Tuesday, September 30, 2008

Financial lubricants

Nobody really questions the fact that the financial world is in a pickle right now. But it's clear that the $64,000 question (or $700 billion) is "What do Wall Street's woes have to do with Main Street?"

Well, a whole lot and not very much at the same time. Mostly, the current crisis has made it clear how complex the financial world has become. Since my "mission" here is to try to see both sides of the issues and (hopefully) find the balancing point somewhere in between, let's see if we can explore it a bit from that perspective.

Actually, let me start at the divergent perspectives, and see if I can capture them.

For the average taxpayer (i.e. Main Street), this is a story about how a bunch of greedy investment bankers made some bad bets and are having to pay the piper. It affects me because maybe my 401k or pension plan bought into some of those bad bets, and if I was close to retirement that's gonna put me a bit less close to retirement. It affects me because a high foreclosure rate in my area may be depressing my home price, but as long as I'm in a 30-year fixed mortgage and not planning on moving real soon, I'll be okay. So why should I be asked to take on a big expense to save these guys who should have known better? Why are government officials who for the past 8 years have been preaching fire-and-brimstone against regulation and government involvement suddenly looking to buy into all of the financial institutions they said needed to be left alone?

For the financial community (i.e. Wall Street) it's obvious why something needs to be done, and they're rather afraid it won't happen in time (hence yesterday's precipitous drop in the markets after the House rejected the bailout bill).

Hmm...but to understand that we need to grok liquidity, the lubricant of the financial world.

You see, banks lend money to each other all the time. And when I say "money", I use it as a specific financial term. Money, or Cash, in the financial world is something that is liquid. It flows. It can be used immediately as needed. You can buy things with it. You can sell things to get it (but someone has to have some to buy with). It is the lubricant of the financial system. When you put your savings into a money market account, as opposed to a savings account or a mutual fund or a CD or some other investment, your money goes into that giant pool of money that sloshes around the world. This, in fact, is why you get a better interest rate on money market accounts than regular savings... the banks have more leeway to play with it, so they pay you better.

So, you've got these money markets that provide flows of money to slosh around the world. When a bank loans money to another bank, they need to provide collateral (just as when you get a car loan or a mortgage the car or the house is collateral for the loan). Often, this collateral takes the form of bonds (basically, a piece of a long-term loan) or other financial "instruments" which are less liquid than the cash being borrowed. This system generally runs smoothly because the bonds that are used as collateral for those short-term loans are rated by agencies, and so the lender in principle has some assurance that it is "good paper" (as opposed to, say, junk bonds that are "not worth the paper they're printed on"). Of course, all of this is in computers these days and very little is actually on paper, but that's beside the point.

In general, this system works. The problem that we're having right now is that it has stopped working. Why? Because banks don't trust each other to have "good paper" to back the short-term loans they're making, so they're not making those short-term loans. It's not that the money doesn't exist. It's that it's not flowing the way it's supposed to flow, because the trust upon which that flow depends has been broken. Once that happens, the bankers are struck with the fear that they won't be able to conduct business the way they want to. Since they can't borrow, they stop lending, which means other banks can't borrow, so they stop lending, and so on.

How does this move from Wall Street to Main Street? Well, the fear (and to some degree, the reality) is that eventually as banks are unable to borrow from each other, they stop lending to us. They stop lending to people who want to buy cars and houses. They shut down the lines of credit that let small businesses operate. (For example, when you buy home heating oil, you buy 150 gallons delivered, and you either have an agreement with the delivery guy or you pay cash on delivery. When he gets his tanks filled, he needs to pay for 10,000 gallons all at once, long before he delivers it to you and your neighbors. And he has to pay the delivery guy even if you don't pay him promptly, etc. So he needs a credit line to float his expenses until the real money comes in.)

So the fear is that the lack of financial lubrication on Wall St. will cascade out into a lack of lubrication in the larger economy, and then it really hits the fan.

Okay...that's all for now. Next episode will be about what we keep hearing about: mortgage backed securities, CDOs, and other things that would never exist if we had kept to the path and never allowed the spheres of "creative" and "accounting" to intersect. These things are at the root of the liquidity crisis, and understanding how they work and came to be and such will help in understanding why this crisis is so widespread and so potentially disastrous.

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