Here are the headlines today: Fiscal armageddon. The worst crisis since the Great Depression. Entire economy in danger, Bush warns Americans. $700 billion rescue package in peril.
Over and over, we’re told our financial system is in an unprecedented crisis. But how did we get here all of a sudden? What went wrong? Can’t someone answer these questions in plain English?
I’m not an “expert” or even a financial journalist, but the experts are too busy writing about Sarah Palin, politics and God knows what to answer such a simple question from a rube like me. But I wanted to know. So if no one ever reads this, at least I’ll have some idea how I came to be standing in the bread line.
According to the Treasury Department, the root cause of this mess are “illiquid mortgage assets” that have lost value as the housing market collapsed and are now clogging up the financial markets and stopping the flow of credit.
So what, you might say. Fuck those greedy Wall Street assholes. Let the whole thing crash. Well, hold on, there, Mr. Outrage. Credit is the grease that allows the U.S. economy to run.
Let’s say you, Mr. Outrage, order pizza from Domino’s on your VISA card. It takes a while for Domino’s to get your money from VISA, and in the meantime, the company needs money to pay employees and order pepperoni, mozzarella and tomatoes.
Just like you, Domino’s doesn’t want to go to the bank every week and fill out forms and pledge collateral. So it borrows in what’s known as the commercial paper market. Commercial paper is essentially a system of short-term IOUs issued by banks and big companies like Domino’s. It’s grown into an enormous market, more than $2 trillion.
Right now, the commercial paper market is shriveling up like a vampire in the sun. It shrank by $100 billion in the past two weeks. If the commercial paper market keeps shrinking and Domino’s can’t find short-term cash, it might not be able to pay its employees. Like it or not, you rely on American companies every day. So, when you hear people say the economy will come to a halt, this is what they’re talking about.
Commercial paper used to be considered very safe and boring. The system worked just fine. But Wall Street can’t leave a good thing alone. It came up with a different kind of commercial paper. This kind wasn’t sold by Domino’s or other companies that actually made something. It was issued by banks, hedge funds, and investment banks. Lehman Brothers used to be one of the biggest issuers of commercial papers. And a lot of it turned out to be crap.
This crap was backed by credit-card debt, student loans and residential mortgages. Wall Street took your mortgage or loan and repackaged it with thousands of other people’s debts. Some of these mortgages were “subprime,” which is another word for junk.
It wasn’t sold as junk though. Through the magic of financial “engineering,” it was transformed into high grade AAA investments. How this happened is incredibly complicated and may involve things like tranches, CDOs, Gaussian copula models and credit-default swaps (which is how insurance giant AIG got into trouble). Suffice it say that only Wall Street can turn shit into gold.
Money market funds, which were also supposed to be as safe as cash, bought up a lot of this crappy paper. It was thought to be so safe that federal regulators allowed companies to keep it off the books. So that’s another problem: we don’t know who is holding this stuff. Or how much of it. And the stuff is so complicated that no one really knows how much it’s worth.
But the paper was only as safe as the mortgages it was based upon. And a home loan is only good if the homeowner is paying it off. As we know, a lot of people bought homes they couldn’t afford. So the banks foreclosed on those homes. Millions of homes. And this crappy paper, these “cash equivalents” started to have that not-so-fresh feeling.
Suddenly, nothing looked safe anymore. Reserve Primary, the money market fund that invented money market funds, “broke the buck” because it had a lot of suddenly worthless IOUs from bankrupt Lehman Brothers. That means that the $1 you invested in the fund was worth less than $1.
When $1 is worth less than a $1 you hoard your cash. You don’t buy crappy paper. You don’t lend to companies that may be holding a ton of it. The credit markets freeze up.
That’s what’s happening and that’s why everyone is freaking out.