Financial Catastrophe

[Demonic Attorney]

Lehman Brothers, one of the biggest investment banks in the United States, filed for bankruptcy protection last night.  Merrill Lynch, another such investment bank, agreed to a buyout from Bank of America for $50B.  Several other banks, most notably AIG, are in dangerous territory.  The FDIC expects more bank failures in the future. 

For the first time in its history, the Wall Street Journal had on its front page a banner headline announcing the recent events as a financial crisis that shook Wall Street to its foundation.  The New York Times predicts additional financial collapses are inevitable.

People are comparing this to the Great Crash of 1929.  I'm not convinced we're there yet, but this is bad, bad, bad.  Even markets outside the U.S. won't escape this unscathed.  I make this post as a public service announcement to anyone out there with money tied up in the wrong markets.  Feel free to discuss, but try to refrain from unnecessary political proselytizing or finger-pointing.     

[Juggernaut GO]

Put your money in your pillow and hang on to your butts...

Considering how bad the inflation is in comparison to our economic development this problem has been brewing for a long time and the shit has just started to hit the fan.  Unemployment is the highest since late 90's, winter is coming and fuel prices are going to jump due to the heating oil demands.

It's about to get much much worse, time to open a pawn shop.

[Grand Inquisitor]

Some good discussion here: http://www.metafilter.com/74892/Brokergeddon

Try to skip the political herring in the early/middle.

money tied up in the wrong markets

That's a little ambiguous, did you have anything in mind?

[Smmenen]

Anyone involved in work around the foreclosure crisis has seen the roots of this for some time and has recognized the self-destructive path we are taking.   

I have been telling people now that we aren't even half way through this crisis yet.   Another whole set of ARMs resets in 2009.  The worst is yet to come.   

The fundamental problem is that you have a collective problem with no consensus collective solution.   Classic tragedy of the commons.

 It will be years after the crisis before people come to realize that a foreclosure on a stranger affects everyone. 

[ELD]

This was beyond predictable, was is inevitable.  The worst is yet to come.  People haven't even started talking about the Credit Card bubble.  If you thought the housing bubble was bad, sit back and prepare for the show. 

[Godder]

This has all the hallmarks of the Great Depression, particularly the crash that set that going. The two key differences are that economists better understand how to stave off the worst effects (hence the stacks of money being flooded into the system to protect it) and that everyone involved in the relaxing of the laws and regulations surrounding the banking and finance industries (e.g. the 1999 repeal of the Glass-Steagall Act) forgot what made the Great Depression so bad in the first place and why those laws and regulations were there.

All that said, while there is and will be some protection, there will still be major casualties and a serious shake-up of the system.

[Moxlotus]

This was beyond predictable, was is inevitable.  The worst is yet to come.  People haven't even started talking about the Credit Card bubble.  If you thought the housing bubble was bad, sit back and prepare for the show. 

This.  Housing buble hit those who were, well, who didn't have a high financial IQ and took subprime mortages or mortgages with adjustible rates.  Financial bubble is hitting those who took risky investments looking to make a buck.  The credit card bubble is when the shit will really hit the fan, because there are too many people (1 is too many) with credit card debt.  It's seriously not hard to not have credit card debt.  Hell, a large chunk of people with credit card debt actually have enough money in the bank to cover it but they choose not to!  When the credit crunch hits, people will actually care because it will affect our family and our neighbors. 

Lesson to be learned: don't buy a house you can't afford, don't think you can get rich quick, and don't buy shit you can't pay for immediately--only use a credit card as a way to avoid the time writing checks and not to put off paying for something.

[Smmenen]

This was beyond predictable, was is inevitable.  The worst is yet to come.  People haven't even started talking about the Credit Card bubble.  If you thought the housing bubble was bad, sit back and prepare for the show. 

This.  Housing buble hit those who were, well, who didn't have a high financial IQ and took subprime mortages or mortgages with adjustible rates.  Financial bubble is hitting those who took risky investments looking to make a buck.  The credit card bubble is when the shit will really hit the fan, because there are too many people (1 is too many) with credit card debt.  It's seriously not hard to not have credit card debt.  Hell, a large chunk of people with credit card debt actually have enough money in the bank to cover it but they choose not to!  When the credit crunch hits, people will actually care because it will affect our family and our neighbors. 

