khan’s understanding of the economy

Perhaps I’m being smug, but I think that the financial crisis is clouded in enormous mystery, when the problems are not actually that complex. And perhaps it’s because I’m not as smart as I think and don’t understand the situation. So, at the risk of being patronizing and/or revealing myself as a fool, let me outline the financial situation as I understand it. And I look forward to being corrected. Andy’s post is worth visiting on the political fallout. And I my colleague’s blog is helpful (he knows more than I about this stuff). In what follows I outline what I understand the problems to be, and what the solutions might look like.

(1) The problem is that mortgage securities have dropped in value because of the extension of bad loans and the decreasing likelihood of these loans getting paid back. In English, banks gave out bad loans. Those loans aren’t getting paid back. So the money given out is less than the money coming in.

(2) Banks and other financial institutions now have a higher than desirable debt load (in some instances more debt than capital).

(3) The pervasiveness of this problem of debit to capital means that there are few left in the financial industry to provide capital.

(4) It is this capital that the economy requires (hence the Paulson plan, and many “taxpayer check” models). So where is the capital to come from?

(5) The market solution has been for banks and financial institutions to sell off their debts.

(6) Insodoing they have made matters worse, as the flooding of the market with (bad) debt has lowered the price of such debts, and even other debts. So institutions find that while selling their debt, they’re actually loosing more money. They may be getting some capital, but perversely, the debt:capital ration can get worse.

The solution is quite clear: the state has to provide the capital required for the economy. No one else is in a position right now to extend money. The debate is over how this can/should be done.

The Paulson plan is basically that the US government buys up the bad debts. The advantages are clear:
(a) The value of such debts does not decrease the value of other, not so bad debts (the market is no longer flooded). So the debt:capital ratio goes down in two ways: (1) some debt is actually purchased, (2) the price of debts stops falling.
(b) And more importantly, there is now capital in the markets. Which is what is required.

But I agree that this plan is idiotic. It basically means the state buys the bad debt, creates incentives for poor financial decision making, and gives Wall street a pass. The state can have little expectation of getting paid back anything close to what it purchases the debt for. Hence, this is a “blank check” to the rich.

The (simple) solution is quite similar to the Paulson plan, but does something different (and this is in no way MY idea. I think a lot of folks are basically on board). Rather than buying the debt of institutions, it buys part of the institutions. This has several advantages:
(a) The gets capital into markets. This is part of what’s needed.
(b) Rather than buying up bad debt, the state buys up shares in institutions that incurred such debts.
(c) The state can have a reasonable expectation of return on its investment
(d) Oversight of financial practices can happen not just from outside, but from within firms (a long term advantage).
(e) Firms are not given incentives to act poorly.
There is one big disadvantage. At least as far as I can tell, it will be more expensive. The bad debts will still be there. And it will take more capital within the markets to solve the problem they create. But this plan will infuse markets with capital (reducing the debit:capital ratio). It will give the state wider oversight. And it will give the taxpayer not just the responsibility of writing a check and seeing the money disappear, but rather an not-so-unreasonable expectation of seeing a return on their bailout of the rich.

Paulson’s plan is basically a bail out. Main street gives money to wall street and hopes that it will eventually “trickle down” – the markets are saved and the people benefit from a better economy. Every ounce of understanding and intuition I have suggests that it won’t work out well for Main Street. The alternate plan is that Main street buys out Wall Street. I’m optimistic about this.

I think we should make signs. No Bail Outs! Only Buy Outs!

12 thoughts on “khan’s understanding of the economy”

  1. One more quick amendment: it’s not simply that financial institutions are unable to buy debts (a complete lack of capital). It’s also that they’re unwilling. Part of the basic problem is that debts have been packaged and repackaged. So when buying debt (which can actually be quite profitable) it is difficult to know WHAT you’re buying.

    Think of it this way: when you apply for a loan, you get different rates (if you’ve never applied for a loan, think about applying for insurance – some companies will charge you more than others for the same basic set of services). This is because different institutions calculate risk in different ways. No one is “right” – it’s just a balancing act. So if I’m a lender (or insurer) I construct a logic by which I grant loans wherein I take on some risks but not others (and am heavily profitable with some but not others).

    Imagine, though, if a third party came along (so not me, the lender, and not you, the lendee). And decided to buy up my package of loans, and other people’s packages of loans. And then this third party RE-packaged these loans, and sold them. And there are many of these third parties who do this again and again. Suddenly, it becomes more and more difficult to figure out what’s in any one of these packages of loans. Because though any one actuarial calculation is fairly transparent (how I, a lender, decide to give out loans), once you start combining and dividing, combining and dividing, it becomes quite complex.

    So firms are less and less willing to extend capital. Because they don’t know what they’re getting when they buy. So it’s not just that, “we’re out of money!” it’s that Wall Street has created a set of conditions where no one is willing to extend it.

