Financial Crisis in English

Before a few weeks ago, layoffs have been isolated to a few industries (e.g. construction, finance). If you hadn’t been laid off, you were probably taking a hit on your 401k plan, mutual funds, and stock portfolios. More recently, stocks have plummeted. I have a big diverse group of friends working various jobs; in the last two weeks, almost all of them have reported layoffs at their companies. Even seemingly strong companies in healthy industries are laying off people. My job for the last 2.5 years has been to analyze companies and find out what may affect them. My experience is limited, but based on research I’ve done and experts I’ve spoken to, I believe ongoing economic/financial crisis has escalated to a higher order of magnitude and I also believe the media is doing a poor job of explaining what is really going on. This is an extremely complex situation and there's no short explanation. Give me a few minutes, and I’ll explain why things are really f***ed right now and why our future is f***ed.

Credit, the Frozen Credit Markets, and the Alphabet Soup
In the business world, almost every financial transaction involves cash and borrowed money (i.e. credit). This includes buying inventory, paying employees, paying rent, and in many cases paying off borrowed money. If your company has trouble accessing credit, they’ll have trouble meeting these obligations (i.e. not enough goods on shelves, lay offs, eviction, and bankruptcy). Assuming your company is healthy (i.e. strong balance sheet, well-capitalized), at least some customers and some suppliers will having trouble operating because of lack of credit. Everyone from the Gap, to Ford, to Boeing sells stuff to customers on borrowed money. And even Chinese sweatshops operate on borrowed money. If your customers can’t buy stuff and your suppliers are preventing you from selling stuff, you’re going to take a hit. Right now, a sh*tload of people/companies can’t access credit because credit markets have been frozen for a while. And every day credit is frozen, people are getting laid off and companies are going out of business.

Why aren’t banks extending credit (i.e. lending money to people and companies)? Well, banks need that cash right now for at least 4 reasons:
1) Banks own a lot of unsellable (i.e. illiquid) MBSs, CMOs, CDOs and a ton of other securities whose worth is determined by home values, which are plummeting. Because banks have to constantly update the cash values (i.e. mark them to market) of these securities, it looks like banks are losing money.
2) Banks have already lent out a lot of money so that people could buy homes, buy cars, and get college educations. They’ve also already lent money to those companies we just talked about. And now banks are terrified that a lot of those borrowers will not be able pay them back.
3) Banks are afraid that customers and clients will pull their deposits out of the bank (i.e. a run on the bank).
4) The CDS problem: Holy sh*t. Literally, God only knows how big this problem might be. A CDS (or credit default swap) is an insurance policy on a bond. It’s estimated to be a $62,000,000,000,000 unregulated market. Let’s go straight to an analogy. Nick has a car. AIG sells him a car insurance policy. Then I think, “Hmm, I don’t own a car, but I’d like to get money if Nick crashes his car.” AIG is convinced he won’t crash his car, so they are happy to sell me a policy and collect an insurance premium. In fact, they sell a hundred people like me that policy on Nick’s car. Then other people realize how AIG is making money. They start selling insurance policies on Nick’s car. For years, people make and lose money when the chances of a car accident increase and decrease. This process is repeated for other people’s cars. But now Nick totals his car. Suddenly, billions of dollars of cash needs to trade hands on one $30,000 car. It gets worse. Nick’s car accident directly causes the losers in this transaction to crash their own cars. In reality, Nick’s car is Lehman Brothers and that insurance policy is a CDS. All of those other buyers and sellers of CDSs are banks, insurance companies, hedge funds, pension funds, etc. all over the world. What’s worse? They all engaged in these transactions with borrowed money. Nobody knows for sure who owes how much money. CDSs were and are also traded on mortgages and all of the alphabet soup.

Banks make money because they are allowed to take a fraction of customer deposits, lend them out, and collect interest. Regulators require and investors want banks to always keep a fraction of that money on their books. The 4 reasons we discussed make banks’ books shrink. That’s why they won’t lend money. The last time banks were this tight, we ended up in the Great Depression. The business aspect of World War II got us out.

