What is the problem?

Since Paulson, Bernanke, and Company aren’t forthcoming with layman’s explanations , I thought I’d take a little closer look at the problem to see if I could understand what’s happening here. What I found is that the problem is very large—potentially catastrophic. I’m also astounded by the hubris that got us into this mess, but that’s a topic for another time.

The fundamental problem today is that there is a lack of confidence in the financial system. Not so much by you and me, but by banks that lend money and large institutions that buy the banks’ debt for investment purposes. Investors demand more documentation and higher interest rates, which causes the banks in turn to charge higher interest rates and to be more careful in selecting borrowers. Ultimately, fewer individuals and companies will qualify for loans, and those who do will end up paying higher interest rates. Credit hasn’t dried up, but it’s a lot less available than it was previously. Creditors and investors got burned (in large part by their own greed), and now they’re being very (perhaps overly) cautious.

A key factor in the lack of confidence is that financial institutions’ portfolios have large numbers of assets that are difficult or impossible to value. A simple example would be mortgage backed securities. A mortgage backed security is, in essence, a bundle of loans that a lender has packaged up and sold as a single investment instrument. The price the bank asks for the package is based on the quality of the mortgages that make it up: their face value, the interest rates they pay, their maturities, the quality of the collateral backing them, and the credit worthiness of the borrowers. Industry rating agencies such as Moodys and Standard & Poor’s assign ratings that give some indication as to the risk level of such securities. Investors demand higher interest rates (or, sometimes, lower prices) for more risk.

But there’s a problem. It’s exceedingly difficult to know the real value of even one mortgage. Imagine the difficulty involved in computing the real value of a box that contains 100 mortgages. If you buy the box directly from the originating bank then you can have some confidence in the box’s value. Assuming, of course, that you trust the bank and the rating agency. But if you as an investor want to sell that box on the open market, you’re subject to the whim of the market. When things are going well, that’s a good thing. People are willing to spend $1,000,000 on that box of low-risk loans that pay an average of 5% interest because they have confidence that they’ll get their payments and that they can re-sell the box if they need the cash.

But the market can go sour. If a bank starts reporting higher levels of loan defaults, then every box of loans that the bank sold becomes less valuable because the probability of the box actually paying the stated interest or being sold at face value is lower. You could find that the market value (the price people are willing to pay for) your million-dollar box of loans is only $900,000.

Because of the difficulty in valuing mortgage backed securities (and many other investment vehicles), a very commonly used method of determining their value is mark to market. The box’s value is what people are willing to pay for it. Generally accepted accounting principles state that financial institutions use mark to market in determining their assets’ values. And transparency laws on the books insist that banks and other regulated financial institutions calculate the value of their assets on a daily basis.

Now, imagine that you’re a small bank. You take deposits from customers and lend money to individuals and local companies. You also buy high-quality (i.e. low-risk) mortgage backed securities to invest the depositor’s money. You’re very conservative with your investments, always get good documentation from your borrowers, and everything’s going great. Whenever you need a little cash to meet depositors’ demands, you sell one of those securities on the open market. This is how the financial system works when people have confidence in it.

But if the bank from whom you bought those mortgage backed securities starts seeing a higher than usual number of loan defaults, the value of the security you’re holding in your vault declines. As that bank’s troubles deepen, so do yours because it becomes increasingly difficult to sell those securities–not only at face value, but at all. If the originating bank defaults, you could very well end up unable to find a buyer for your box of loans. At any price.

You know that if you could open the box and show the individual loans to potential buyers, you could at least salvage some value from your investment, but that’s not the way it works. Your investment is essentially worthless. And since you have to report your financial condition on a daily basis, it doesn’t take long for the public (your depositors) to find out and begin demanding their money. You’re wiped out, and you didn’t do anything wrong.

I’m not just spinning a fantasy here, by the way. Such things do happen, and they have a cascade effect. As more securities become worthless, investors become less inclined to buy any securities. Institutions who hold those securities are unable to sell them in order to meet other obligations, and the financial system grinds to a halt.

That’s it in a nutshell. I’m sure there are economists who will say that the problem is more complex than that. In some ways, that’s true. I haven’t mentioned the more creative investment vehicles (like tranches) and the mania that helped get us where we are. I’ve tried to concentrate on what the problem is, rather than what caused it.

The problem, then, is that financial institutions are holding securities that nobody wants to buy. The securities’ values, based on mark to market, are essentially zero because there is no market for them. The truth is that some of those securities are very valuable and some really are worthless. But right now there’s no way for buyers to know which is which. The point behind the bailout is to create a market—to buy securities and by doing so restore some investor confidence so that they, too, will begin buying.

So that’s the problem and the rationale behind the proposed solution. Whether the proposed solution is right or even necessary is still a matter of some debate among economists, and also in my own mind.

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