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How Credit Works

The present financial crisis boils down to one fundamental issue - the credit crunch, now gone worldwide. The short explanation of how we got here, is that credit is an easy system to understand and use, yet one where plans are far too often short-sighted. One entity provides a good or service to another, and in lieu of immediate payment terms are set up for delayed payment, usually in a set of payments and with a charge for the credit being extended. The amount of credit charges is usually determined through negotiation and careful attention to necessary goals. For example, the reason almost no one really gives 0% interest rates on credit, is because over time that would unfairly benefit the buyer. Let's say someone buys a car and gets a deal to pay $25,000 over five years with no interest. If the buyer pays an average of $5,000 a year with no interest, then most of the money for the purchase stays in the buyer's hands for years, and he gets the use and profit from it. If the seller had received the entire $25,000 at the time of the sale, there is a clear profit compared to receiving the same money but later, so financing or credit terms are designed to make up the money that the seller loses by not demanding full payment up front (not to mention the money lost when someone buys on credit then defaults). It's all about risk management, accepting the possibility of bad things happening in order to increase the profits from a venture. The credit system works because of two fundamental forces - the buyer is willing to pay more over time for something, in order to be able to make payments instead of paying for it all at once, and the seller is willing to take payments over time and risk a certain amount of default in order to increase overall profitability. That simple rule applies to all credit conditions.

So what went wrong? Greed on both ends, actually. Buyers bought homes they could not afford, while sellers built high-risk ventures into mainstream investment packages, on the theory that diversifying the investments would keep the high-yield aspects while some how mitigating the risk exposure. To make matters worse, high-risk mortgage investments became politically favored in order to offer not just home ownership to low-income families, but also offer high-end properties to people who could not possibly afford them, on the expectation of best-case scenarios, or in a phrase, the absurd belief that nothing but good things will happen in the foreseeable future. ARM loans, balloon-payment mortgages, and interest-only loans came into being in recent years, all of them extremely high in risk by their nature. The culture of saving up for what you want most had long ago been abandoned for the 'buy now, pay later' mantra, which itself had been set aside in favor of the even more basic 'Gimme' culture. I mention this for several reasons. First, you have to understand that in a culture catering to increasing levels of personal greed, expectations of responsible behavior become less and less practical. A generation used to getting whatever it wants in toys and social norms, has now taken control of an economy and government wherein it believes that someone else can be made to pay for whatever these people want. Second, political duty has devolved from stewardship of the nation's welfare and a duty to those who abide by the rules of order and commonwealth, to a state where any promise necessary to retain office will be made (like 'lowering' taxes for 95% of Americans, including those who pay no taxes at all). And third, for the past generation those who work hard and save have been the target of many unscrupulous criminals and congressmen, who see the needs of the lazy as far greater than those of the industrious, since the ratio of honest workers to lazy bums appears to have reached the order of about 1 to 6.

- continued -

So here we are, the dominoes falling and everyone suddenly realizing they are standing underneath them. What to do? The simple answer is obvious; let the consequences work their way through. But doing that would mean letting a lot of mortgages crash, and with them a lot of banks would fail. Yes, the surviving banks would be much stronger and in the end the total costs would be minimized, but who in Washington has the courage to tell about 2 million families that they would have to lose their homes, and tell three or four dozen small and a couple major banks that they are out of business for their greed and stupidity, especially when this would disproportionately affect minorities? There is simply no such political will, nor am I sure that there ever has been, for what this would require. Instead, the Congress has decided that everyone should suffer a bit in order to prevent a minority from suffering a lot.

There is also some rational basis for the bailout decision. The failure of the stock market in 1929 was a bad thing, but not especially crippling for the country. What brought the recession into a full depression was the collapse of thousands of banks and savings & loans across the country, and these fell in large part due to a collapse of confidence. We see that to some extent in every economic downturn. Bad times hit, a company worries about its condition, they buy fewer supplies, hire no new people and maybe lay off folks, who spend less because they worry about their jobs, and fewer people spending makes things worse for the companies, who lay off more people and the cycle continues until it bottoms out and someone has the nerve to start hiring folks and buying things. When banks get hit, they make fewer loans and offer less interest on deposits and that slows down the economy too. If you can't get a car or house loan, you won't buy even if you want to buy. So, Congress does not have reason to worry so much about the investment firms or even the car makers - sorry GM - but they do worry about the banks in general. Loans have to be made to keep the economy from getting worse, and that means liquidity issues have to be addressed.

