Saurabh has this tongue-in-cheek remark about the recent demise of free market capitalism
If you screw up, it is your problem. If you screw up big time, it is your boss’s problem. If you screw up really well, big time, for a long time and make a lot of money in the process, the US Fed will take care of you.
The US government (or, more accurately, taxpayers) will take ownership of all bad investments that no one else is willing to buy. These investments that the US will buy will be financed by more debt ($700 billion worth). So the Fed is going to print even more money. The dollar, therefore, ought to depreciate. Given the perverse state of the world financial system with freely floating currencies, it is not likely that other currencies will appreciate much either. So what else is left? Gold, oil and commodities?
At the end of the day, here is how history will record the events of the last 10 years:
- The Fed printed tons and tons of money and increased the money supply (M3). They even stopped publishing the numbers of how much money supply is increasing.
- A lot of this money found itself going to pump bubbles – first the dot com bubble of the late 1990s and then the real estate bubble
- The banking industry professionals (some of whom may lose their jobs in the 2008 financial crisis) made tons and tons of money in the process. The firms made money by making bad loans, the employees of these firms made money in record bonuses
- Here is how the money making machine worked: financial institutions made loans to borrowers who had a snowball’s chance in hell to repay. They made money in mortgage fees and also when they sold these loans by repackaging them to other investors. Real estate prices were soaring, so no one cared about the ability to repay (they thought prices were always going to go up, so even if the borrower defaults on the loan, the principal can be recovered through foreclosures). The ability to repackage mortgage loans helped “socialize” the risk. Credit rating agencies gave AAA ratings to these repackaged securities and much of the blame falls on them for not identifying the risk inherent in the bubble. Long story short, mortgages turned into securities that were packaged, repackaged and sold God knows how many times to God knows who. The terms credit default swaps and collateralized debt obligations (CDOs) are used in this context.
- The money they made during the boom financed by the loose monetary policy was actually based on poor investments. Starting August 2007, it became clear that the investments were poor. A large percentage of loans were not going to get repaid because borrowers did not have the ability to pay.
- The real estate bubble stopped inflating, started deflating. Since house prices were falling and mortgage defaults were rising, it became clear that the packaged and repackaged securities based on mortgages were not AAA and were of dubious value.
- No one knew what the value of these securities was. Banks are required to mark their investments and assets down to market every time they release results. A huge portion of their investments were in these securities. The market for these securities tanked and no one was able to trade these securities. There was no way of knowing what these investments were worth. Banks guessed every quarter what these might be worth and every quarter their notional “value” kept going down. So every quarter, banks and other financial institutions holding these securities announced losses.
- The credit market tightened as banks were reluctant to lend to each other – they didn’t even trust other banks because no one was sure how deep the others are in this mess.
- To avoid the freezing of credit market, the Fed reduced interest rates. This was a bit bizarre because the problem was caused by loose monetary policy in the first place. In any case, the loose monetary policy created a new bubble – this time in the commodities market. There was a brief food crisis where prices of key food items like rice went through the roof. The price of oil and gold skyrocketed.
- In 2008, things finally came to a head and several banks failed – Bear Stearns, Indymac, Lehman Brothers. The insurance company AIG also had to be rescued via a US government bailout of $85 million.
The government is now proposing to create a $700 million fund to buy these securities that no one in the private sector is willing to buy because no one knows what they are worth. Some politicians are also proposing that the government use this new power that they will get through their bailout to help “struggling homeowners”. It is strange that renters are not up in arms about using taxpayer money (theirs and homeowners’) to
- Bail out financial institutions – their shareholders and, more importantly, executives who get severance packages in the millions of dollars
- Buy securities at a price presumably higher than what the market price (there is no market price because no one is willing to buy them)
- “modify existing mortgages to make them more affordable” – essentially rewarding people for buying more house than they can afford.