Lesson to be learned: don't buy a house you can't afford, don't think you can get rich quick, and don't buy shit you can't pay for immediately--only use a credit card as a way to avoid the time writing checks and not to put off paying for something.

It's alot more complicated than that.   I'm doing some some pro bono foreclosure defense work in my free time, and I've seen what's been going on.   First of all, alot of the ARMs actually made sense.  But only if home values continued to rise.   In that case, you would refinance before the rate adjusts.     Secondly, it's not simply individuals who are making bad decisions.  The banks were giving out loans like candy.  In fact, they didn't even care in many cases about ability to repay because the originators sold the loans down market.   They were actively setting up the whole system for collapse because it was going to be someone else's problem (i.e. investors).   Finally, all of the other players are actually feeding off the homeowners.  The mortgage brokers made money both at the closing and then again, in many cases, when they renegotiated before the ARMs reset.   The servicers actually make money when people fall behind, because then they can tack on all kinds of fees.   

In short, it was a massive greedy feeding frenzy.   Most importantly though, the incentives were structured 100% wrong.  Every party tried to get as much as they could and then made it someone else's problem.  That's why it was a classic tragedy of the commons problem.   Just think overfishing where every fisherman knows that there are a limited number of fish.  Solution?  Fish as much as you can for yourself.   Everyone from the originator to the servicer to the broker made money.  And the investors that were sold these securitized loans were sold a product that had a much higher rate of return than many other products.  That's why the CEO and Lehmen invested so heavily in these things.   

[Dr. Sylvan]

This was beyond predictable, was is inevitable.  The worst is yet to come.  People haven't even started talking about the Credit Card bubble.  If you thought the housing bubble was bad, sit back and prepare for the show. 

The 9/1 issue of Fortune notes: "Since credit card debt has been growing much faster than the economy---more than 8% in last year's third and fourth quarters and over 7% in May (the most recent month reported)---people are apparently using it as a substitute for income." I am expecting this to become very ugly in, say, spring/summer of 2009, particularly because that's when oil will ramp up again if it somehow manages to stay near $100/barrel all winter.

Credit cards make financial sense as long as you never pay interest ("financing charges") or fees; under those conditions it's a free month-long lag built into your costs. I use them instead of a debit card for the added benefit that your liability is limited if the card is ever stolen. It's even okay to have more than one, because different places don't accept Discover, or, more rarely, Visa/MasterCard.

Tight control is a pre-req, though, and most Americans are bad at math. PBS Frontline's 2004 coverage of credit cards explained how the industry came up with the 2%-of-balance minimum payment as a way to encourage consumers to borrow more. I can't find the article, but I'm convinced that I read in the WSJ in the past six months that the historical average of recent years was people paying five times the minimum payment, and recently that has dropped to about four times the minimum, indicating that consumers are having more trouble paying.

EDIT: I think this is the bit I'm remembering (Wall Street Journal, "Is the Future in Plastic?", Peter Eavis; May 20, 2008 pg. C14)

Card borrowers are starting to pay back less of their outstanding balances each month. Analysts at Oppenheimer & Co. say that a sustained decline in the amount borrowers repay each month, compared with a year-earlier, can be a leading indicator that borrowers will start to fall behind on payments.

Oppenheimer calculates that, for the companies it covers, borrowers paid back 19% of their balance on average in April, down from 19.7% in the year-earlier period. American Express's borrowers paid down 23.8% of their balances in April, down from 25% a year ago, according to Oppenheimer. Conversely, Capital One borrowers paid down 18.5% of their balances last month, up from 17.6% a year earlier.

Also worrisome are data from Moody's suggesting that borrowers are finding it harder to become current on credit-card loans once they fall behind. The ratings firm notes that the amount of loans on which borrowers have skipped three or more payments has started to rise more quickly than loans that have missed one or two. Once borrowers are three payments behind, fewer of them ever catch up.

[Zombie Shakespeare]

Credit cards make financial sense as long as you never pay interest ("financing charges") or fees; under those conditions it's a free month-long lag built into your costs. I use them instead of a debit card for the added benefit that your liability is limited if the card is ever stolen. It's even okay to have more than one, because different places don't accept Discover, or, more rarely, Visa/MasterCard.