But you cannot just give money away, or at least you should understand that doing so is extremely stupid. So, there is an argument for spending $700,000,000,000.00 if it is done wisely, but then again we are talking about Congress here. Wisely would mean an investment that offered a reasonable return, not money spent as a giveaway to reward bad behavior and foolish decisions. That's why the "bailout" money must not be spent directly to pay for bad mortgages, and why - sorry GM - the money may not be spent on the automakers. The money may be spent in any way that is likely to result in an improvement in the economy greater than the amount contributed. That is, just as is done with small matters of credit, the actions taken should be a balance of concessions in the short term granted in order to produce superior long-term results. That is the template which ought to be used in the application of these funds.


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Comments (10)

Credit is <a href="http://w... (Below threshold)

Credit is the credibility of the borrower -- and for years, law and regulation have been used to compel lenders to lend to persons with no credibility. The lenders tried to make a necessity into a virtue. The rest follows.

"especially when this would... (Below threshold)

"especially when this would disproportionately affect minorities"

Ah, therein lies the key to this whole issue.

Low income housing advocates and racial agitators simply failed to consider a basic mathematical truth -- within any specific group of people, the pool of qualified home buyers is limited.

But apparently the diversity police completely failed to comprehend this simple idea. And so they still pushed for banks to give more and more and more loans to low income borrowers, with little regard for how those borrowers would be able to afford their mortgage payments.

Eventually, variable rate loans, reverse mortgages, balloon payments, and other incredibly risky instruments were introduced by banks because they were forced to keep writing more and more loans, and they had to come up with ways to loan money to an ever increasing number of people who had no savings, poor or non-existent credit, and no steady income.

And no one -- NO ONE -- could dare question these policies, because doing so would mean that you were a "racist" who wanted to "shut minorities out of the American dream."

Then greedy bankers and mortgage lenders realized that they could take these same incredibly risky loan schemes and sell them to middle and upper middle class Americans, who would be thrilled at the prospect of buying a $1 million home for the same money that a $400,000 home used to cost. And investors feverishly bought mortgage bonds because they were "guaranteed" by the US government.

The greed of middle and upper class Americans certainly added momentum to the mortgage spiral, but ultimately the responsibility for its collapse should fall squarely on racial agitators, who forced a disproportionately high number of racial minorities into these bad deals in the first place, and then kept anyone from looking too closely at their flimsy house of cards by repeatedly crying "RAAAAAAAACIST"!

Well said Mike and exactly ... (Below threshold)

Well said Mike and exactly right.

How Credit Does Not Work... (Below threshold)

How Credit Does Not Work

In a few years some enterprising writer will tell the tale of the really seedy side of this credit disaster: Credit Default Swaps, aka CDS'.

In a traditional loan their are just two parties: lender and borrower. However, during the last decade a third party came to the credit extavaganza peddling something called a swap agreement, which in and of itself is not unusal because swaps have been around for a long time as they assist borrowers and lenders manage the risk of big swings in interest rates.

However, the CDS morphed into an exotic side bet between two parties that were not even the original borrower and lender.

So the problem of bad lender and dumb borrower was made worse by the guys who made a side bet on the bad lender and dumb borrower.

Why was it made worse? Because commercial banks (FDIC insured deposit institutions) and investment banks (FINRA insured institutions) and insurance companies lathered their balance sheets with not only the bad loans but also the Credit Default Swaps (the side bets).

It sounds complicated, and to be honest their will always be some complexity in a major FUBAR, but at the end of the day we are left with this:

AIG, recipient of $140 billion tax payer bailout dollars, was the largest counter party (read: side bet party) on CDS's. Who, one wonders, was on the other side of AIG's side bet? Hmmmm. Morgan Stanley? Goldman Sachs? Bank of America? Bear Stearns? Lehman Brothers? Those names sound familiar?

Tax payers need to understand that they are not only dealing with lenders and homeowners that are in trouble. They are also bailing out institutions that BET money (your money) on which party would pay.

