Friday, January 2, 2009

WALL STREET AND MAIN STREET ARE THE SAME

1. The economy is all interrelated. If your neighbor loses his job, he is very likely to cut back on spending. Let’s say he cancels his vacation. That hurts the airline and the travel agent and the hotel. If enough people cancel their vacations, then the airline and the travel agent and the hotel may need to lay people off. Then those people will cut back on their spending and not buy as many Christmas presents or cancel some of their cable channels or not go out to restaurants as much which will cause the department store and the Cable company to fire some of their people. Etc. Etc. and this his how recessions get started, and if there are enough industries going through enough difficulties all at the same time, this is how recessions get really bad and once every 50 or 100 years or so you get a really bad one which is called a depression which is where we may be now.

2. What does a credit crisis or credit freeze mean? Well, if you know anyone who got a little worried the past few weeks and went to the bank to take some actual cash out for a rainy day, imagine that happening on a huge scale. People don’t realize the extent to which an economy relies on credit. If you look at the balance sheet of most companies, they have assets and liabilities, and some of those liabilities are very short term. If someone wants to buy a car that costs $20,000, they rarely pay $20,000. They usually pay $2,000 and get a loan for the other $18,000. If the car finance company is not willing to loan them the other $18,000, then they can’t buy the car and both they and the car company are screwed. For the last 10 years, it was easy to get that car loan (”no money down!”). Now there are fewer places for that car loan to come from. The car companies themselves have finance companies that do a lot of the loans, but those finance companies are in danger of going bankrupt and have been for several months. Your finances are in much better shape than GM or Ford. But it’s not just the car companies. General Electric is in horrible shape. They have huge amounts of very short term loans that they constantly refinance. This is called commercial paper. Who is giving them the money? Well, a lot of it comes from money market funds that want to buy very short term safe assets…..let’s say they invest for 30 days at 3%. Those funds come from people like you and me that have money market funds and also from companies that have extra cash that they invest short term. What’s been going on in a massive scale in the past few weeks has been that people like you and me have been selling money market funds and getting the cash or just putting the cash in their bank account AND companies that would normally invest their cash on a short term basis either directly or indirectly with General Electric have elected to not reinvest when they get their money back, so GE is having some trouble borrowing money which is why they did the deal with Buffet and the big stock sale. GE’s problems stem from their GE Credit Company, which has huge amounts of investments in loans and bonds which needs to be financed. And GE is rated AAA. Now, one place companies go for in times of trouble is the banks. They generally have contractual agreements which say they can borrow for several years at a specified rate. What we’ve seen lately is several companies “drawing” on these revolving credit agreements. But the banks don’t really want all the companies to do this…….the banks are in horrible shape and are having the same trouble borrowing money as everyone else. The whole system is based on Trust and once you lose that trust, the whole system can fall apart.

In times like this, the only one people trust (at least for now) is the Government, which is why they have been getting so involved with everything. And you can’t stop people and companies from doing what they will do to survive, even if it hurts the system. In other words, Bush can’t go out and give a speech that tells everyone to just be happy and go back to doing what they were doing a year ago with their money. The natural reaction for everyone is to cut back and tighten lending standards, but that’s actually the opposite of what we need right now.

3. It’s annoying to listen to people call this plan a “Bailout” and for politicians to talk about “Wall St. greed and corruption”. This has been a case of a massive deleveraging. (Leverage means credit is flowing freely, and lots of stuff gets financed easily and prices tend to rise. In deleveraging, everyone is trying to sell assets and pay down loans, and if it happens all at the same time it’s a vicious circle). Basically, Wall Street is caught up in something very powerful that it can’t really contain……you can probably call Wall St. stupid, but not really corrupt. And I’m sure there’s been plenty of cases of individual bad behavior, but not that many cases of real corruption. Think about who has been hurt worst in all this and it’s the people on Wall St. The job losses their will be huge. And the $$ lost in investments in stocks like Bear Stearns and Lehman Brothers…not to mention Merrill, Morgan Stanley, Goldman, etc., has been massive in the extreme. The plan is not a “bailout”…a bailout is when you give someone money free and clear. This is a case of the Government making investments. If enough people pay their mortages, the investment will probably work out reasonably well. But if they actually do invest $700 bil, it’s pretty likely in my mind that your downside is probably $500 bil and your upside is probably $800 bil…or something like that.

4. As far as why this happened, I have a few points. First, stuff like this happens every once in a while. It’s a combination of human nature and financial markets. It’s hard to explain, but it’s not really anyone’s fault. But on the specifics, we have seen a massive increase in home ownership which was brought about by a) official government policy to encourage home ownership, perhaps driven by “liberal” laws that forced banks and institutions like Fannie and Freddie to increase their portfolios to weaker borrowers despite “conservative” attempts to force Fannie and Freddie to get smaller and raise more capital and b) the securitization process which let companies like Countrywide make loans and then sell them to investment banks which packages them together and sold them to investors. The total value of all the houses in the U.S. is huge. I think one number is $14 trillion. Let’s assume the value of that housing stock 10 years ago was $7 trillion and it doubled. Against that $14 trillion there might be $12 trillion of loans….I’m totally making up that number. Let’s say the value of the houses drops from $14 trillion to $10 trillion….not impossible that the market “overshot” by 30%. So now you’ve got $10 trillion worth of houses with $12 trillion of loans and there are $2 trillion of losses. That’s a huge number. It’s 3x the $700 billion and it would mean that ….no, the value of your house may not come back…or at least not for a very long time. But….like I said, these things have happened before and it usually works out….but there will be winners and losers for sure. It’s quite annoying that the value of the S&P 500 is about what it was 10 years ago. It’s not really supposed to work that way, but of course sometimes it does.

I could go on