BMORENEWS.com

Ian Briggs

(OWINGS MILLS - October 17, 2008) - Well, it is official.  Whether we like it or not, we as a nation are locked into bailout (assistance, really) for Wall Street.  But will the average man in the street (what every TV pundit and talk show host refers to as Main Street) really be ok with the passing of this assistance package?  No one really knows, as a financial crisis like this has never happened before in the history of this great nation.  No history means no frame of reference.  Our financial system is a very complex interweaving of Wall Street and Main Street, both locally and globally.  However, there are components of this quagmire (which is what it really is) that is our financial system that should be explained to and understood by the public so that one can understand not only why this assistance package is needed (House and Senate representatives you may want to sit in on this tutorial, as it may save you more embarrassment in the future) -- but why it is needed now. 

Why this assistance package is needed

First of all let’s clear up one misnomer.  The notion that this proposed financial package bill is a bailout in incorrect.  It is an assistance package to the banking sector, akin to what the Federal Reserve is currently doing.  This assistance package is not about a bailout of Wall Street “fat cats”.  It also is not about falling for another Bush Administration misrepresentation of the facts or stretching of the truth.  It is really about keeping the one thing constant that has not totally fallen through the floor-- the resolve of the American worker. 

Banks and Credit

Though it has always been said “Cash is King,” in America credit is what makes our financial world go around.   “So what?” you say, “I can still buy whatever I want if I have good credit, and I make decent money”.   Well, let’s examine the reality of the economy in relation to this belief.

In order for any person to obtain credit from any financial institution, that institution actually has to have cash in order to lend.  If we use the example of banks, banks use deposits made by customers in order to create loans for potential customers. 

However, banks also generate cash to lend by borrowing from other banks. 

When banks lend to other banks, the borrowing banks have to pay a certain interest rate to the lending bank (this is what is known as the Fed funds rate).  The amount of interest a person pays for a loan (among other factors such as credit score and income) depends on how much it costs a bank to finance additional funds.  

Make no mistake about it, President Bush and Secretary Paulson did a horrible job of presenting this plan to the US Congress. Congress, on the other hand has done an equally horrible job of leading by not properly explaining what the bailout is about to its constituents. The media has done an even worse job of getting this thing right. This mess is not easy to understand as it has many moving parts.

How does this relate to the Assistance package?  Well, currently the bank to bank lending rate is 2%.  So based on the above explanation, loans to the public should be cheaper now than if the bank to bank lending rate were at say 6.5% ( as it was when President Clinton left office.)   

However, Banks are in a predicament.  A lot of the mortgages that they own are bad (slow pay or foreclosure) and are not generating any income for the bank.  No income means that they will have a problem repaying the people that they borrow from – the banks and its depositors (this will be you Joe public).  Also, since house values decline in areas of reduced demand and high foreclosure, it becomes difficult to sell these loans in order to recoup any spent money.   Moreover, for accounting purposes, these homes have to be valued at the market rate (what you have heard in the news as marked to market) as opposed to what the homes were initially valued when the loans were processed.  It is based on the current value of the home (even if it is not sold) vs. what the home is worth.  Because of this, the balance sheets of banks that have a lot of these loans are becoming weaker and weaker.

But this is not even half of the problem.  When banks see assets that are not liquid (cannot be sold) they stop lending not only to other banks, but also to people.   Banks are predominantly in the guarantee business, i.e. they have to make sure that whatever investments they make ensure a return so as to meet their financial obligations to their depositors and other lenders.  However, when cash became more accessible in the 2001-2002 era they became more risk tolerant (took more chances) and exposed themselves without enough coverage to guarantees the new business that they started to underwrite.  Now, riskier products were backed by even riskier and more complex financial instruments called derivatives.   Here is where Wall Street starts to meet Main Street.  Unfortunately, the level at which this game is played is so high up in the food chain that the bottom feeders (Joe public) has no clue or idea (like many of our congressmen and women) of these precarious relationships.