Fear, The Central Banks, and the $700bln Bailout Plan
Central Banks across the globe have been lending trillions of dollars to banks (via rate cuts, TAFs, TSLFs, etc.) so that they have more cash on their books. Central Banks thought this would give banks the confidence to lend money, but instead, banks are hanging on to this money because they’re still afraid of going the way of Bear Stearns, Lehman Bros, and Washington Mutual.

You should also know that banks constantly borrow and lend from each other; this is key to the flow of money. But they’re not lending money to each other either (as reflected by high LIBOR rates). Why? It’s kind of like the banks are not having sex because of fear of STDs. Some banks have different levels of STDs (in the form of MBSs, CDOs, etc.). If bank A lends money to bank B and B dies of an STD, then A will get sick. The cure for these STDs is improving home prices. Central Banks are handing out condoms in the form of federal loans and insurance, but banks are still terrified.

The $700 bln Bailout Plan will buy MBSs, CMOs, CDOs from banks, effectively converting these things to cold hard cash. In theory, the government will buy this for more than nothing (helping banks) and less than they’re really worth (which is great for tax payers). The government will be able to do this because the only non-govt investors willing to buy these won’t pay sh*t for them. And the banks aren’t willing to sell for sh*t prices. Unfortunately, it will take weeks before we know it works.

The Spiraling Problem
Banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker, banks lend less, companies default, unemployment rises, individuals default, banks get weaker…

What Else Do We Know
On average, economists expected the U.S. would lose 100k nonfarm jobs in September. Last week, we found out that we lost 159k jobs. Year-to-date, U.S. companies have cut 760k jobs. Also, more and more people know something is wrong. They might not understand what’s going on, but they know their 401k plan is evaporating, their friends are getting laid off, and all those people on TV say things are terrible. Remember, 70% of GDP is consumer spending. If consumers spend less, companies make less stuff, companies need fewer employees, and even fewer people are buying stuff. This speeds up that downward spiral.

What if Credit Unfreezes and Businesses and Consumers Are Free to Borrow Again
Let’s assume the government interventions work and credit markets unfreeze completely tomorrow. This would help the spiraling slow and perhaps stabilize. But things won’t go back the good ol’ days that we’ve had in recent years. Banks are currently deleveraging. You see, banks borrowed a sh*tload of money so they could lend a sh*tload of money. After seeing other banks collapse (e.g. Bear Stearns, Lehman Bros, Washington Mutual) and struggle (e.g. Goldman Sachs, Morgan Stanley, Citigroup, Bank of America), banks will lower their borrowing levels and ultimately, they will be lending money at lower levels. Fool me once, shame on you; fool me twice, shame on me. Say goodbye to easy credit. Joe Sixpack won’t be able to buy that pickup truck, that house, or that LCD tv. [This cycle will last a generation. Leaders who live through the current crisis will die, and a new generation will make our mistakes all over again.]

But even if you do have credit, do you think the average consumer is going to borrow like they used to? Millions of people are getting kicked out of their homes. You or someone you know just got laid off. Your 401k plan just went straight to hell. Most of us have less money or we’re scared of not having enough. The President and the government all want us to go back to spending so that the economy gets rolling again. As long as we spend like crazy, people will have jobs, and the politicians will have done their jobs. Maybe we’ll continue to buy sh*t we don’t need, but I think there’s a good chance we won’t be buying as much as we used to. [This cycle will last a generation. Parents who live through the current crisis will die, and a new generation will make our mistakes all over again.]

Conclusion and the Outlook
The recent economy had been built on a foundation of high levels of borrowed and lent money, collateralized by mortgages. Everyone (borrowers and lenders) thought housing prices would increase forever. Americans spent $1.38 for every $1 of income during this period. (Mexicans spend 60 cents and Europeans spend between 85 cents to $1.) Wall Street and home buyers bet trillions of dollars on this idea. Well, they were wrong. And now everyone’s paying for it.

The old economy was built on this bad assumption and no government intervention will change this realization. The new economy won’t make that mistake again. Americans are not as dumb as they look and they will be smarter about their purchases. Unfortunately, this will cause the economy to shrink toward some sort of equilibrium. Millions of jobs will be lost, unemployment will rise, real income will fall, and we will struggle as a nation for years.