What the Hell Happened to Our Economy? (In Plain English)

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.

17 comments

  1. Linda L.

    Excellent…now explain to me how McCain can rewrite his history so as to appear virginal and pure of any misdeeds ever! The public sure has a short memory!

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  2. David S

    Great Seth. The message I took away is if we all leave off the pepperoni, Domino’s will have to borrow less money, we’ll eat less saturated fat and everything will be fixed. Right?

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  3. Scott Rubin

    Seth,

    Great work explaining commercial paper. Most people don’t get how credit helps operate all of the small and large businesses we interact with. Your work in this regard helps a lot. Here’s my rambling suggestion:

    Consumerism finally broke it big into cars, and homes, where the growing middle class could reach for it. It did it through the invention or creative placement of incentives for those who guarantee and provide credit. Incentives in the form of cash, for those who loan it out.

    The credit markets have been going through all sorts of gyrations in the last few years, and we could probably build a series of undergrad classes around them. How they operate. Who set them up. How they’re traded. How they’re marketed. Who wins, and loses.

    But back to the incentives. What I mean is, with the end of the last wave of wealth to blow through the middle classes during and after dot com, suddenly, there were neat new ways to buy houses. Creative financing. Additionally, car loans were getting longer and longer on their terms. When we live in a world when people want a new car every two to three years, how can we rationalize five year and longer car loans, or loans with balloon payments on the back end that will be twice the value of the car in any condition? In a world where the depreciation of cars is about as bad as it can get?

    Consumerists renationalized by the merits of another market – homes. Home equity was booming, but it was simply another market on the same trend as cars, just in a different phase; a different business cycle. The Consumerists saw it as the next wave to ride. Home equity would cover the bets on cars and crap with the House later. Pass me the dice; I feel lucky.

    But I passed on the incentive point again, didn’t I? What made the car loan idea worked was the same mechanics operating in the home business, in a way. The incentives were for the loan officers, the underwriters, and their bosses. I’m all for incentivizing a boring, administrative process, but there needs to be some limits. I lack the data at the moment, but I do recall reading stories about how loan officers were being given jobs at lightning speed, and their training had a hard focus: close the deal, get the commission. I recently read that at one major institution, people with bad credit on applications were sent to the “Art Department,” or an office where the borrower’s “story” could be creatively cleaned up, so they’d qualify. This kind of bureaucratic buffoonery only works when they watchmen themselves have found that they can benefit more from working the system than they can operating it correctly.

    Here’s the kicker: They did this in their own neighborhoods and they did it to their own friends and communities. The Man didn’t ride in on a steed and drop cash from his mount, with chains for Consumerists (or traditionally downtrodden Blacks or Hispanics) to wear when they weren’t looking. The people who cut the loans and made the deals live on my street, and work down the road from me in the nearest Countrywide building, or Local Title office, or at the car dealer. Sure, Wall Street, through financial instruments put it in place. But if credit is the grease of the commercial world, then my Consumerist neighbors have their hands on the controls of the machine that invents and eats credit. Go look at stories around Maryland’s own Prince George county – how the mortgage cum foreclosure story is a complete lesson. While some people want to cry out and say that this is yet one more rape of Washington DC’s most classically troubled county, I ask: Who marketed the homes? Who bought the homes? Who sold them the homes? Who cut the loans and titles for these homes? Who bailed out and ran? I suspect that one answer to all of those questions is: Prince George county residents, for the most part.

    It seems that this model of close-them-get-paid went far enough up the chain that the managers allowing shaky deals to go through were more on the Consumerism side of the line as opposed to the Safety-of-the-Business side of the line. I suspect that the market for incentives found a sweet spot in the hearts and souls of the spenders (I think I just channeled Jackson Brown). I suspect that the managers who sent these loans up the line were also the same people buying six-year loans on Cadillac Escalades and getting the latest X-Box on their recently limit-extended credit cards; that by the time the loans were packaged into larger instruments, the managers who oversaw this stage of the game were either still Consumerists themselves, or that the process below them covered the tracks of the bad deals well enough from sight.

    In other words, the watchers of deals were now of the same type and class as the purchasers of the deals. The Consumerists fucked each other in the end, so’s the way I see it.

    I’d tell you this was my .02, but I’m not sure I’d spend it right now.

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  4. Laki Recanati

    Seth,

    An explanation of a very complex matter in plain, good chosen words, understandable by all.

    Now that all understand, will they be start enough to vote for a long overdue change of what we have had for the past eight years?

    That is the big question today.

    The ancient Greeks used to say that “to make a mistake once is human.” (Electing Bush the first time.) “To make the same mistake twice, is stupid.”
    (Reelecting of Bush.) The American public deserves its fate! The unfortunate thing is, to quote another Greek saying, “together with with the burning of the dry good for nothing wood, the green bushes also burn.”