Using credit cards just to eek out a few bonus points or sky miles is stupid. Studies have shown that when your make a purchase with a credit card you are more likely to spend upwards of 18% more then if you paid with cash. That's what got most average Americans into credit card debt in the first place. Then they lost their job. Or their ARM went up. Or they had an unexpected bill. Suddenly they can't pay the credit card off and they get hit with higher interest rates and late fees. If you play with snakes eventually you will get bit.

All debit cards with the Visa or MasterCard logos come with the same faud protection as their credit card counterparts. Very few places don't treat those debit cards just as the credit card counterparts.

[Anusien]

All debit cards with the Visa or MasterCard logos come with the same faud protection as their credit card counterparts. Very few places don't treat those debit cards just as the credit card counterparts.

I believe with a debit card you lose things like the ability to dispute charges or the automatic rental car insurance coverage and things that you get with some credit cards.

But here's what I never understood about that argument.  Don't those studies assume that people spend differently with a credit card than with cash?  I don't see why people would pay for things differently with a debit card than a credit card?  I'd much rather avoid ridiculous overdraw charges because the bank decided to fuck me.

In fact, the banks process charges to your account from largest to smallest, to hit you the most possible number of overdraft fees.

The moral here is spend responsibly, not use a debit card.

[wiley]

The moral here is spend responsibly, not use a debit card.

Exactly, cash is useful for more than just snorting coke off it.  There is likely an atm near wherever you are making a purchase, try to keep $50-100 in pocket and for anything over $100 check your balance and use a debit card then.  This will keep you from thrift spending, unexpected overdraft and subsequent debt very well.

The government has never, and should never be responsible for our personal fiscal management.  It is solely the individual's duty to ensure that they know the risks they take with their money, fly as high as you want but don't expect a safety net.

[Demonic Attorney]

The Federal Reserve bails out AIG, to the tune of $85B in exchange for an 80% equity stake.  And the show rolls on...

[Smmenen]

The government has never, and should never be responsible for our personal fiscal management.  It is solely the individual's duty to ensure that they know the risks they take with their money, fly as high as you want but don't expect a safety net.

I agree with you in principle.

The problem is that individuals do not exist in isolation.   We exist in relationship with each other.   That is more than just a platitude.

When your neighbor is foreclosed on, the property value of your house declines.    Every foreclosure costs cities thousands and thousands of dollars, more the longer the homes remain vacant.  Who pays for that?  Taxpayers. 

The giant insurers like AIG are so intricately connected to the financial system that its collapse would trigger feedback loops and long-term consequences that can't be foreseen,which could affect everyone. 

[wiley]

Indeed, poor decisions on such a massive scale will affect those uninvolved.  I don't believe that the government should be required to step in at that point though.  The collapse of a company the size of AIG is sure to ripple for years and cause a great deal damage to the pockets of all involved and splash damage to those who aren't.  This is the risk of having such a large business and those with fiscal intelligence will be able to ride out the storm and start anew.

I would be happier if the government spent the $85B to give a free financial course to prospective home owners (say via regular TV broadcast or something along those lines) than bail out a company that is likely to repeat its past mistakes the moment their customers will let them.

What happens to the loans a bank has out if it claims bankruptcy?  If I remember correctly the laws are different between companies and individuals.  What will happen when a credit card company goes under?  These would be pieces of information to base your future financial plans off; minimizing the damage is a good thing.

In sum; educate the people beforehand instead of bailing them out after the fact.

[mike_bergeron]

This is just my personal opinion, but the government should not be investing/bailing out any of these firms.  This is a complete failure, and needs to be treated as such.

If these other companies/consumers/anyone does NOT feel the effect of this company blowing up, they are destined to do it again. 

[Shock Wave]

This is just my personal opinion, but the government should not be investing/bailing out any of these firms.  This is a complete failure, and needs to be treated as such.

If these other companies/consumers/anyone does NOT feel the effect of this company blowing up, they are destined to do it again.

I am a strong advocate for accountability, and thus am inclined to agree with you, however I suspect that neither you nor I are able to foresee the economic repercussions of these businesses collapsing.

In principle, I agree with you, but I have the feeling it might be best to err on the side of caution. I could be wrong.

