (which I still don't exactly understand) will help the crisis move along, what needs to be done and why it would work. But I just have a real derth of information and knowledge.

I want to defend the free market, and I know that the only way we can win is on moral grounds, but when I can't give a good, competent argument, or explain cohesively why the markets need to be regulated, in concrete terms, it undermines my attempts to tie it all back to the fundamental efficacy of free-market economics - that free men will make the right decisions (or face the consequences).

[adrock3215]

I feel like I have a pretty good working knowledge of the crisis, without particularly technical details.

Although I don't really know where to start. The problem is not the result of any one particular concrete issue, rather the result of many many things. However, you can divide blame up as follows: The largest problem is fiat money. Under that overarching umbrella fall the derivative problems: the existence of Fannie and Freddie, the various politically-motivated legislations to increase "affordable housing", the market-distorting FDIC deposit insurance, and the heavy-handed regulation of the entire banking and financial services sectors.

Morally and philosophically, you can blame the entire crisis on altruism. It is the doctrine of altruism that has lent credence to all of the above issues.

[Tenure]

So, fiat money I think I understand. That's when money is no longer based on an Objective Value, like, I don't know, Gold? Or at least, only a fraction of the gold. That's fractional reserve banking right? Only it's done by a central bank, rather than private bank. So the worth of the dollar is inflated to cover the desires and needs of the government - like making sure more people have paper money in their hands, or their accounts - and it is placed on the tab of the tax-payer (not the one who needs that extra money, but the one who doesn't, the rich taxpayer).

Eventually, a bubble bursts, and in the correction of that bubble, it is realised there is more paper money than there is objective value. There is objective value somewhere, but the paper money is far above the real value. Eventually, the market falls, until that real worth of the fiat currency is met.

Am I right so far?

[EC]

Am I right so far?

Yeah, now add on that the government encouraged people to buy homes that they couldn't really afford and began thus eventually began defaulting on, and you pretty much have the makings of this "crisis". Now take all those government errors and add a trillion dollar intervention via the "bailout" and you have the mess that we have today.

[D'kian]

I recommend Robert Tracinski's article in Real Clear Politics: http://www.realclearpolitics.com/articles/...he_bailout.html

A point that's worth repeating is that as the housing bubble burst, government kept interfering to keep it from doing so. That obscures the financial situation and prevents the market from acting. But this merely hides the true problem and lets it grow unatended. So when the crash innevitably comes it's much worse than it would be otherwise. Imagine there's a fire in the room, and instead of callinf the fire department or using an extinguisher on it, you lock the door so it won't be seen. Innevitably it will burn through to other ooms, and by then it is too late to limit the damage.

[adrock3215]

So, fiat money I think I understand. That's when money is no longer based on an Objective Value, like, I don't know, Gold? Or at least, only a fraction of the gold. That's fractional reserve banking right? Only it's done by a central bank, rather than private bank. So the worth of the dollar is inflated to cover the desires and needs of the government - like making sure more people have paper money in their hands, or their accounts - and it is placed on the tab of the tax-payer (not the one who needs that extra money, but the one who doesn't, the rich taxpayer).

Eventually, a bubble bursts, and in the correction of that bubble, it is realised there is more paper money than there is objective value. There is objective value somewhere, but the paper money is far above the real value. Eventually, the market falls, until that real worth of the fiat currency is met.

Am I right so far?

Fiat money is, quite simply, paper money that is declared legal tender by government fiat. The value of a fiat currency is the "full faith" in the issuer's ability to levy and collect taxes from its citizens at some future date.

The problem with this setup is that it creates malinvestment. This is the central idea of Austrian Business Cycle Theory. By fixing interest rates, the Federal Reserve simply controls the price of money. We would stand up in outrage to price controls on cars or computers, but we sit in silence every day while the Fed fixes the price of money. The price of money is, in essence, the value people place on time. By keeping interest rates low, and floating more dollars in the economy than are warranted by productive output, the Fed distorts the perceptions of market participants. For instance, an entrepreneur would be warranted in thinking that there is more aggregate savings available for investment than there actually is. Therefore, he is likely to spend time investing in an enterprise that would not actually be feasible, were it not for the excess supply of dollars in the economy. In this manner, fiat currency misdirects investment to non-productive and non-value creating enterprises.

