Banking system and the 2008 financial crisis

Halloween weekend. Woke up late, read a slashdot article  “When Having the US Debt Paid Off Was a Problem” which claimed that US had a budget surplus in 2000 and could pay off its entire debt by 2012 and much more surprisingly how that would be harmful to the US economy. I don’t even pretend to understand the finance and my usual strategy is to dismiss it as a shitty unproductive zero-sum game greedy people play. But today, I had more important things to study – i.e more important things that could be put off. So, I ended up watching 15 Khan Academy videos about “Paulson Bailout“.

Here’s what I learnt…for future reference.

In order to calculate what you’re worth, you list all that you own (Assets)  and all that you owe (Debt) in some currency and the difference is the answer (Equity). The whole problem is to determine what constitutes your Asset, Debt, and figure out how to map them to, say, USD. We should learn some terminology first.

Mortgage Backed Security – People need to buy houses. They don’t have all the money. They get loans from commercial banks or wherever, and pay mortgages for 30 years covering interest and principal. Investment banks with liquid cash (C) set up a company “Special Purpose Entity” with some liquid cash and buy these mortgages. So now, homeowners pay their monthly mortgage to these SPEs. SPEs bundle up these mortgages into bundles called “Mortgage Backed Securities” and trade them on stock exchange (perhaps to make up their initial cost C). Why would people want to invest in such stocks? Because stocks pay dividend and if it is more than what your Savings account interest is, then why not? Wait – what is going on? Investing in a regular stock means that you are placing your confidence in the productivity of that company, i.e you think d = company_productivity(your money +  company’s money) – company_productivity(company’s money) > 0. Moreover, you think that d > your money, which means that investing in this company makes the society more productive. But in the case of SPEs, or MBS the how-does-my-investment-make-society-more-productive-loop is much much bigger – you invest in an Investment bank, which lends more money to people to buy houses, which makes them work harder to pay their mortgages improving society’s value. If everyone paid their mortgages, it wouldn’t be a problem. But there exists a discontinuity in the system – insolvency. Now, the game is about who’s going to hit the bound statistically speaking. So, SPEs package their MBSs into classes “tranches” – high risk (unsecured), medium risk(mezzanine), and low risk(super secured), with correspondingly decreasing dividend rates, and these are called Collateral Debt Obligations (CDO), where the risks are evaluated by rating agencies. When someone defaults, money vanishes from the unsecured CDOs first and then maybe mezzanine if needed.

US Treasury Bonds – When you lend someone some money, they give you a receipt which contains details, i.e who borrowed from whom at how much and for how long at what interest etc etc. This receipt is called a bond certificate. When you buy US Treasury bonds, it means that you’re lending the US govt. some money.

Good. So, now what does a bank’s balance sheet look like? Its assets include some liquid cash, perhaps some good corporate bonds (money lent to Microsoft perhaps :P), maybe some US treasury bonds, and maybe some “high risk” CDOs. For some reason banks have liabilities – they take short term loans, ( for ex. 3 months ), pay interest on them, and pay the principal off by taking out another loan. I don’t exactly understand why, but it seems these loans form a large part of their liabilities. For ex. today wikipedia says Goldman Sachs has about $900B of assets, but only $77B of equity, which means over $800B in loans. Lehmann Brothers had over $600B of Assets when it declared bankruptcy! Equity = (Assets – Liabilities) can be hard to estimate when there are risky CDOs. Banks bought these CDOs at a high price during the housing bubble when everyone thought that housing prices keep rising eternally which was reflected on their “book” value on balance sheets. Some people begin to default on their mortgages. This affects the “high risk” category of CDOs which are now worth far less than what the banks bought them for, i.e their “market” value on balance sheets is far less. Banks need to write them off to retain trust. This brings down their Equity. If Equity goes below zero, the bank declares insolvency ( like Lehmann Brothers did). This means all its creditors lose money. But its creditors are other banks, which had these loans listed in their assets. Now people look at these surviving banks’ balance sheets with a suspicious eye wondering if their assets represent their real market value. Banks don’t want to default, so they hold on to their liquid cash to pay off their loans when they’re due. Market slows down, and the “real” value of anything is not easy to determine. A few more banks default.

What can the government do? Well, nothing. If a society is capitalistic, it should be so when banks are profitable and when they make losses. That did not happen. Paulson bailout injected $700 billion into these banks by buying the risky CDOs at a much higher price than market value. Reverse auction – where the feds setup an auction saying they want to buy come CDOs with some cash. The company that sells it to them for the cheapest price wins it. This is a terrible idea – a company desperate enough to sell its CDOs for some quick liquid cash isn’t going to garner more trust. Who know what else it has overstated or fudged in its balance sheet? Moreover, what will a bank that receives this bailout fund do? It will hold on to its cash so it can repay its loans and not default. All these bailout funds go stagnant. Some banks die, some survive. Government debt increases, and a few weeks ago that hit the ceiling as well.

Making money off money stinks.