Credit Crisis FAQ! All you ever wanted to know but were afraid to ask.

March 10, 2009 at 1:53 am (Economics)

It’s about time I started posting original content on this blog, not just rip-offs from other sites. I’ve decided that for the sake of keeping interest alive, I’ll be posting a series of FAQ (Frequently Asked Questions) on several topics rather than essays as I’d originally planned. It’s easier reading than a wall of text on highly esoteric affairs. So, for my first topic, and complement the video I posted earlier: The Credit Crisis.

Who are the responsible culprits of the affair? Who should we hang?

Everybody. Nobody. Truth be told, it was a failure by all three parties involved that led us to this mess. On the one side, we have the bankers, the objet of everybody’s ire nowadays. Yes, they’re a bunch of thieving, cheating, lying scoundrels who are only in it for their short term gain, consequences be damned. They subjected their banks, sometimes hundreds of years old, to Enron-style practices that were guaranteed to make them crash and burn.

So it’s only the bankers fault?

Such a massive fraud would not have been possible without government protection. Enron was a single company and required a massive effort to keep their practices secret. But what happens when you have dozens of institutions incurring in the same illegal practices? Somebody had to know, surely. And indeed they did. It’s well recorded that the incompetence and outright corruption of the regulators, the SEC and OTC, facilitated this mess. They are in it up to their necks, and can’t plead ignorance. And of course, knowing that the government will bail you out because “you are too big to fail” facilitated Citigroup and Bank of America loading their balance sheets with toxic debt.

What of the people who lied about their income?

Of course, there’s the people themselves. They knew it was too good to be true. Mortgages on dream houses with ridiculously low monthly installments and no down payments? The right question to be asked is, Where’s the catch?, not: where do I sign up? Nothing comes for free. People have been so caught up on trying to keep up with the Joneses that they lost all semblance of reality and started living on a fantasy world. They thought housing was the perfect get-rich-quick scheme. But lets be realistic, McDonalds workers cannot afford, under any circumstances, five bedroom, lake-view mansions. They thought they were getting rich by beating the bankers at their own game. In hindsight it does sound ridiculous.

The stock markets are just paper changing hands among speculators. Why should such activity impact the real economy?

Imagine the world economy like a house. The stock markets are the décor and paint job of the house. They make it seem pretty, and usually lead to a pointless overvaluation of its price based on such little details. But as any realtor would tell you, you’ve got to have a look at what’s important in the house before buying it: the cabling, the plumbing, the functionality, and the foundations. In economics, all these are represented by the bond market. Sure, just like the plumbing, it’s not half as sexy as its stock counterpart, but it’s ten times more important.

In the stock market, ownership of companies is traded. You buy IBM stock, you own a small part of the tech giant. But you don’t buy IBM stock directly from the company; you buy it from somebody willing to sell it. The company earns nothing when you buy their stock in a secondary market. In the bond markets, it’s debt that’s traded. You buy IBM bonds; you are owed money by IBM itself. This little part is crucial to the economy, as corporations and governments, require their bonds to be sold in order to finance their operations. What happens when their bonds aren’t being sold? You guessed it, companies freeze. Without credit, contractors can’t build houses, farmers can’t transport their goods to the cities, and factories can’t buy raw materials. This leads to a downturn in economic activity, with only the companies that are engineered to operate without debt being able to continue in business.

But why isn’t anybody lending? Weren’t the trillion dollar bank rescues aimed at solving that problem?

There’s enough money in the world to lend to everybody. But this is not a crisis of credit. It’s a crisis of confidence. What’s happening is that lenders and investors are stuffing money under their mattresses because they don’t trust anybody anymore. Companies and corporations are falling like flies these days because they’ve loaded themselves with toxic debt thinking they could make a cheap profit, even if they don’t focus on finance! What’s happening now is that risk is being multiplied by a vicious cycle.

What of the honest business and tradesmen?

I’m a farmer. I produce tomatoes. I won’t make any money until after I sell my harvest in the city. But I need money to get my tomatoes to aforementioned city. How do I get it? I ask for a loan. Now, I haven’t indulged in any funny business with exotic finance products. Why is nobody lending to me? Because they lack confidence. Perhaps not in me, I’m an honest hardworking farmer. But in my clients. How am I going to sell my tomatoes when the convenience stores are going bankrupt?

This chain reaction is threatening to halt the entire economy.

But we’ll start recovering at the end of the year, right? Obama said so!

Right. Obama says a lot of things. Have you noticed every time he or his tax cheating Treasury secretary open their mouths the markets plummet even more? Obama has been as worthless a president as Bush. He inherited a bunch of problems, true, but he’s done nothing solve them. Why? Because that would involve locking up his banker buddies back in New York.

What is the solution, then?

Obama does not need to inject more money and debt into the American system. They’re already overloaded with it. It’s confidence that’s needed. Confidence that businesses are once more are incurring in honest practices and are not just ticking time bombs because they loaded themselves with funny finance products. The moneylenders and investors are not going to release more money into the markets until all the fraud and corruption has been watered out. There’s two ways to do this, either the government prosecutes and locks up the criminals responsible for this mess, including high ranking bank executives, government regulators, and Wall Street titans, or the market deals with it.

Granted, the first option is a titanic job and requires a lot of political capital. But it will restore confidence, attack the root of the problem, and the economy might actually begin recovering by 2010. But they don’t seem to be close to doing anything like it. Hell, they’ve even left the same boards of directors responsible for this mess in the companies that they’ve nationalized.

So what happens if the market deals with it?

The market cannot target and prosecute individuals. It’ll try to price in all the fraud and corruption in the system, leading to an undervaluation of all stocks. By doing so, it will wash out the fraud, but it’ll also take the honest businesses with them. It’s the financial equivalent of nuking a city to eliminate the gangs and criminals in it. A lot of innocent people would die, just like right now, a lot of solid companies are being brought under.

And what are the prospects for the future?

Unless Obama and his useless administration start fulfilling on the promises of their campaign, the future looks bleak. When the fraud is finally washed out by the markets, there won’t be much left of the economic landscape to speak of. But in short, it’ll be Depression, not Recession. Depressions come in cycles, just a little after the generation that remembers the last one has left power in society. After those who lived through the Long Depression in 1873 died or retired, new leaders took over, forgot the lessons of the past, and caused the turmoil of 1929. Now, those who actually remember the Great Depression of the 1930s are dead, dying, or retired, and a new generation has taken over. A new generation that refused to learn from history.

We, as a society, have been living beyond our means for a very long time. What follows will be a brutal corrective move that’ll try to reverse this. The consequences will be dire and the future is not promising. And, I don’t have to remind you, World War 2 was a direct consequence of the Great Depression.

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4 Comments

  1. dabubu said,

    Man, I’m studing Economy. And this was the best explanation of te Crisis I’ve read. Congratulations!

  2. scottdylan said,

    Just came across this, this is a great explanation of the crisis!

  3. bubba said,

    So, could expand on:

    1) the particular corruption from the soundrels. how did they particularly break any law by giving loans to the undeserving? (although it made no business sense)

    2) Connections of Obama to his Wall St/ Banker friends, any references.

    Great article. Answers much appreciated.

  4. MEF.Sophie said,

    Once again you surprise me by how concise and well you explain all these economy stuff that I find so complicated haha… It made me remember about all those history, politics and economy talks we used to have back a high school. Man… I miss those good days…
    Excellent post DMI!!! I can’t wait for the next one 😉

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