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  5. Josh H

    Nice job! The only thing I would suggest adding is possibly a tie to the 1929 stock market crash which led to the Great Depression when instead of subprime and CDOs the buzz word was margin debt (consumer and shareholder). Same crisis of confidence, same tendency to cash hoard. The difference then was we allowed banks to fail with no government intervention and every failure had the effect of exponentially shrinking the credit available to the consumer which also produced massive home foreclosures with no counterpoint from the Fed to offset culminating in the Great Depression. I think people forget that the Great Depression didn’t start until 1932 and the financial crisis that precipitated it began in 1929, which I think goes back to why the bailout is so important now (my personal bias).

    You might also consider an analysis of the now forgotten May rebate checks. These checks totaled $106 billion, nearly 20% of the proposed bailout. But the post mortem on the rebate checks is they were a nice shot in arm for consumer for about 30 days and helped pay for gas and groceries, but had little impact on the underlying economy.

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  6. Shakeel Kazi

    Seth:
    Excellent explanation for even followers of the market. Here are 2 suggestions to incorporate into the piece:
    1. A little explanation of Credit Default Swaps (CDS) – These are unregulated contracts written insuring Subprime mortgages. AIG overextended itself in writing these contracts. When the mortgages started failing AIG had to pay. The losses apparently were so large that it depleted its capital.
    2. For now, the government has come to the rescue of money market funds to protect them from breaking the buck.
    I refer you to Newsweek Sept 29 issue 2 pieces, one written by Robert Samuelson and another by Jane Quinn. While the losses are real, it appears that the loss of confidence is feeding on itself and exponentially exasperating the situation. Of the approximate 50 Million mortgages outstanding in the US about 1.5 million are in trouble or foreclosed. That is bad but does not seem disastrous enough to frreze the economy.
    My 2 cents worth.
    Shakeel

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  7. sethhett

    A friend writes:

    “I still think Americans–including me–have trouble understanding how the grinding of these financial gears plays out in the real economy. For all the handwringing about the worst financial crisis since the Great Depression, my local Dominos is still selling pizza, and I can still pull cash out of my ATM to pay for it, and there’s still gasoline at my local filling station, and I still pay my credit card bill at month’s end. Until any of that changes, it’s going to be hard for people to accept the need for a 700-billion dollar rescue plan. (Of course, if we’re lucky, much of that money will not go down the drain but will simply be parked somewhere till the market recovers.)”

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  8. Samantha

    Seth –
    Thanks for the link. Questions for you though – dumbing it down a little bit more… “illiquid mortgage assets” that means that you can’t pay for your pizza with your house or the ‘value’ of your property – right? (or am I wrong on the definition of “IMA”).
    When do we discuss/deal with the fact that these homes and properties were/are so artificially inflated? Or is that what we are doing now, but just not spelling it out to people that – hey you know that house you bought for $1M dollars (or re-mortgaged for that amount) – well guess what, it really wasn’t worth that – so you may have thought you were a millionaire – or living like one, but you were wrong… and now the 6 flat screen tvs that you bought with that re-mortgage smoke & mirrors backed money (and which should have helped the economy or at least the people at Best Buy) are just wasteful – because 1) did you really need them? and 2) what did you do with the five other ones that you had before?
    In Los Angeles – tear downs are going for $1000/ft! I mean really!!!??? I know people making 6 figures who can’t afford a home, who are concerned about their rent, and worry that all that they have put aside in their 401k won’t be worth the monthly statement that they get in the mail. I know other people reaching out to those people for help to feed their families! Who made out here? Is our society going to eliminate the middle class? Are we going to become the haves and the have-nots? The greed and the need for more is killing us. The golden parachutes have got to go. Those CEO bailouts that have taken money out of the general basket and put it in one provenly corrupt person’s back yard is fundamentally wrong. (how many millions/billions have gone to those parachutes?) can someone do the research on that? has it been done? if we took all that money back – or at least some of it – make those f**kers go back to work for christ sake, re-evaluated the housing market, re-evaulated the oil crisis – what is it worth – how much is there are we going to run out – what can be done to avoid it… then… maybe we could all just get along and go back to worrying about important things – not sure what that is, but it’s out there.

    Is that the point? that these illiquid mortgage assets which are what the economy is based on are now not worth the paper they were written on? but weren’t they never really worth that paper?

    Seriously, just trying to understand – or confirm that I do.

    Thanks again!

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  9. Rayfer

    Well done. For a closer look at what root cause generated this mortgage crisis in the first place and how to start fixing it listen to one of the best 10 minutes on the subject you can find and then DO SOMETHING locally with your congressman about it…

    Like

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