Hello, and I guess el mundo de dinero
Not really sure what I want to write about but I feel like writing. Well, not writing so much as ruminating. I don't really feel like writing about the stuff I think about now'a days. Those things that I am relatively sure about have, I think, been adopted by most sane people. Those things that I am wondering about are so complex that I hesitate to write and expose my naiviete.
For instance, I topic of interest for me recently has been international finance and the Fed in particular. What role does the fed play and what is its purpose? We know that they set interest rates but why do they do so and what is the result. I won't say that I called the sub-prime mortage collapse but I do think that I agreed with the correct people. The most fascinating part about this whole thing though is trying to figure out why the Fed continued to artificially lower interest rates even after the housing bubble became painfully evident.
Whats the big deal? Well, an amazing amount of money gets lent and traded back and forth every day. The fact that there are such things as day long loans between corporations and banks is amazing to me. This is however overwhelmingly a good thing. Money, with the advent of computerized banking, can flow with almost no resistance to the people who need it most. Unfortunately as the flow of money becomes more complex so does cause and effect.
When you purchase a mortage you are agreeing to pay back the money at a future time and with interest. Now, the bank that gave you the loan would really like to use that interest money now rather then 15 or 20 years from now when the loan matures. As a result a niche market has sprung up where a very large bank will "buy" these mortgages from smaller banks. Everyone wins! Smaller banks only get part of the interest that they would have collected but they get it now and the larger bank gets a fairly secure promise of income since the smaller bank assumes most of the risk in this situation. This larger bank then bundles a whole bunch of mortgages together and sells them again to other institutions.
This can happen several times as each bank takes alittle bit of the promised interest for themselves. This practice also reduces the risk associated with mortgages since once a whole bunch have been grouped together the law of large numbers means you can very accurately predict the percent that will default and therefor have a secure and stable income stream.
Here is where it gets even more tripy as far as I can figure it out. Once a bank buys a large hunk of mortgages it then uses this to leverage other more risky investments. In a sense, they are using these promises of future money to be able to inflate the current amount of wealth at their disposal and therefor the amount of loans that they can take out. This is not a bad thing because then the banks or companies can use these new loans to do good things like buy capital for manufacturing or research.
This all works really well so long as one can predict accurately the percentage of mortgages that will default and thus the future value of all this money that everyone is depending on. What happened here is that the small banks stopped caring so much who got loans because it was cheap for the people. Also, the market for mortgages skyrocketed as fully international and computerized money markets came into their own. Lastly, one needs to buy alot of low interest rate mortgages to get a certain amount of future income.
So people were eager to get low interest rate morgages and banks were eager to give low interest rate morgages because larger banks were eager to buy up these low interest rate mortgages. With all this easy *large sum loans* floating about it is not a wonder that the price of homes in many areas became so inflated. As the price of homes continued to rise it became possible for people to take out even larger mortgages backed by the new value of their homes. And I think you can see how this cycle continues.
It all came crashing down as people began buying homes with the expectation of quickly rising home prices and more importantly small banks began issuing loans with the expectation of quickly rising home prices. When interest rates started rising again and people who had variable interest rate loans starting defaulting on their loans the small banks said no problem, I'll sell the home and recoup my loss. But when they tried to resell the home, they couldn't get the price they were expecting. This means that they couldn't give the money they had promised to the larger banks who had bought those mortgages oh so long ago and are now entitled to the money. The larger banks said oh shit because a much larger number of these mortgages were now defaulting then they had predicted.
So, now these larger banks are stuck with future obligations (essentially payments on loans that they took out) that were supposed to be mostly backed by these mortgages that have disappeared. The banks stop taking out loans because they are not sure of what they can pay back and further more stop buying up mortgages because they stop trusting them and the whole system grinds to a halt, which is exactly what happened about 2 months ago.
An interesting parallel is the sight Prosper.com. The premise of the site is that individuals can make loans to individuals. If you want to borrow money you put up an ad saying how much and at what percent interest rate. Then, people willing to loan money make bids as low as 50 dollars at a certain interest rate. As a result, a borrow get money from 50 - 100 different people and a loaner might have money invested in 50 - 100 different people. This spreads out the risk, theoretically, for the loaners. The website, in this case, is actually the one that makes the loan to the borrower and then sells parts of it to the loaners on the site.
