I am no economist. I am an Environmental Governance and Management Adviser. What I know about the economy is that companies are always 'on the brink of bankruptcy' when you ask them to comply to the law and treat their effluents and wastes properly, but always have huge dividends to pay out to their shareholders.
So I guess I know less than McCain about the economy.
What I DO know, if you want to fix a problem, you go and find the root cause for the failure. To find the fundamental reason for a management failure that lead to an environmental crisis, you gather as much information as you can, you define the problem, and you start asking WHY. You have to ask WHY at least 5 times, to get to the root cause of the failure. And THEN you address the root cause, and the problem is solved.
Please follow me over the jump, where I try to follow this method to explain the 'crisis' to myself, and arrive at my conclusion regarding the root cause:
So, I started to read some diaries here on Kos. Like here and here. And I googled, and I wiki'd. Until my head hurt. But I could not find a any explanation of what the 'fundamental cause' of this economic failure is, and exactly why a bailout is needed, and why it is needed so urgently. I will try and explain my understanding, with my Grade 9 accounting, as best I can, with the following as 'for instance':
How did it start?
Company A has $1 000 000.
It borrows $9 000 000 from an Investment Bank, Company B, who has read Company A's business plan, and understands the risks, and accepts it. Company B has shareholders, whose shares are used to fund this investment. (Some investment banks even own mortgage companies, making this easier, and creating, imho, a conflict of interest)
Company A then uses this $10 000 000 to finance a couple of middle class lenders (Citizen X's) to buy houses, at 10% interest per year. At $100 000 a house, it can finance 100 such citizens. For payback over 30 years, the interest makes it a great business opportunity.
Company A is assured of getting its money back, with interest, as each of these middle class people are hard working citizens, and pay their monthly installments. At $1100 per month, for 100 citizens, company A's monthly income is $110 000. In just ten months, it will have recovered its original investment of $1 000 000, and would have made a profit of $100 000, without calculating the interest. Lets say $50 000 of this profit is for Company A, and $50 000 used to pay back the Investment Bank.
In addition, the increased activity in house buying forces the market up, and each of these houses are now worth $200 000. Company A now has $20 000 000 worth of assets. As these houses come onto the market, they are sold to new buyers at the new price. This implies an monthly income of $220 000 for Company A, recovering its original investment in just 5 months, making a profit of $200 000. The investment bank gets $100 000 of this profit.
Instead of paying back its original loan to Company B, Company A borrows more money from the Investment Bank, using the mortgages of Citizen X's as securities. But at the inflated values. The Investment bank and its shareholders again considers the risk, and lends more money to Company A, who gets more Citizen X's to sign up. And the house market keeps rising.
In this speculative frenzy, house prizes keep going up. Citizen X's house, originally worth $100 000, is now worth $400 000 on paper. Citizen X goes to Company A to obtain a loan for $200 000 to start a small business, increasing his mortgage to $300 000. More money (from interest) for Company A...
So far, so good, I think. A classical ponzi scheme. In South Africa, its called a "Rotting Milk" scheme, for a good reason. But it gets worse than ponzi.
WHY did it get out of hand?
To keep feeding the scheme, Company A needs to sweeten the deal for the potential home owner. All kinds of attractive options are included with the home loan, and Citizen Xs buy houses that they barely can afford, at so-called sub-prime lending and adjustable rate mortgages.
Bloke helps me understand what happened next with hisdiary:
So why do we have a crisis? well its what happened to those mortgages after the new home owner signed the paper. Used to be that the bank who sold you the mortgage held your mortgage for 30 years as you repaid it plus interest, how quaint. This of course means that the bank had some self interest in making sure you could repay the money.
This process did slow things down and often the bank had to stop giving out mortgages, not because they ran out of qualified customers, but because they ran out of capital to lend. To over come this the option of unloading the mortgage to another bank was created hence we get Fannie and Freddie, they too purchased the mortgage for its duration and because they could borrow money a little more cheaply from other banks due to the implied (now explicit) government guarantee they made money.
Let me see if i get this: Company A sells the mortgages of its original 100 homeowners to another Investment Bank, Company D, who wants in on the easy profits. Instead of selling this 'mortgage package' for what it is actually worth to the Investment bank, it is sold for the 'FUTURE market value'. This creates value on paper, but it is not real value. It is virtual FUTURE value...
In addition, insurance companies get involved. They provide 'insurance' (called Credit Default Swaps)- credit derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad. Its a gamble. This article, states that its like taking a bet on which subprime mortgages will not be paid off, and if their bet succeeds (ie if someone fails and forecloses), they make huge profits. But according to Bloke , only 5% of the total US mortgage market is sub-prime. So, its not the subprime mortages that caused this astronomical deficit.
Because, they do not only issue this Credit Default Swaps against the current value of mortgages, they issue it against the FUTURE value of the mortgage. In addition, the Insurance companies provided these Credit Default Swaps to insure against the Investment Banks themselves going under... This created more 'value' on paper, but it is more 'virtual money', without real monetary value. AND, they started to trade with these Credit Default Swaps... using it as securities for yet more loans. So lots of people borrowed against the same $1 many times. Based on the value of $700 billion of the mortgages, the Credit Default Swaps is valued between $40 to $70 trillion...