[Moxlotus]

When your neighbor is foreclosed on, the property value of your house declines.

Hell yeah.  Less property tax to pay then.  Property value only matters if you are planning on selling your property in the near future.  Even better if you're looking to buy property.

Every foreclosure costs cities thousands and thousands of dollars, more the longer the homes remain vacant.  Who pays for that?  Taxpayers

The taxpayers aren't going to pay for it unless they approve a referendum to increase their taxes.  And every foreclosure that is happening right now or over the next 3 years is AMAZING for me because I will be buying a house in about 3-4 years and the law of supply&demand will be working overtime for me.

I expect the government to take a shotgun to some of these large firms once this has passed and bust them into a bunch of smaller companies so this doesn't happen again.

When other governments buy up 80% of a company's stock, its called nationalization.  When the US government does it, it's called something else and people make excuses for it.

[mike_bergeron]

This is just my personal opinion, but the government should not be investing/bailing out any of these firms.  This is a complete failure, and needs to be treated as such.

If these other companies/consumers/anyone does NOT feel the effect of this company blowing up, they are destined to do it again.

I am a strong advocate for accountability, and thus am inclined to agree with you, however I suspect that neither you nor I are able to foresee the economic repercussions of these businesses collapsing.

In principle, I agree with you, but I have the feeling it might be best to err on the side of caution. I could be wrong.

I totally agree with you- there is no way that I can forecast economic conditions.  I just get confused when the government decides to bail out a company like Chrysler and 12 years later it is still a pig with no lipstick.  I know my tax dollars can be better spent elsewhere. 

I think it would be awful if AIG collapsed. that is why I want it to happen in a way now, so that way we can feel the pain as consumers, and companies adjust their investing/ business strategy. if they get bailed out, we never feel the crush, and develop a crutch. 

However, I do feel bad for a lot of the people working at these companies who had no clue this was going to happen. 

on the flip side, like moxlotus, I will be in the housing market in 2-4 years.  Timing is everything I guess.

[Smmenen]

Every foreclosure costs cities thousands and thousands of dollars, more the longer the homes remain vacant.  Who pays for that?  Taxpayers

The taxpayers aren't going to pay for it unless they approve a referendum to increase their taxes. 

Wrong. 

First of all, the foreclosure process uses up judicial resources, which is alot of time and money.   Second, even if you are in a non-judicial foreclosure state, the state is involved in the foreclosure process from start to finish.   The Sheriff's sale, the auction, the oversight.

A foreclosure costs taxpayers money in lots of other ways.   First of all, vacant property tends to attract criminal gang activity and vandalism, including prostitution, drugs, squatting and other criminal activitees.  This requires increased police presence, and can involve firemen (if there is arson) and other taxpayer services.  The state has to secure and acquire abandoned property, if the bank relinquishes the deed (as they have done in Baltimore, Detroit, Cleveland and many other places).   This costs alot of money.
There are many administrative, legal, and social expenditures that each foreclosure imposes.

The declining revenue stream from lower property values increases the tax burden on everyone else in the region but a more than 1-1 rate, since your property values have fallen as well. 

There are much broader effects as well.   Homes are the biggest asset people own.  If people's wealth declines, then they have less resources to consume and spend.  It results in a shrinking economy, which means, long-term, fewer jobs for everyone else. 

[Dr. Sylvan]

What happens to the loans a bank has out if it claims bankruptcy?  If I remember correctly the laws are different between companies and individuals.  What will happen when a credit card company goes under?  These would be pieces of information to base your future financial plans off; minimizing the damage is a good thing.

@wiley: I think I can answer this, though I am not a lawyer, so I don't know lots of specifics. If a bank or credit card company (in many cases they are the same) goes bankrupt, its loan customers still owe on their loans as before, but the control of their loans will be sold to some other company, so the checks may get mailed to a different place. When the bank's assets are sold, the bankrupt company probably won't be able to pay everyone it owes (hence why it is bankrupt). The law assigns priority to who gets paid first. Bondholders are almost always first in line, and the shareholders are last---meaning they get wiped out. In AIG's case, I've read that policyholders are heavily protected throughout this process, while their policies are sold to other insurers.