Here is another point to ponder.  Before, loans were held by a bank with the hope of generating income.  However, with age comes sophistication and banks decided that this was not good enough. They see the type of money Wall Street makes in profits and being predominantly Stock Market participants, they too have to find ways to get in on the action.    Wall Street is no fool and creates products that in essence will take a regular loan, package it with a bunch of other different mortgages, price it and sell it.  These types of packages are called Collateralized Debt Obligations or CDO’s.  Not a bad move for the banks as it has created liquidity and allows the bank to lend the same money it initially used over again.  How? Say, for example, you have a mortgage for $100,000 at 8% for 30 years.  Instead of collecting interest on this loan the bank will sell this loan to wholesaler for $100,000.  Your mortgage will now belong to someone else and the bank now has its original $100,000 it has lent you to lend to someone else.

Banks in this instance are willing to forego future interest for fees charged during the mortgage origination and closing process.  In some instances it is cheaper and more lucrative to turnover money in the short run rather than wait on long term payout.  This is in fact totally counterintuitive to the rationale that all investment houses preach to investors-investing is for long term horizons-while these businesses results are only as good as your last quarter’s (3 months) quarterly statements. 

When a wholesaler gets a hold of your mortgage, it is then packaged with a bunch of other mortgages with different time horizons, rates, balances and potential revenue streams.  These packaged loans are then re-sold to the Public in the form of a security.  When dealing with mortgages, this type of Debt Obligation is called Mortgaged Backed Securities (i.e. the payments made by the pool of mortgages will offset the amount requested by the security).    It is not uncommon to have portfolios consist of thousands of loans. 

In a perfect world, these things make sense –theoretically.  However, when these products start to falter, it becomes extremely difficult to unwind them.    In the real world, what all these geniuses who have created these products have now come to realize is that it is virtually impossible to gauge what the prices are on these things when house prices drop.  Now add this model to that of banks who didn’t unload their bad loans, but were unable to sell them to someone else.  Now both financial entities have no real cash to cover its obligations.  This starts the eventual demise of the entity.   So what do banks do in these types of situations-They tend to hoard cash and charge exorbitant rate to ANYBODY who wants to borrow.  This is what we are experiencing right now.

How This Affects You

So what has changed in the economy since the collapse of a couple major banks (Wachovia and Washington Mutual)?  Well, as of September 30^th 2008[1], the same bank to bank lending rate is about 7% (though the actual fed Funds rate is 2%).  This means that a loan that would have been 6% could now priced at around 11%.   If you want to buy a house, then you will have to come to the table with at least 30-40% cash up front and secure a mortgage at around 7-8%.  Oh by the way, this is only for people with “A” credit.  If you have any blemishes on your credit you have a better shot of raising the titanic than getting a loan from the bank.

Here is another point to ponder.  Unless you work for the government, or your employer is a tremendous cash generator like a Microsoft or even McDonald’s, your employer is dependent on credit.  In the United States more than half of the small and medium size businesses in existence rely on credit to meet short term obligations, like payroll and paying bills.  This is because most pay cycles for collecting revenue (every 30 days) do not correlate with payroll schedules (normally every 2 weeks).  With the slowdown in the economy (another topic altogether), some companies are starting to see more nonpayment for services or products produced.   With this, more companies are going to have to turn to using credit in order to pay their own obligations.  The current problem is, if that company who is having trouble did not have an already existing contingency credit line, then they will be out of luck.  So the end result, do not  be surprised if that job you thought was secure, is gone in the next 3-6 months. 

Here is another example.  Say you own a small garage and you employ 4 mechanics.  You depend on credit to buy the parts you need in order to fix the car.  However, you are not able to buy the parts from your supplier as you do not have access to credit.  The bank is not willing to float you until you get paid.  What is the end result? Well, since you cannot get the part it means loss of revenue (you cannot fix the car).  It means that if this continues you have no choice but to lay off some of your mechanics or even shut down the business altogether.  This will happen not because of poor business practices, or a slump in the economy (which is another issue in of its self), but because a bank who has money does not want to risk parting with it in the event it will never come back.  This is where we currently are in our Credit Crunch Cycle (CCC).