This was made easier by the Gramm-Leach-Bliley_Act. Because of the swap-related provisions of the Act, a $62 trillion market became completely unregulated. From this point on, no one was accountable to ensure that the banks and hedge funds had the assets to cover the losses they guaranteed.
And then, the bubble bursts. House prices start falling, people to whom lucrative mortgages were given start to fail on payment, foreclosures start springing up all over. If one mortgage fails, held by Citizen X, and the property is sold at a loss of $100 000, it amounts to a $500 000 loss for the Investment Banks and Insurance Companies. The banks and insurance companies had filled their pockets with toxic paper that no one wants to buy. This link explains very well:
There is a risk that some entity E could purchased a CDS from insuring counterparty A (e.g. J.P Morgan Chase) insuring against a default on a bond bought from party B (e.g., Washington Mutual) and may not be informed that the insuring counterparty sold the CDS liability to counterparty C (e.g. AIG). If counterparty C (e.g., AIG) goes bankrupt, followed some time later by party B’s default, the insured counterparty E would have difficulty collecting what it was owed on the CDS, and might not have known that it should have been on the list of creditors involved in counterparty C’s bankruptcy proceedings.
This example is not trivial. Barclays analysts estimated in February that if a financial institution that had $2 trillion in credit-default swap trades outstanding were to fail, it might trigger between $36 billion and $47 billion in losses for those that traded with the firm. That doesn’t include the market-value losses investors face as the cost to protect companies against a default widens.[iii] So, assuming linearity, the bankruptcy of AIG could have resulted in between $7 billion and $10 billion in losses for its counterparties. Since investment banks are often leveraged at 20 to 1 or higher, the asset sales necessary to maintain a leverage of 20 to 1 could have been of the order of $140 billion to $200 billion.
Large commercial banks (e.g. JP Morgan Chase and Bank of America) use CDS as part of their risk management. However, many speculators, including hedge funds, use these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.[2] In times of market turbulence, such as we have seen recently, undercapitalized participants could have trouble paying their obligations. This perceived threat adds to the instability and lack of liquidity in the financial markets.
But, instead of shareholders of Investment Banks taking their risks and swallowing it, as they should, instead of the insurance companies making good on what they insured, they run to the government, and ask to be "bailed out".
WHY?
In July, Paulson said the root of the problem is that "some people took out mortgages they can’t possibly afford and they will lose their homes. There is little public policymakers can, or should, do to compensate for untenable financial decisions." This is a lie. and a Marie Antoinette approach...
WHY does the government even CONSIDER bailing these Companies out?
This is what makes my head hurt most. These Companies were greedy, they tried to make a quick buck, and they burned their fingers, because they wanted to make profit of virtual 'future' money. The 'money' they made is not real. It does not exist. It is not their's. They should take the loss.
But, we are told that,if the government does not 'rescue' the Investment Banks and the Insurance Companies, they will go on strike, and threaten bring the financial system to its knees and to trigger a global depression.
That partly true. These investment banks are not only players on the US market, they are global players. So their stocks are traded on the global market. Hence, greed on Wall Street is now causing a global economic meltdown. As stated here:
The interbank lending rate rise fed into the global stock market decline, as investors dumped financial stocks. On Tuesday, London’s FTSE 100 fell below 5,000 for the first time in seven years, with HBOS, Britain’s largest mortgage lender, seeing its shares plummet by 40 percent.
The Tokyo stock market fell by more than 4 percent, while in Paris and Frankfurt markets were down more than 2 percent. In Russia, the country’s main stock market halted trading after suffering losses of 11.47 percent.
and
In response to the deepening financial crisis, the Federal Reserve Board and its counterparts in Europe and Asia poured hundreds of billions of dollars in fresh credit into the economy. Between them, the Fed, the European Central Bank, the Bank of England and the Bank of Japan pumped $210 billion into the money markets on Tuesday in an attempt to prevent a seizing up of the global credit system. Central banks in India and Australia also carried out major injections into their banking systems.
However, it does not seem to explain to me the root cause of why the bailout is needed only in the USA, and not in the rest of the world. This brings me to my next question, which is the same as what inky ended a diary with yesterday:
Who are these people?
I have a lot of additional questions as well:
Why is the financial system 'at risk'?
What is this 'financial system'?
Who will win the most with this 'bailout'?
Who will lose if houses are 'devaluated' to current market value and mortgages adjusted accordingly?
To answer these questions, I did some more googling, wiki'ing and reading, and found that the institutions that failed to date, and who bailed them out makes for interesting reading, and share a common denominator:
<list>
- Fanny Mae and Freddy Mac - Mortgage Companies - bailed out by US Treasury and US Federal Reserve
- Bears Stearns - bailed out in March 2008 by US Federal Reserve via JP Morgan Chase, granting JPMorgan Chase an 18-month exemption from Fed statutes governing capital requirements in connection with the Bear Stearns acquisition
- Goldman Sacks - bailed out by AIG in August.