What makes it interesting is that many people jumped in thinking wow, I can loan to poor credit people at a much higher interest rate then a bank would give me (15 - 24%) and do good at the same time by giving people with poor credit a chance. In reality enough of the people with poor credit have poor credit for a reason and have defaulted on their loans to dissuade alot of people from lending. Now, the only way to get a loan on the site as a borrower is to have either phenomenal credit or some other aspect of your financial history that is attractive to loaners.
This is what is happening now in the financial markets. It is becoming harder for people to get mortgages because people are realizing that giving loans to people with poor credit is a bad thing. Lucky, this fear seems mostly contained to the housing market at this time because business to business loans are still going strong.
Unfortunately Americans have gotten used to the idea that their house actually makes money for them and even more so is a liquid member of their wealth. As a result, we should see over the next two years a drastic increase in the savings rate. This is a good thing! Currently americans spend more then they make and a large part of this is likely because they feel confident that they can remortgage their house or sell to pay off the debt. As house prices fall due to both a renormalization of prices and a reduction in available buyers (the people who shouldn't have gotten loans in the first place) people will literally see their nest eggs evaporate in front of their eyes and will become much more conservative in their spending.
Simultaneously, oil prices will continue increasing (which won't be helped by the falling value of the dollar) and it is likely inflation will take hold as the increased cost of energy and they value of the dollar move to partially compensate for the over valuation of both the stock market and the housing market. What this means is that instead of housing prices and the stock market falling the dollar becomes worth less so a 300,000 dollar house that should be worth 200,000 dollars might still sell for 250,000 dollars but that 250,000 dollars is only worth $200,000 in 2007 dollars. Basically bad news.
On that note, tomorrow is National Novel Writting Month and I think I am going to give it a shot. I have no plot and no idea of what I am going to write but we will see:-) I am going to be posting what I write each day here on the website in an effort to keep myself honest. In anycase, I have written enough non-fiction here lets see what the other side of Euclid looks like :-) .
For instance, I topic of interest for me recently has been international finance and the Fed in particular. What role does the fed play and what is its purpose? We know that they set interest rates but why do they do so and what is the result. I won't say that I called the sub-prime mortage collapse but I do think that I agreed with the correct people. The most fascinating part about this whole thing though is trying to figure out why the Fed continued to artificially lower interest rates even after the housing bubble became painfully evident.
Whats the big deal? Well, an amazing amount of money gets lent and traded back and forth every day. The fact that there are such things as day long loans between corporations and banks is amazing to me. This is however overwhelmingly a good thing. Money, with the advent of computerized banking, can flow with almost no resistance to the people who need it most. Unfortunately as the flow of money becomes more complex so does cause and effect.
When you purchase a mortage you are agreeing to pay back the money at a future time and with interest. Now, the bank that gave you the loan would really like to use that interest money now rather then 15 or 20 years from now when the loan matures. As a result a niche market has sprung up where a very large bank will "buy" these mortgages from smaller banks. Everyone wins! Smaller banks only get part of the interest that they would have collected but they get it now and the larger bank gets a fairly secure promise of income since the smaller bank assumes most of the risk in this situation. This larger bank then bundles a whole bunch of mortgages together and sells them again to other institutions.
This can happen several times as each bank takes alittle bit of the promised interest for themselves. This practice also reduces the risk associated with mortgages since once a whole bunch have been grouped together the law of large numbers means you can very accurately predict the percent that will default and therefor have a secure and stable income stream.
Here is where it gets even more tripy as far as I can figure it out. Once a bank buys a large hunk of mortgages it then uses this to leverage other more risky investments. In a sense, they are using these promises of future money to be able to inflate the current amount of wealth at their disposal and therefor the amount of loans that they can take out. This is not a bad thing because then the banks or companies can use these new loans to do good things like buy capital for manufacturing or research.
