The simple domestic chain reaction in the current financial crisis is outlined below. We're facing a systemic financial crisis; failure in one sector of the economy is spreading to the larger economy threatening a substantial reduction in aggregate economic activity.
Before outlining the chain reaction, some background. It didn't take an economist to know that this was coming. We've known that pronouncements about a robust economy were hollow, and reflect a phony Wall Street economy that has little in common with the
Main Street economy.
First, we knew the dot-com phenomenon was a bubble built on hype, and it burst. In the run up to the burst, dot-com seminars devolved to lessons on how to hype a product concept and cash out to a big firm.
Next, we watched the dot-com bubble-wealth run to stocks on Wall Street in a transparent irrational exuberance. That new bubble burst as the fraudulent practices of the corporate sector were exposed. All of the corporate sectors were in on it: Banks were financing bogus business activities, the consulting divisions of accounting firms were helping cook the same books being certified by their audit divisions, legal firms were helping corrupt clients wiggle out of the illegalities, the corporate media was singing the praises of the robber barons, and the good will of various civic organizations was being purchased with philanthropy from the corrupt corporations. This is all continues.
Third, after the Wall Street bubble burst, the accumulated wealth ran to real estate, triggering an upward series of self-fulfilling cycles of price increases. Laws to prevent predatory lending practices were gone and boundaries on who could finance real estate were lifted. The bubble inflated as people bought multiple properties on the back of cash from refinanced properties. Some of that activity was legitimate, and the profits were somewhat real... "somewhat" real, as long as the Federal Reserves' current struggle to bail out the financial institutions doesn't cause inflation that decreases the "real" value of those profits. You know you have a bubble when practically everyone is saying, "You know, I couldn't even afford to buy the house I'm now living in." That bubble is deflating. Where will the money run to create the next bubble?
So, what makes up the the chain in the real estate reaction?- Mortgage Brokers (not always the lender themselves)
- Mortgage Buyers/Bundlers (Create Mortgage-backed Securities (MBS - bonds))
- MBS (Bond) Buyers (e.g, Pension Funds, University Endowments, Hedge Funds, Banks use them as reserves)*
- Primary Dealers (21 large commercial banks that interact directly with the Federal Reserve and with whom large lenders deal)
How does the chain reaction work? First, the prices on homes are artificially inflated by excessive accumulated wealth and rules rigged to help an elite minority make more wealth off of the real estate market as described above. This is a failure of the capitalist system, which makes homes unaffordable even to middle income people, setting them up as scapegoats.
Second, mortgage brokers scam buyers into accepting exotic loans, such as interest-only adjustable rate mortgages (ARMs), assuring them that "This is common these days. It's just the way things work." The mortgage broker has no risk. He just takes a fee and never holds the mortgage. The lender only holds the mortgage briefly, usually selling it to the secondary market, experiencing no risk. The secondary market buys bundles of mortgages that are used as collateral on bonds known as mortgage backed securities (MBSs). These are sold to pension funds, endowments, and others, including banks that use them to meet their reserve obligations.
The risk associated with the mortgage is passed on so far from the the point of initiation that the system seemed designed for failure. Actually, it was designed by votes in Congress paid for by lobbyists whose clients knew they could make money off the system
before they knew it would fail. An insider's game. Yes, we could see what was coming, and we knew "the economy" was a
house of cards, despite what well-paid business pundits were saying on phony TV.
If you think this type of game is limited to real estate sector, think again. This same game has become the American way, according the a recent report by the US Comptroller General
comparing the United States to failing Rome.
But I digress...
Third, the buyer who, was scammed by mortgage brokers into taking a very risky mortgage, can't meet the payment; maybe the rate has finally adjusted on the ARM, or a health problem is limiting income and creating additional costs. They buyer becomes the scapegoat. The financial industry saw this coming and worked with both Republicans and Democrats in 2005 to toughen the US
personal bankruptcy law, contributing to the creation of what Warren Buffet calls a "debt peonage" society.
Fourth, as the "debt peons" fail to pay their artificially inflated mortgages, the owners of the mortgage backed bonds don't receive their regular dividends. Many large banks to own such bonds as part of their mandatory reserve. Not only are their reserves losing value, but in many cases, banks and others take out low interest loans to buy such bonds (a carry trade: low interest loan pays for higher interest investment and the difference is taken as profit). Without the income from the mortgage backed bonds, these banks and others can't pay their loans. It's a classic carry trade trap that has caused the failure financial institutions in the past.
In many cases, the lender who provided the loan for the mortgage bonds
also has debt payments to make, or has loaned out the same dollar 5 times as part of the leveraging that is implicit in fractional reserve banking (banks only hold a small fraction of hard money, or bonds, in reserve to back up their loans. They assume it is very unlikely for everyone to demand their cash at the same time. Note that some of that "hard money" is in the form of mortgage backed bonds...).
If the institutions caught in this kind of bind are big enough, there is a risk of a domino effect affecting the entire economy. It's already expected to happen, given layoffs of failed mortgage companies like American Home Mortgage, and First Magnus Financial Corp., and reduced purchases of hardware and home products associated with the exchange of home purchases, a large sector of the US economy. You know you have a crisis when the Federal Reserve steps in to give short-term loans in the hope that these chain reaction liquidity problems can be resolved. They buy bonds from primary dealers, who in turn make credit available to banks facing a liquidity crisis.
Macro-scale Liquidity CrisisThis is an example of a direct chain of liquidity crises at the micro economic scale among individual institutions. But there's also a macro economic liquidity crisis, which takes the form of less money available for loans. Recall above we mentioned that some banks use mortgage backed bonds as their reserves. The logic follows:
1. Much of the world's investments are in real estate and related financial instruments (MBSs), because of the historic real estate boom over the last six years. This means a lot of mortgage backed bonds are sitting in vaults out there, including as reserves (collateral to support loans).
2. As the value of these mortgage backed bonds declines, bank's reserves shrink. They can loan out less money, that is, credit liquidity shrinks on a macro scale.
Going InternationalThat's the domestic story for the US. The macro-scale story continues as the financial problems jumped the Atlantic and Pacific Oceans . That's a separate story.