- AIG - Insurance Company - bailed out in September by US Federal Reserve, which means that both Goldman and AIG now owned by the Federal Reserve
- Morgan Stanley - auditors of Freddie and Fannie to be helped by Paulson's Bailout Plan
- Lehman Brothers - to be "helped" by the Federal Reserve and US Treasury in the Paulson bailout...
- The Lehman Bothers failure also affected millions of UK citizens, who are members of the Lehman Brothers UK pension fund, which is to be bailed out by the UK Barclays Bank, in a deal brokered by Credit Suisse, Deutsche Bank and JPMorgan Cazenove.
- HBOS (UK) - bailed out by Lloyds of London</list> in a deal brokeredby Merrill Lynch and Morgan Stanley.
In answer to the question WHO are these people, three names keep re-emerging: The Federal Reserve, Morgan Stanley, and Lehman... And this is ridiculous: Just last year, Wall Street’s top five financial firms — including names such as Lehman Brothers, Morgan Stanley and Bear Stearns — awarded $39 billion in bonuses at a time when stockholder value in those companies fell by $74 billion.
In July this year, the Federal Reserve announced that it will extend its policy to provide unlimited loans to mayor Wall Street Investment Banks. To illustrate what this means, this graph of the magnitude of the pre-bankruptcy assets of Lehman Brothers:
It seems to me, that these failing companies, were all rescued from going bankrupt, like they should have done, by intervention from the Federal Reserve. This is strange to me, because I was under the wrong impression that the US Federal Reserve was like the South African Reserve Bank, a arm of Government, which controls the rate at which loans can be made, and determines how much money that can be printed and be in circulation to prevent devaluation. It certainly does not bail out companies on the verge of bankruptcy to ensure financial stability.
This brings us to the next Question:
What does the Fed have to gain/lose, and, more importantly, WHO is the Federal Reserve?
Well, apparently the US Federal Reserve System is not government owned or controlled. According to Wikipedia, this is the structure of the Federal Reserve:
Most of the current members of Board of Directors have strong ties with Investment Banks, especially with Goldman Sacks, Lehman Brothers, and Morgan Stanly. Kevin Warch was a Vice Chairman for Morgan Stanley. This diary by turning makes the same point. The other members of the Board served the George W Bush administration proudly. And Henry Paulson used to be the CEO of Goldman Sacks...
The Wikipedia article also refers to the lack of transparency regarding the member banks and meetings of the Fed. The only reference I could find regarding this is here. Its an old article, but makes for interesting reading. Investment Banks such as Morgan Stanley, Lehman Brothers, and other interesting names appear there as comprising the shareholders of the Fed.
This made me read some more on the Fed. And it is in this research, I think, that I found the root cause of both the failure, and the reason for the "urgency" with which the bailout is required:
The Fed is facing bankruptcy.
WHY??
Because, as so well illustrated in gjohnsit's diary, the basis of the Fed's assets are no longer real assets, but are these very same Credit Swaps:
It would seem as if the magic figure of $700 billion, the 'bailout' needed for Lehman Brothers, is the same as the value of the securities held by the Fed...
Sagebrush Bob came to the same conclusion in this diary, which did not get much traction, but which contained a video in which Jim Jubak reported that the Federal Reserve started the year with about $800 billion in cash, and that it is down to below $200 billion, which could cause the US to lose it's AAA credit rating. Jerome-a Paris in yesterdays diary said that
The theory here is that the Fed has destroyed its balance sheet by taking on increasingly large chunks of non performing assets (the "toxic waste" made from mortgage-backed securities and the like) in exchange for loans of "real" cash to banks that may still end up not repaying them.
Although I did not understand this yesterday, what made me go sit down and figure this out was his question "whether the $1 trillion from the Paulson Plan goes to recapitalise the Fed as I suggest, or whether it goes into offshore flight capital before the criminal mafia in Washington and Wall Street flees the jurisdiction"?
I think, now that I understand this, the answer is simple.
Addressing the root cause, the potential bankruptcy of the Fed, will address the problem. The Fed should be nationalized. And the IRS with it. .
But not in a way that the government owns it. No. By giving each American Citizen shares in the Fed, to the value of $2500. Without them having to pay for these shares. This will create a buffer for the virtual money on which the deficit is based, and will clear the $700 billion deficit. It will also ensure that, as shareholders of the Fed, citizens will gain profit when the Fed is out of the mess, and profitable again. It is time government start working for its people, who are its prime funders. I hope this is what Barack Obmana had in mind when he said
If taxpayers are being asked to underwrite hundreds of thousends of dollars to solve this crisis, they must be treated like investors
at this press conference (at about 1:20):
The first step is to IMMEDIATELY remove all private banking interests from the Board of the Fed, and by appointing a new Board. And those companies who used to be on the board of the Fed, who caused this mess? Well, they wont need any bailout anymore. Their shareholders can also, as concession, get one of those $2300 shares. That's it. They can just go bankrupt, like they were supposed to, having made idiotic financial decisions. The new shareholders, the citizens, wont be hurt one bit by their bankruptcy.
And neither will the rest of the world.