@everyone skeptical of bailouts:

I am quite libertarian-inclined, and as such skeptical of government intervention, but let's not misconstrue the nature of these bailouts. Unlike the preposterous "infinite free money" that the Detroit automakers are asking for, these companies are not exactly getting off lightly. Also, as Steve mentions, if the collapse threatens the financial system in general, then even the most responsible companies and individuals will suffer consequences unrelated to their own decisions, and taxpayers would end up bearing much greater costs to clean up the rubble.

To review, Bear Stearns shareholders lost nearly everything when they were sold to JP Morgan Chase (JPM) in March. The senior managers for the most part were large shareholders, and while they're not exactly poor now, they lost huge fortunes. JPM got a good deal because it had made relatively much more responsible decisions. If the sale to JPM hadn't been arranged by the Federal Reserve, no one could be sure what would happen, and there would have been a "run on the bank" scenario for nearly every brokerage firm on Wall Street, regardless of merit. The banks are very interconnected, and Bear's demise was quite sudden.

Fannie Mae and Freddie Mac have always been, unlike other corporations, called Government-Sponsored Enterprises. Congress did basically nothing to reel them in for years, even after multi-billion-dollar accounting scandals. These two companies have their own regulator, OFHEO, whose website has on the front a Mission "To promote housing [...] by ensuring the safety and soundness of Fannie Mae and Freddie Mac." Obviously, that didn't go so well---OFHEO had far fewer Congressional friends than Fannie and Freddie did, so they couldn't actually control the giant companies' risks. Blame, first of all, Congress for the way these two fell apart, and for how disastrous their failure would have been for the entire nation-wide housing market.

Lehman Bros.: Letting Lehman die unaided was wise. The difference between their situation and Bear's is that while Bear's would have been a sudden shock, there have been rumors that Lehman would be next ever since March. Banks have had months to evaluate their exposure, and moreover, investment banks now have access to the Fed directly, so investors are not as concerned about liquidity, i.e., there is less risk of a run on the banks.

AIG: As with Bear, shareholders of the irresponsible company will lose their investment, much as they would if the company had been allowed to fail entirely. The Feds also insisted that the CEO be replaced. (I would have preferred that more upper-management be sacked, but a sudden corporate beheading would probably cause too much internal chaos.) In this case, AIG was widely involved in the same credit-default swap market that Bear was so huge in, and its debt was widely held by many parties, including money market funds for small investors. Letting it fall apart would risk too much damage.

I'm not a big fan of Fed Chairman Bernanke---I think he has lowered interest rates too much, stoking price inflation that erodes my savings---but I don't think any of these can be labeled a truly bad decision. Fannie/Freddie is not a bailout error, it is a deeper, institutional error. In the end, all of Wall Street, upon seeing these bailouts, can't possibly see them as absolving the risk-takers for their mistakes. Instead, the Fed is acting imperfectly but reasonably to protect the entire economy. That most of us still have jobs and homes a year into a global credit crisis is a testament to their success.

[Godder]

If you want to see what happens when governments either don't intervene, or intervene poorly, look at the 1929 Stock Market Crash which was followed by the Great Depression. If you want to see what happens when governments do it properly, look at the 1987 Stock Market Crash. Both were massive Stock Market Crashes, but the latter didn't lead to the ruin of the economy, unlike the Depression which followed the 1929 Stock Market Crash.

[Scott_Limoges]

The problem is explained in simple words here.

http://finance.yahoo.com/banking-budgeting/article/105782/How-We-Got-Here-It-Is-Housing-Stupid

[Moxlotus]

Homes are the biggest asset people own.  If people's wealth declines, then they have less resources to consume and spend. 

That's only if you coult your home as liquid wealth you can spend.  My parents don't.  I sure as hell won't.  Whether my home is worth $50,000 or $500,000 means nothing on my bank account because I live in my house-I don't use it to buy food.

First of all, the foreclosure process uses up judicial resources, which is alot of time and money.   Second, even if you are in a non-judicial foreclosure state, the state is involved in the foreclosure process from start to finish.   The Sheriff's sale, the auction, the oversight.

It may still use resources, but my taxes still don't actually go up unless it passes referendum.  That's the only thing I care about--how much do I owe to the city at the end of the year. 

