The PracticalDad Guide to the Credit Crunch

The speed of the financial and economic changes in the past decade reached a crescendo this week when the credit system came to a startling and terrifying halt.  The Federal Government, in its infinite wisdom and hope for a miracle, has approved a massive bailout with no clear idea as to whether it will even work.  What exactly has happened and what does it mean?

Let’s start by looking at what the credit market is.  The typical person looks at the Stock Market/Dow Jones Industrial Average as an indicator for the health of the economy.  That’s natural since the large majority of the 401k retirement options pertain to stocks; there might be a single bond option in addition to a money market fund, and these are both members of the credit market.  It’s this credit market – with huge daily flows of money siphoning through the system – that provides the daily operating funds for financial and non-financial firms to operate.  Simply put, firms borrow the everyday/short-term funds for their daily operations – paying vendors, taxes, employees…and it’s this particular item that has everybody spooked.  Firms will have cash on hand, but it’s simply never going to be enough to meet all of the obligations.  Consequently, you could think of credit as the oil that keeps the gears of the grand economic engine turning smoothly, pistons pumping on all cylinders.

And what happens when you don’t check the oil?  Geez, how can the economic pistons wind up thoroughly jammed?

It all comes down to debt.  Debt in and of itself isn’t a bad thing.  The average person would never be able to afford a home without borrowing the principal, and the same goes for cars, and so on.  But in the course of the past several decades, debt has gone from being a useful financial tool to a mechanism to satisfy every consumer’s wildest fantasy.  It has become acceptable and even encouraged – think all those rebate credit cards – to use credit to pay for anything you might want, let alone need.  Mortgage programs were made available that encouraged people to buy beyond what they could reasonably afford by the use of teaser introductory rates; some were even allowed to borrow large sums based solely on what they said they earned.  These were the no-document  NINJA – No Income No Job/Assets – loans.

And at the same time, genius financial engineers with mathematics degrees were learning to create financial instruments for sale, and these instruments were packages of those same mortgages bundled together.  The cumulative payments from the homeowners were the cash flow on which the value of the instrument was based.  These instruments were called MBS for Mortgage Based Securities.  This appeared to work so well at first that other asset classes were constructed on the same premise – credit card payments, auto notes, you name it.  And the collective group was named CDO, for Collateralized Debt Obligations.  These became so popular that they were sold throughout the global economy.  A Chinese bank can conceivably own a bond backed by an apartment building in Poughkeepsie, New York.  It is a small world, after all. 

So they combined a very loose lending policy with a vehicle for spreading this loose policy throughout the global financial system.  This sounds suspiciously like a communicable disease with a virus encapsulated in a vehicle for faster spread.  And this is the point at which people remember that geniuses frequently have a very poor grasp of the real world.

Lax lending, overfed consumerism and a virus-like financial package meant that this chinese bank owned a bond back by an apartment complex that simply didn’t have the cash flow to support the mortgage payments.  Now multiply this by hundreds of thousands, if not millions, of like products.  And in the course of a decade, there isn’t a country which hasn’t had these products flood throughout their system.

So how does this get to a credit crunch?  Remember that all of these banks lend to other banks and also non-financial companies.  The notes of the non-financial firms are the basis for something called commercial paper, or very short-term debt; it is this debt that serves as the bulk of the assets held by the deemed-safe money market funds.  Well known disasters like Bear Stearns, Lehman and AIG simply exposed that many institutions are supported by financial instruments backed by failing assets, like house values.  And with firms not willing to divulge what they have in their books, trust amongst the firms and banks has collapsed.  Over the last week, this was demonstrated by the increasingly higher rates that firms and banks had to pay one another for the commercial paper.  As of yesterday, October 2, the rates were meaningless as banks simply refused to lend to anyone else as they hoarded the money to rebuild their own MBS-depleted books.

So what does this mean?  Simply put, that if this continues for several more days, businesses of all sizes will be unable to obtain the money necessary to meet their obligations.  Vendors aren’t paid and this ripples through the economic fabric, and ultimately, employees are laid off for lack of funds to pay them.  It amounts to a replay of the Depression of 1929.

The Paulson Plan is simple and akin to a plague city worker.  The intent is to remove the dead or dying assets from sick institutions via purchase and replacing them with healthy capital, think Treasury Notes.  If the government purchases the bad assets for more than Fair market value, then the institution can use the excess proceeds to rebuild their assets and hopefully spur lending again.  Will it work?  The scarily interesting part is that no one knows.  There’s simply no guarantee that impaired banks will resume lending instead of just taking the assets onto their books and hunkering down for the duration.

This is economic terra incognita.  And like the old maps said, "here there be monsters."

Next…how does this affect me as a father?


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