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October 6, 2008

Explaining the Credit-Crisis: Why The Bailout Won’t Work

Filed under: Uncategorized — alex @ 12:27 pm

from breadwithcircus.com

People don’t seem to understand the conditions that have led to what is being called the “Credit-Crisis.” I’ve been doing a lot of research on this and I think that I have a pretty good handle on what really happened here, so I’m going to try to explain it in a way that people unfamiliar with the disastrous practices of Wall Street can easily understand. Its complicated, but bear with me.

First, banks and other agencies began issuing what have been called sub-prime loans. These were mostly mortgages with really low interest rates. The loans were structured so that the people who took them out would have very low payments for the first eighteen months or two years of the agreement, but much higher payments after that. In many cases these loans were given to people who had no income, no job, no assets, and no ability to make payments once the higher rates kicked in. However, because of the time-lag between the issuing of the loans, and the day when payments would inevitably stop, firms realized that they had a brief window of opportunity to turn temporarily valuable loan papers into billions of dollars.

Enter the Collateralized Debt Obligation. (CDO) Firms would carve the sub-prime loan debts that they owned into pieces and repackage them as a product called a CDO. A CDO would have little slivers of all sorts of different loans pieced together. A CDO might consist of 1% of Mary’s second mortgage on a house in San Diego, 1% of Manuel’s car-loan in Atlanta, 1% of Mohammed’s mortgage on a house in Kansas City, and 1% of the money that Acme Widgets Inc. borrowed when they wanted expand their factory in Pittsburgh.

Even though the firms knew that many of their loans would and could never be repaid, because of the time-lag between when the loans were good and when they went bust, the firms could temporarily list their CDO’s as assets. Because of this, it was in the interest of firms to issue as many dodgy loans as possible, in order to create as many CDO’s as possible, in order to hold as many assets as possible. Firms began buying and selling their CDO’s and using them as collateral when taking out loans of their own.

Enter the Credit-Default Swap. (CDS) Firms holding CDO’s made deals with highly-rated firms. (Companies with good credit ratings like the now nationalized AIG) The small firm would pay the bigger firm to co-sign with them on a very large loan, often from a privately owned bank called the Federal Reserve. The small firms would list the income they were making on their CDO’s as collateral, and then make a payment to the large firm for their golden signature. Having a large firm with a good credit rating as co-signer, dubious firms were able to borrow at astronomical rates, in some cases at a ratio of up to 40 times of what the CDO’s were (temporarily) worth. Big firms saw windfall profits through their ability to sell their signature to smaller firms. Smaller firms borrowed tens of billions of electronic dollars at low interest rates from the Federal Reserve Bank, among others. The stocks of the firms involved in the scheme went through the roof as they were able to show massive amounts of money on their balance sheets. A handful of CEO’s made billions of dollars.

Now the chain reaction. The time-lag has caught up to us, and the higher payments on the sub-prime loans have kicked in. People can’t make these payments, so one of the slivers in a CDO package, then another and another becomes worthless. The value of the CDO is compromised, but the firm who holds it had already borrowed an astronomical amount of money against it. With nothing coming in from these now worthless CDO’s, firms holding them no longer have enough income to make payments on their debts. Since the smaller firm can’t meet its debt obligations, the company that co-signed the CDS deal with it has to pay. The larger firm, which has made many CDS deals finds themselves owning the debts of many smaller firms, and they have to “write-down” their profits. Stock prices dive and some firms go bankrupt while others are nationalized.

Now the final piece. These large firms are the ones who have been lending money to regular people, regular businesses, and your bank. Perhaps your RRSP or 401K has put part of your life savings into some of these firms’ stock. Now the big firms can’t make loans anymore, they have diverted all of their assests to making payments on the bad debts they hold. It is all that many of these firms can do to avoid going bankrupt themselves. One fails, then another, and the problem is compounded. There is very little money available now for people to get a loan to do anything at all, from buying a house, to sending their kids to college or buying new infrastructure for their businesses.

The suggested solution to this problem has been for the US treasury to give troubled firms a “bailout”, but that’s not even going to come close to solving the problem. With interest factored in, there are tens, or maybe even hundreds of trillions of dollars worth of bad debts out there. The bailout, if it were passed, would do very little to the solve the problem, though perhaps it would delay the inevitable collapse of the credit markets until after the US election. Personally I think that the bailout is just a scheme for Bush to loot the treasury as a parting gift to the US…he did this to the other companies he bankrupted earlier in his career. A better option than the bailout would be for the US government to nationalize the Federal Reserve Bank, but that’s a discussion for another day.

Really, things are way worse than the media is letting on. Wall Street bet your house and mine, and now everybody loses. There are some monumental days in our near future. The entire financial system is about to be re-organized. Think of the last days of the Soviet Union. It could only be a matter of weeks before the American System comes crashing down. If this happens, try to remember that the money being played with is actually an illusion, and that troubled times will pass. On a positive note, the destructive ideologies of the “Free-Market” and “Neo-Liberalism” are about to be completely discredited. I hope that whatever financial system rises up from the ashes will be more principled, transparent, and equitable for everyone.

1 Comment

  1. Thanks Alex.
    Lets hope We can throw the dirt over Bush Neo-liberalism for the very last time,this time.

    Comment by Rainlander — October 6, 2008 @ 12:52 pm

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