If the city ends up owning the vacant lots, then it is their duty to either spend $ keeping them ok or build something.  It is their duty to present the situation to the tax payers and say "look, you get to make a choice: spend $ on cops patrolling this, give us more money to build something here to benefit the community and save on $ in the long run, or give us no money which forces us to cut other services."  The taxpayers then end up making the decision which they believe is best.  The glut of vacant properties also gives incentives to private people to buy them since they are cheap.  So some people lose and some people win. 

[Smmenen]

Homes are the biggest asset people own.  If people's wealth declines, then they have less resources to consume and spend. 

That's only if you coult your home as liquid wealth you can spend.  My parents don't.  I sure as hell won't.  Whether my home is worth $50,000 or $500,000 means nothing on my bank account because I live in my house-I don't use it to buy food.

Yeah, but one's ability to send a kid to college or borrow against a house, refinance or get a second mortgage declines if home values fall.   Moreover, if your nest egg declines in value, more income will have to be used to save toward retirement, which means less disposable income, and less economic growth. 

If people become less wealthy, that is bad for everyone. 

First of all, the foreclosure process uses up judicial resources, which is alot of time and money.   Second, even if you are in a non-judicial foreclosure state, the state is involved in the foreclosure process from start to finish.   The Sheriff's sale, the auction, the oversight.

It may still use resources, but my taxes still don't actually go up unless it passes referendum.  That's the only thing I care about--how much do I owe to the city at the end of the year.

If you were paying 12 cents on the dollar for teachers, police, judges, and social workers, now you will be paying 16 cents on the dollar, and that money has to come from somewhere.  It comes from budget cuts, budget deficits, or tax increases.   At the end of the day, whether is budget cuts, budget deficit, or a tax incrase, it's a de facto tax hike.  Each tax dollar is either getting less for its money, is being borrowed against hte future, or your taxes are going up. 

EDIT:
http://www.nytimes.com/2008/01/08/us/08baltimore.html

"The study, commissioned by the Homeownership Preservation Foundation of Minneapolis, identified 26 different costs incurred by government agencies responding to foreclosures in Chicago and in Cook County, Ill., in 2003 and 2004. The analysis concluded that total costs reached $34,199 for each foreclosure."

According to that study, taxpayers pay $34,199 for EACH foreclosure. 

[Moxlotus]

Well of course Baltimore is losing money.  But Baltimore shouldn't have had that money in the first place.  Those people should have never gotten the bank loan with their crappy credit rating due to the high risk of lending and therefore would have never been paying property taxes to the city.

[Godder]

If government offers voters the choice via referendum of increasing taxes to pay for everything, or decreasing services elsewhere to make up for the new expenditure, and the voters choose the latter, the government will likely get booted from office later because the decrease in services will annoy voters, and no amount of telling the voters "this is your own fault" will save the government. Rationality is not commonplace, unfortunately.

[Moxlotus]

If government offers voters the choice via referendum of increasing taxes to pay for everything, or decreasing services elsewhere to make up for the new expenditure, and the voters choose the latter, the government will likely get booted from office later because the decrease in services will annoy voters, and no amount of telling the voters "this is your own fault" will save the government. Rationality is not commonplace, unfortunately.

It's all in how it's portrayed.  "this is your own fault" can easily be rephrased as "followed the will of the people and let you keep money in your pockets."

[habragg]

At the end of the day, whether is budget cuts, budget deficit, or a tax incrase, it's a de facto tax hike. 

When government expenditures are cut, that is not a de facto tax hike -- that's shrinking government.  I actually think it's pretty dangerous to make that association, as the obvious corollary is "Government spending is up, so I got a tax cut!"

The essential problem with Fannie / Freddie is that we're dealing with private firms who's debt was guaranteed with government money.  It was capitalism without risk.  There must be consequences -- and dire ones if need be -- for conducting risky business.

Get the government out of the private sector.  Treat Freddy/Fannie like Ma Bell and sell them off in pieces to true private ownership.

[Smmenen]

At the end of the day, whether is budget cuts, budget deficit, or a tax incrase, it's a de facto tax hike. 

When government expenditures are cut, that is not a de facto tax hike -- that's shrinking government.  I

My mistake.  You are correct.  When you actually cut the budget, then there is no de facto tax hike.