[stonebuddha]

One of the best articles on the matter is here. Though written in 1969 it is very timely and explains in clear, simple terms the cause & cure for the boom/bust cycle.

[Thales]

George Reisman, I'm sure you've heard of him, is an Objectivist economist.

This article should help. Hope it's not too technical:

Our Financial House of Cards and How To Start Replacing It With Solid Gold

The first paragraph:

A credit crisis has been spreading through the economic system.[1] It began with the collapse of the housing bubble, which was the result of years of Federal-Reserve-sponsored credit expansion. This credit expansion poured hundreds of billions of dollars into the purchase of homes largely by sub-prime borrowers who never had a realistic capability of repaying their mortgage debts in the first place. And, not surprisingly, large numbers of them in fact stopped making the payments required by their mortgages.

[Tenure]

Fiat money is, quite simply, paper money that is declared legal tender by government fiat. The value of a fiat currency is the "full faith" in the issuer's ability to levy and collect taxes from its citizens at some future date.

I believe I understand this. There is the dollar, which has a certain amount of actual, objective value. However, the value of the dollar that we see in the market has more inside it than just its actual objective value - this is the inflation going on*. As the government wants people to spend more, believing spending, not production, drives the economy, they inflate the money supply, so that people can spend more (on the assumption that, as people can spend more money, they'll invest it in things which will produce more objective value).

In theory, they believe this will mean more people invest mo' money in good businesses, making things mo' better. However, since people are spending money untied to actual productive capacity (and, if I understand you, covered on the basis that should the dollar fail, tax dollars [which incidentally, have been inflated anyway, surely?] will make up the loss) they end up investing in things they wouldn't otherwise invest in.

It's like if I look at the salary for a job, make plans for my budgeting, going ahead financing a car and mortgaging a house, all the while ignorant (let's assume I'm a liberal College graduate) that what I'll actually be paid a 20-30% reduction for tax. A few months down the line, I'm unable to keep up payments, because I invested money in something I couldn't afford, based on the assumption that I had more value to put up than I actually could.

I can understand why this means people may invest more than they would otherwise, but not why it would go into bad markets. I mean, yeah, they might say, 'Woo! Yesterday I had $1, now I have a buck fifty!', but they may just go on and just buy a larger loaf of bread, rather than buying their normal needed food along with a ton of ice-cream that they wouldn't normally get. This would lead to a bubble in one area, but it wouldn't explain the focus of bubble in one area.

So what's needed to explain our current situation, are things like the CRA, right? Along with low interest rates on mortgages (is this what you mean by the Fed controlling 'interest rates'? I always get confused on that, whether it means bank rates or the rate of inflation) and the CRA, people 'invest' more money into properties they couldn't otherwise get, piling all this monopoly money into one place, until when that bubble pops, it doesn't just bring down the housing market, but the whole dollar...

... Am I getting it right?

As for the links, D'Kian, Stonebuddha and Thales, thank you very much. It's 22:14 here, so those are set up for me to read over breakfast tomorrow (and to probably spit up back in anger over what I find out about the government doing).

*This confuses me - the rate of inflation is made public every year, so can't we just adjust for it and publicise that the money is still only worth a certain amount? The government claims we all have more slips of money, but we know the truth of how much it's really worth, surely?

Edited October 6, 2008 by Tenure

[softwareNerd]

I think the best way to describe this to someone who is unfamiliar with the way banks etc. work, is to begin with the more immediate and the non-controversial, rather that starting with the theory and principles. (This runs the risk of beginning with the "too obvious", but no matter.) With that intro...

Right now, the direct pressure on financial firms comes from the following (related) sources: firstly, borrowers are defaulting more than usual; secondly, the current expectations of default are higher than they were (say) 2 years ago. Both these (the real loss and the expected future loss) are nearly as "real" in accounting terms: i.e. they cause accounting losses. When companies make profits and do not pay it out, their capital goes up; when they make losses and do not get new funding, their capital goes down.