A more real world version of this CCC is now even McDonald’s (yes the Big Mac people) is having problems extending credit to its own franchises.  The problem here is that the bank the McDonald’s deals with, Bank of America, has reached its limit for lending through its America's franchisee-loan program faster than anticipated, causing some very nervous moments for the vast majority of McDonald’s 14,000 franchise owners.  It means that McDonald’s may have to delay a key operating roll out plan as its franchises are having difficulty raising capital to implement the necessary changes.  So here is a situation of a company that has a solid, stable, cash generating model, and even they are playing by these new set of rules.   This credit crisis has quickly become the greatest financial equalizer in American history.

It is natural to think that since we live in America that capitalism is just and should be allowed to exist in its purest form (by the way it was capitalism in its purest form that got us into this mess in the first place).  While banks tumble around us both locally (12 regional banks have failed this year so far), nationally (Wachovia and Washington Mutual), and bailouts happen across the world because of our mess (in the UK, Belgium and Germany), the FDIC and the Fed are standing strong.  Here is the catch.  By allowing the weak banks to be swallowed up by the stronger banks (and in this environment “strong” is a relative term) we are in turn making the banking system not only less competitive but also more unsound. 

The FDIC does stand by our bank deposits up to 250 thousand dollars.  This is great for most Americans.  However, here is the FDIC’s dilemma.  The FDIC reserve Fund is roughly around 50 billion.  The banking system has trillions of dollars worth of assets.  Hmmm…I see a small problem brewing.  The FDIC may be in a pickle if they tried to cover everyone in the event of a financial meltdown.  What is even more disturbing is that back in August the FDIC chairwoman Shiela C Blair announced that at the beginning of the year the FDIC had 90 banks on its watch list (possible failures pending) and by August that number had swelled to 117.   The FDIC has been real savvy in its current handling of the current banking crisis.  But savvy will only get you so far, and we are one big bank failure away from economic life as we know it shutting down completely.   “No way”; yes way.  If the FDIC can’t cover your deposits, what do you think the natural human response will be?  Yes, you guessed -- it time to get my money out from _____ bank (you can fill in the blank here) and hoard it until the next coming of Noah’s Ark.   The irony is that our government has put legislative measures in place since 1933 to ensure that our country will never have to experience a repeat of the 1929 depression.  Yet, even with these laws that have stood the test of time, we can possibly end up in the same situation.   

Why this assistance package is needed now

Right now there is a fear that is gripping the financial lending sector globally.  Banks are scared to lend to anyone, including banks.  Bank to bank lending is extremely vital to the continued existence of our society.  When banks stop lending to banks consumers suffer.  Why?  We are a credit based society and if we as consumers (and consumers here I mean individuals and any size corporations) do not have access to credit then it will become extremely difficult to continue function economically.  Even if you don’t use credit, the company you work for may need it to meet its financial obligations.  What is even scarier is that because the ripple effect of the US financial crisis is being felt globally, a lack of credit could spell layoffs and unemployment even for those who consider themselves financially responsible.  This is the type of crisis that will spare no one if it truly manifests itself.     

Also, we live a world in which financial variables change by the minute; it is important to keep the US moving.  No or slow assistance to help alleviate this current financial situation will then remove the one constant that we know (people still have jobs and businesses can still function effectively) to an unknown variable in the very precarious financial model.  This means that possible rising unemployment [2] can cause even more strain on an already weak economy. 

THE BOTTOM LINE

We can stand here and argue that we should not use tax payers’ money for a bail out.  But, the problem is that your money is already at work.  Make no mistake about it, President Bush and Secretary Paulson did a horrible job of presenting this plan to the US Congress.  Congress, on the other hand has done an equally horrible job of leading by not properly explaining what the bailout is about to its constituents.  The media has done an even worse job of getting this thing right.  This mess is not easy to understand as it has many moving parts.  But if explained correctly, the rationale behind why the bailout was necessary becomes more understandable.  America may have produced one of its finest hours in exercising its democratic rights as individuals.   The irony is that it could possibly have caused America to lose some of the economic freedom that goes along with it.  

Tags: business, economy, mortgages, recession, stock market