This all works really well so long as one can predict accurately the percentage of mortgages that will default and thus the future value of all this money that everyone is depending on. What happened here is that the small banks stopped caring so much who got loans because it was cheap for the people. Also, the market for mortgages skyrocketed as fully international and computerized money markets came into their own. Lastly, one needs to buy alot of low interest rate mortgages to get a certain amount of future income.
So people were eager to get low interest rate morgages and banks were eager to give low interest rate morgages because larger banks were eager to buy up these low interest rate mortgages. With all this easy *large sum loans* floating about it is not a wonder that the price of homes in many areas became so inflated. As the price of homes continued to rise it became possible for people to take out even larger mortgages backed by the new value of their homes. And I think you can see how this cycle continues.
It all came crashing down as people began buying homes with the expectation of quickly rising home prices and more importantly small banks began issuing loans with the expectation of quickly rising home prices. When interest rates started rising again and people who had variable interest rate loans starting defaulting on their loans the small banks said no problem, I'll sell the home and recoup my loss. But when they tried to resell the home, they couldn't get the price they were expecting. This means that they couldn't give the money they had promised to the larger banks who had bought those mortgages oh so long ago and are now entitled to the money. The larger banks said oh shit because a much larger number of these mortgages were now defaulting then they had predicted.
So, now these larger banks are stuck with future obligations (essentially payments on loans that they took out) that were supposed to be mostly backed by these mortgages that have disappeared. The banks stop taking out loans because they are not sure of what they can pay back and further more stop buying up mortgages because they stop trusting them and the whole system grinds to a halt, which is exactly what happened about 2 months ago.
An interesting parallel is the sight Prosper.com. The premise of the site is that individuals can make loans to individuals. If you want to borrow money you put up an ad saying how much and at what percent interest rate. Then, people willing to loan money make bids as low as 50 dollars at a certain interest rate. As a result, a borrow get money from 50 - 100 different people and a loaner might have money invested in 50 - 100 different people. This spreads out the risk, theoretically, for the loaners. The website, in this case, is actually the one that makes the loan to the borrower and then sells parts of it to the loaners on the site.
What makes it interesting is that many people jumped in thinking wow, I can loan to poor credit people at a much higher interest rate then a bank would give me (15 - 24%) and do good at the same time by giving people with poor credit a chance. In reality enough of the people with poor credit have poor credit for a reason and have defaulted on their loans to dissuade alot of people from lending. Now, the only way to get a loan on the site as a borrower is to have either phenomenal credit or some other aspect of your financial history that is attractive to loaners.
This is what is happening now in the financial markets. It is becoming harder for people to get mortgages because people are realizing that giving loans to people with poor credit is a bad thing. Lucky, this fear seems mostly contained to the housing market at this time because business to business loans are still going strong.
Unfortunately Americans have gotten used to the idea that their house actually makes money for them and even more so is a liquid member of their wealth. As a result, we should see over the next two years a drastic increase in the savings rate. This is a good thing! Currently americans spend more then they make and a large part of this is likely because they feel confident that they can remortgage their house or sell to pay off the debt. As house prices fall due to both a renormalization of prices and a reduction in available buyers (the people who shouldn't have gotten loans in the first place) people will literally see their nest eggs evaporate in front of their eyes and will become much more conservative in their spending.
Simultaneously, oil prices will continue increasing (which won't be helped by the falling value of the dollar) and it is likely inflation will take hold as the increased cost of energy and they value of the dollar move to partially compensate for the over valuation of both the stock market and the housing market. What this means is that instead of housing prices and the stock market falling the dollar becomes worth less so a 300,000 dollar house that should be worth 200,000 dollars might still sell for 250,000 dollars but that 250,000 dollars is only worth $200,000 in 2007 dollars. Basically bad news.
On that note, tomorrow is National Novel Writting Month and I think I am going to give it a shot. I have no plot and no idea of what I am going to write but we will see:-) I am going to be posting what I write each day here on the website in an effort to keep myself honest. In anycase, I have written enough non-fiction here lets see what the other side of Euclid looks like :-) .
posted by Craig Snoeyink at 1:43 PM
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