You might have seen various stories in the news about banks raising fresh capital. Banks all over the world have been raising new capital for a while now. However, at some point new capital will not be interested. That is the point at which a company has to declare bankruptcy (unless someone "rescues" it).

This is a checkpoint. You should resolve questions about the above before going on to ask two follow-up questions:

• why did the borrowers and their banks etc. get into this situation?
  
• what to do about it?
  

[Thomas M. Miovas Jr.]

I think when it comes to inflation, it is important to keep in mind that not everyone using the dollar has a clue as to what its future worth will be in terms of buying goods and services. If you were a really good economist, and you had all the right information, you could probably predict what inflation would be; but most often, the man on the street knows its effect because prices go up -- i.e. each dollar is worth less than the ones before it, so each one buys less products and services.

I agree that fiat money made this mess possible, because if the government, while loaning money to the banks, had to transfer real wealth (either gold or money backed by gold) then it wouldn't happen so easily -- remember, we are running at a deficit, which means the government has no money to loan out. What they do is sneak in freshly printed money (on paper or via electronic transfers) into the system, devaluing the dollar, which effectively makes everyone using the dollar pay X% interest on every dollar.

Now here comes the crux of the current problem. You, the bank, has money to loan out for housing. The government says you must loan out some of it to people who cannot afford to pay the principle, especially with interest. If your bank refuses to go along with this, you get fined per customer denied and you won't get your government loan to continue operations. A lot of your cash gets tied up in bad loans, loans you were forced to make and that you cannot retract (foreclosure) without government approval. However, you are not too worried about this, because all houses are going up in price -- partially from inflation and partially from increased demand via the governmental force. So, if you do have to foreclose, some of that house has already been paid for, you take it over at a fraction of the price you had to pay for it, the price goes up, and you sell it to someone else making a huge profit, even though you had to foreclose on it. To top it off, the housing building industry is booming as new houses are built left and right to meet this artificial demand. It all works pretty smoothly until too many people begin to default because of inflation and adjustable interest rates -- i.e. they could pay out $1000 per month, but they can't handle $1300 per month.

Now the banks have lots of houses they have foreclosed on that they cannot sell, because so many new homes are on the market, and the supply has met the new demand (the artificial demand), and because of this backlog of new and foreclosed homes, prices begin to fall dramatically. It was a ponzie scheme that could only work so long as the artificial demand was there -- and once that is gone, the whole system goes to pieces. As prices where going up, demand rose, because buying a house now made sense, since it would cost more a year down the road. Once prices begin to fall, people wait for a better bargain before buying. So, the banks can no longer count on people buying foreclosed homes at a profit to the banks. Instead of long-term assets, they become long-term deficits -- and the banks are running out of money to lend out, which is how they make their living.

It may sound like 5%-10% default isn't all that much, but when you realize banks only charge something like 5% interest, they don't have a huge profit margin in terms of percents. When times are good, we make much more profit than that in the picture framing business. A few defaults hurt us, for sure, but so long as business is good, we can take the loss. For banks, a few percent profit doesn't go very far; and when times go south, they don't have any cash to lend out.

So, it was a combination of factors, mostly brought about by government edict, that distorted the housing market until there was way too much supply out there. And now that markets are coming back to where they ought to be in a free market, the government wants to step in because housing prices are falling, destroying their ponzie scheme, and making house values fall like a brick, similar to the recent stock market plummets. If you own a house, it might be worth one third what it was a year ago, which has not only a psychological effect, but a real effect on one's personal credit worthiness, so the credit markets tighten. They no longer want your house if you default on their loan to you, and money gets jammed up in the system.

However, since the recent Emergency Economic Stabilization Act of 2008 doesn't solve any of these factors, it might be a while before your credit worthiness based on your house means much to the banks. So, the Fed is going to inject more fiat money into the system to give banks cash for their bad loans, which will set off another inflationary spiral and a boom somewhere along the lines, that will likewise come crashing down.