So, as Eddie Murphy (Trading Places) so quickly surmised of the murky world of the Street, (Those) "guys are just a bunch of high priced bookies".

Sorry for the abuse of the ... (Below threshold)

Sorry for the abuse of the word "there" above....constant distractions and failure to spell check....sigh.

Lenders weren't exactly rel... (Below threshold)

Lenders weren't exactly reluctant to target minorities with sketchy credit products. On the Daily Show (yeah, yeah, I know...) they had a montage of commercial advertising that specifically targeted African American prospective home owners.

All that aside, it's remarkable that anybody could grow up to be 18 years of age and not understand the basic principles of credit. Sad, really.

Sorry GM my foot.T... (Below threshold)

Sorry GM my foot.

The simple problem with GM is a lack of credit. This is not the first time they have had to borrow money - and pay it back thank you very much, it is the first time that money is NOT available.

And no DIP means Chapter 7 instead of Chapter 11. I might go along with Chapter 11 if vendors have some sort of priority, but not, repeat not, Chapter 7.

Just too, too many jobs at stake.

How many unemployed? How much in tax dollars, national, state and local is lost? How much in health care converted from GM to Federal? Unemployment insurance, welfare benefits, food stamps, you name it.

How many collateral jobs down the tubes? Advertising dollars lost (er, maybe that one works), how many mom and pop stores close? How many restaurants? How many retailers?

Sheesh. . .

How many unemployed? ... (Below threshold)

How many unemployed? How much in tax dollars, national, state and local is lost? How much in health care converted from GM to Federal? Unemployment insurance, welfare benefits, food stamps, you name it.

No sympathy from me on this.

Our country has been throught this many times before except in this case there is a large political constituency with a loud voice. That said, nothing changes.

Steel went down
Textiles went down
Metal bashing went down
Machine tools went down
Airlines went down
Coal went down
Even IBM restructured but had the sense to do so before crisis hit.
Paper mills went down
Chemical companies went down
Electronics went down

All those industries restructured in bankruptcy. Why should GM be treated differently?

Ask the hundreds of local communities that were decimated in the restructuring of these industries how they handled it (it's probably not hundreds, it's thousands).

The cost to government? Good question...probably less than $25 billion after GM gets run through the fine tooth comb of Chapter 11.

The current crisis has noth... (Below threshold)

The current crisis has nothing to do with liquidity -- the liquidity shortage is merely a symptom of the disease. The legislated removal of leveraging ratios (e.g., Glass-Steagall) allowed all players to get extremely overwound, often into extremely volatile products -- namely, morgage-backed securities (MBSs) and credit default swaps. A necessary consequence of getting overleveraged is that eventually you must "unwind", or deleverage your positions. Hopefully you can do this in a controlled fashion, on your own terms. What we're seeing now is textbook deleveraging.

Not surprisingly, an overleveraged institution faced with an uncontrolled deleveraging of it's positions is suddenly financially unsound -- especially if they had previously counted the market values of their leverage positions as assets. In the case of a financial institution, these leverage positions were allowed to be counted towards their federal reserve requirements. The flip side is that when the collapse started, all of the fake "value" of those leveraged assets evaporated, so suddenly these financial institutions were in violation of their federally mandated reserve requirements. Unless they were able to raise a few hundred million in the allowed window, poof. So goeth IndyMac, etc.

The current "credit crunch" -- the refusal of lenders to extend credit, esp. at the big institutional level -- is because the players don't trust one another to be good for the loan. It's not a liquidity problem at all, it's a trust problem. Until down-to-earth leveraging requirements are reinstated, until "off-balance sheet" and "mark to ???" fantasy accounting is outlawed ...nothing will change. I fear, however, that the political will to do these things simply doesn't exist -- as it would be political suicide. It would be short term pain, but we should embrace that as better than the alternative: long term BIG TIME pain. Unfortunately, neither DC nor the larger populace has that sort of foresight any longer, so Depression 2.0 it is :/

Buckle up, and take notes: your grandkids will probably want to interview for a school report one day.

Larry, unless they change t... (Below threshold)

Larry, unless they change their business model, we will only delay their collapse. Having them restructure before the money is given will make more sense. You want to throw money at the problem while most want to fix the problem first. ww






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