    Again, the logic of the Paulson plan is: just extend the money. The logic of the alternate plan is: extend the money, but with expectations of two things back: (1) return, (2) say in what is done.

    I should add: I just read GradSchoolMommy’s post on this. She covers it quite well.

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  2. I think that this is a great summary, but I think that it misses one key step that is important for both understanding how we got in this mess and for what plan can save it and is where a lot of the confusion rests. I’ll call it step (1.5):

    Banks, after giving bad loans (because of deregulation allowing “subprime” borrowers–i.e. those borrowers with “less than prime” credit–to get money) then packaged these loans to sell as a bundles.

    The problem is in these new packaged bundles there are good loans (i.e. the borrower will pay back the money) and some bad loans (i.e. the borrower is going to default or foreclose). Because there are absolutely no regulations on either a) how banks are allowed to package these bundles, or b) how these bundles are to be rated as to their risk/reward payoff, no one knows what is inside any of these bundles. You could buy one with all good loans, or one with all bad loans, or most likely one in between with some good and some bad. The problem is that there is no way to assess which of these bundles is which. Hence, no one wants to buy them, which means that all of a single corporation’s capital (and soon to be all taxpayers’ capital) is tied up in things that may or may not have any value. That means that no one trusts any one else to be selling gold rather than lead…

    I think that this is where it gets complicated, but like shakha said, I don’t think it’s even that complicated. Although, I probably didn’t do much to help. My apologies if that’s true.

    It’s interesting watching this, though, because these bundles are nothing extremely new. In fact, some neo-marxian authors like David Harvey, have linked these kinds of financial instruments and Reagan-era deregulation of real-estate markets to the gentrification and redevelopment of many central cities like New York and London, not to mention the “Paper Tiger” real estate bust in Asia in the mid-1990s.

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  3. First, you are my hero. I have been saying for some weeks that this is not as complicated as it seems but you put it all out there very clearly.

    Second, you are totally right about buying the companies instead of giving them money. Duh.

    Third, any money given has to be overseen by more than one person and with some sort of oversight. Paulson wants his decisions not to be reviewable by any court or administrative agency. SAY WHAT?!?! I don’t freaking think so. Think how many reports you have for a $200,000 NSF grant (thank you for supporting my research, NSF!!) . . . I am just saying we typically demand some accountability when giving taxpayer money to accomplish some goal.

    Fourth, will Warren Buffet’s $5B infusion to goldman create optimism? I think so. Then there will be some breathing room and this proposal will go down or be substantially modified in the amount and in oversight. Just a prediction.

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  4. Oh, and fifth —

    This is a huge power grab for the executive branch in which the Treasury Department exists. Because GW Bush hasn’t stolen enough power from the Courts and from Congress already?

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  5. I think perhaps you are being smug. Actually not smug at all – totally reasonable, really – but also not spot-on. Housing was the catalyst, not the cause. It might be analogous (and I hope this is not in poor taste) to the observation that people don’t die of HIV, they die of pneumonia. But the cause is still HIV, so while it would be great to find better cures for pneumonia, it is not necessarily sufficient in an of itself.

    So, the crisis presents as a housing crisis, but I feel like it is more a crisis of financial alchemy overreaching the world it thought it was controlling (though that doesn’t really say enough, I know).

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  6. Amendment 1.75. Not only were the mortgages bundled, which is really a bigger problem in places like foreclosure hearings, they were then used as the equity basis for massive leverage, like 30:1 leverage for the institutions as a whole. That means that it only takes, say, 10 foreclosures out of 100 to wipe out your equity.

    Since historical foreclosure rates were small (3-4%) everyone thought this was hunky-dory. Hahahahahaha.

    This is the problem that all these institutions are having. Their capital position has been wiped out because of the leverage they piled on top of stupid investments. The credit default swaps only make it worse, amounting to even more leverage on the same securities (AIG was big in providing such swaps, never imagining that they would actually have to pay up).

    So, credit locks up. Option 1: recapitalize the banks by bailing them out so they can keep doing what banks do but at the cost of a massive lien on the future productivity of all of us.

    Option 2: recapitalize the homeowners that are losing their homes and that are the basis of all that leverage. This is the proposal that is not being discussed, but if FDR were around that’s what he would be doing (and did in his era).

    My .02

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  7. @7.mikemcq: right on on the capitalizing the homeowners instead of the banks!

    Also: what about, say, a 1% transfer tax on all assets that are never delivered materially, i.e., that involve the sale and resale of contracts as opposed to the stuff the contracts are for? We could put the proceeds in escrow for the next time the system needs lubricant.

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  8. Andy, Yes!

    Excellent idea, perhaps buttressed by a $.01 transaction tax on all stock, bond, foreign exchange, and mutual fund trades?

    Between them you could get a nice little nest egg going that punishes speculators more than investors.

    Alas, Paulson hasn’t called…

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