[adrock3215]

Tenure: The value of the dollar is subjective and is determined by peoples perceptions of the financial health of the US economy. Currencies trade in free and open markets just like stocks and bonds do. In such markets, hundreds of millions of market participants buy and sell dollars and other currencies every day according to any number of reasons. The price of a given currency is determined by the supply and demand equilibrium found in those foreign exchange (forex) markets. For example, suppose you travel from the eurozone to America. In order to do business in America, you will have to sell your euro bills and buy dollar bills. This transaction is performed in the forex market, and your order to buy dollar bills will exert upward pressure on the price of dollar bills. (Any time you buy a good, you make it less scarce, and therefore you exert upward pressure on its price. The opposite effect is achieved by selling a good.) At the current moment, dollars are valuable because the business of the world is done in dollars. Barrels of oil are denominated in dollars, and the lowest risk investments on earth (US government bonds) are also denominated in dollars.

The Fed intervenes in this market by shifting the supply curve of dollars.

There is actually a really good, to-the-point post on the topic of business cycleshere on our own forums by GreedyCapitalist. I think it is a good introduction to the distortions caused by the manipulation of the supply of money.

[source]

Now here comes the crux of the current problem. You, the bank, has money to loan out for housing. The government says you must loan out some of it to people who cannot afford to pay the principle, especially with interest. If your bank refuses to go along with this, you get fined per customer denied and you won't get your government loan to continue operations.

Please, let me just make sure that I got this right - in the US, right now, banks get fined by the government per customer denied?

In any case, this is exactly what I was looking for. Great post, Thomas.

Thanks!

[Laure]

Please, let me just make sure that I got this right - in the US, right now, banks get fined by the government per customer denied?

In any case, this is exactly what I was looking for. Great post, Thomas.

Thanks!

No, I haven't read anything to the effect that banks get fined per customer denied. I spent some hours reading about government involvement in banking a few weekends ago, and it is way, way more complicated than that. Take a look at this article, which is testimony of a "community organizer" who is actually advocating more stringent enforcement of the CRA. His ideological slant aside, you can learn a lot about the situation by reading this:

*on "Fair Lending" enforcement*

(Oh, by the way, don't take this man's testimony at face value. There is a point at which he indignantly mentions a bank that had a written racially discriminatory policy for approving loans. I looked it up, and the bank was actually favoring minorities in order to do better in its CRA audits!!)

Edited October 7, 2008 by Laure

[Thomas M. Miovas Jr.]

Please, let me just make sure that I got this right - in the US, right now, banks get fined by the government per customer denied?

Yes, it is called the Community Reinvestment Act (CRA), signed into law in about 1977 by Carter and refurbished in 1995 by Clinton. In 1977 it was more of a suggestion, in 1995 Clinton put teeth on it by making it a fining offense of something like $10,000 per customer denied. It's tied to the bank rankings who are under the FDIC program. If they loan out to people to get houses and if they do not loan out to low income customers or minorities, they can not only lose their ranking as good banks, but will also be fined $10,000 per customer denied. It also carried with it an implied guarantee of those loans by the Federal government, since they were imposing this on banks. This created the artificial housing bubble / boom that I related to earlier.

I don't know the full details, and some banks were able to comply without getting too hurt by defaults, but the implied guarantee led some banks to greatly overextend their assets to risky borrowers.

It's not the whole cause of our current crises, but it was a major factor.

The justification for this Federal intrusion into banking practices was the altruistic idea that people -- even poor people -- have an implied right to a house, even though they cannot afford them. So the altruists didn't care if the banks were driven broke, so long as poor people got their homes. This is why no one in politics today wants to reverse the CRA, because it would mean that poor people could no longer buy homes, and denying that would require heroic rational selfishness on the part of banks and politicians.

[Laure]

Yes, it is called the Community Reinvestment Act (CRA), signed into law in about 1977 by Carter and refurbished in 1995 by Clinton. In 1977 it was more of a suggestion, in 1995 Clinton put teeth on it by making it a fining offense of something like $10,000 per customer denied. It's tied to the bank rankings who are under the FDIC program. If they loan out to people to get houses and if they do not loan out to low income customers or minorities, they can not only lose their ranking as good banks, but will also be fined $10,000 per customer denied....

Thomas, do you have a reference for this? I can't find anything on a per-customer fine.

[gags]

Please, let me just make sure that I got this right - in the US, right now, banks get fined by the government per customer denied?

That isn't exactly the case. If a bank "discriminates" against mortgage applicants based on geography (called "redlining") and certain other criteria, then they can be subject to fines and/or class action lawsuits from groups like ACORN. For example, if a bank doesn't want to lend in a certain neighborhood because the housing stock (which is their collateral for the loan) is sub-par, they can be accused of discrimination if certain groups are the predominant residents of that neighborhood. If the bank is found to have "discriminated", then there is the possibility of fines, lawsuits, and other penalties. Note that the meaning of the term "discrimination" is left deliberately vague to give regulators the maximum amount of discretion in going after banks.

Given that Fannie Mae and Freddie Mac (two government sponsored entities) facilitated the sale of sub-prime mortgages in the secondary market, it became much easier for banks to lend to people with poor credit. Once the loans were made, they were then sold off as mortgage backed securities (MBS) and purchased by banks, corporations, investors, etc... These mortgage backed securities were given strong credit ratings by a couple of firms that have a virtual monopoly on the ratings system, thanks again to government intervention in the ratings market. Given that MBSs paid a premium to various other types of debt and were highly rated by the credit agencies and in many cases carried an implicit government guarantee, lots of capital poured into this secondary mortgage market. This had the effect of making it possible for banks and mortgage companies to make even more money available to subprime borrowers. When this flow of capital was combined with artificially low interest rates, the two helped to create a large bubble in real estate prices.

The needle that popped the bubble was the fact that many of these mortgage backed securities began to have a much greater incidence of default than was originally thought and their credit ratings and their values were downgraded substantially. As these assets (held on the balance sheets of major banks) decline in value, banks have a reduced ability to lend and must also go out and find additional capital. For some highly leveraged investment banks (which are not "banks" in the normal use of that term) the decline in the value of these MBS assets was enough to wipe out the value of their equity, causing them to go bankrupt or be bought out by larger, stronger firms.

This entire disaster would never have been possible without the market distorting intervention of the government.

[D'kian]

*This confuses me - the rate of inflation is made public every year, so can't we just adjust for it and publicise that the money is still only worth a certain amount? The government claims we all have more slips of money, but we know the truth of how much it's really worth, surely?

It's not that simple. Remember the amount of wealth is not static. Therefore while inflating the monetary supply lowers a currency's value, increased production raises it. Determing an accurate rate of inflation and an accurate rate of loss of purchasing power, are difficult propositions at best.

The best way to understand inflation is to live through a period of high inflation. Low inflation is like having a cold. it's a nuissance and it costs you some money, but it doesn't keep you from doing whatever you want to do. High inflation is like being laid up with pneumonia. It's serious, potentially fatal, it costs a lot of money and it rpevents you from doing much.

Mexico had a period like that in the mid-80s, with the inlfation rate topping out at about 150%-160% (comapred to South America that was mild). One consequence was the loss of purchasing power. For example, salaries were indexed to the minnimum wage, which was indexed to inflation. All wages went up a certain percentage each month, but prices and costs rose more often than that, so there was no keeping up. Besides, the rate of inflation is an average. As price increases go it reflects a general trend, not specific increases. So maybe food went up by 20% in a given month, but everything else only 0.1%, and the inflation rate is, say, 4%. The problem is plain to see.

BTW it cracks me up when discussing an objective currency, those favoring fiat money will often tell horror stories of 1) increased gold production and 2) attempts by governments to "thin" gold coinage. They never realize they experience that same thing in paper money every day and in a greater proportion than the things they find firghtening.

[Steve D'Ippolito]

"thinning" gold coinage is indeed a hazard, but it typically doesn't take long until someone notices. (It's hard to "fake" gold because of its density. Back when platinum was cheap it was sometimes used for this, at today's prices it would be a favor.) Once people become aware of the debasing of gold by the government, they take it into account pretty quickly.

In other words gold coinage would make it easier to detect these shenanigans than it is with paper.

[Thomas M. Miovas Jr.]

Thomas, do you have a reference for this? I can't find anything on a per-customer fine.

It took some research, and I am not a lawyer, but the text of the CRA itself does not mention fines, but banks must comply with other regulations, that include the $10,000 fine per denial.

Community Reinvestment Act, FDIC Rules (nothing explicit about fines or punishments):

http://www.fdic.gov/regulations/laws/rules/2000-6500.html

GAO Study

http://www.gao.gov/archive/1996/gg96023.pdf

Basically, banks were not volunteering to comply, so something had to be done to give them incentives, including rewards and fines.

Can't find specifics in the law that punishes non-compliance with fines, but many side bars referring to other laws.

This news article has a quote regarding the $10,000 fines tied to the CRA:

http://www.foxnews.com/story/0,2933,424945,00.html

Accepting these new criteria was hardly voluntary. The Fed warned the banks:

"Did You Know? Failure to comply with the Equal Credit Opportunity Act or Regulation B can subject a financial institution to civil liability for actual and punitive damages in individual or class actions. Liability for punitive damages can be as much as $10,000 in individual actions and the lesser of $500,000 or 1 percent of the creditor’s net worth in class actions."

Added on Edit:

As with other regulatory laws, it becomes a nightmare trying to understand if you are complying or not. You can read the text of the laws and not realize you will be held accountable for your actions in an arbitrary manner, because each regulation is tied to other regulations which are tied to other regulations, and one needs to hire lawyers to try to figure out what the hell will be your punishment for non-compliance.

Edited October 7, 2008 by Thomas M. Miovas Jr.

[Laure]

...This news article has a quote regarding the $10,000 fines tied to the CRA:

http://www.foxnews.com/story/0,2933,424945,00.html

Accepting these new criteria was hardly voluntary. The Fed warned the banks:

"Did You Know? Failure to comply with the Equal Credit Opportunity Act or Regulation B can subject a financial institution to civil liability for actual and punitive damages in individual or class actions. Liability for punitive damages can be as much as $10,000 in individual actions and the lesser of $500,000 or 1 percent of the creditor’s net worth in class actions."

Added on Edit:

As with other regulatory laws, it becomes a nightmare trying to understand if you are complying or not. You can read the text of the laws and not realize you will be held accountable for your actions in an arbitrary manner, because each regulation is tied to other regulations which are tied to other regulations, and one needs to hire lawyers to try to figure out what the hell will be your punishment for non-compliance.

So, just to clarify, there is no $10,000 fine per denial of loan. There can be up to a $10,000 fine for an individual action that goes against the Equal Credit Opportunity Act. They don't have to lend money to everybody, although from reading the text of the Act, that's certainly the easiest way to guarantee your compliance! Here is a link to the full text of the ECOA:

Equal Credit Opportunity Act

We can't pin the crisis on any one government action, but there are so many actions that have pushed and pulled us toward the state we're in.

[Thomas M. Miovas Jr.]

We can't pin the crisis on any one government action, but there are so many actions that have pushed and pulled us toward the state we're in.

That's a fair assessment.

It's the whole regulatory system that forces actions upon businessman that they would otherwise not do, and the rationale for that is often an altruistic "fairness" standard. But it is also the implied threat that gets businessman to act against their better judgment, and complying with regulations can drive a business broke, though it might take many years for that to happen. The Community Reinvestment Act was reinforced in 1995, and it took 12 years for us to feel the pain in the economy. As I have said before, though, a lot of businessman don't mind the regulations, or at least don't complain about them, because they are not fully for laissez-fare capitalism either. Without rules, the modern businessman wouldn't know how to deal with a free market, and prefer to have laws that they can claim they followed to the letter, even as they go broke. Sad to say, but short-sighted pragmatism has driven them to that. It would be rare for any one of them to make an outcry like Hank Rearden did in Atlas Shrugged. Of course, when one is at the mercy of unjust laws, what can you do when you are such a minority? I would say speak out, but then you might get the wrath of a regulator down your throat.

Edited October 7, 2008 by Thomas M. Miovas Jr.