Today, the United States has a rare window of opportunity to encourage negotiations toward a cease-fire in Somalia, but we must take action immediately. On October 26th, one of Somalia's insurgent groups agreed to put down its arms in exchange for a promise by the Transitional Federal Government (TFG) to include it in the national military, and to set an exit plan for Ethiopian troops. While it is reported that internal fighting has weakened this particular group, and none of the other stronger insurgent groups have offered to join the deal, this is still a significant and symbolic event. The failed state of Somalia has been plagued by internal chaos and anarchy since the early 1990s. And after a failed UN humanitarian mission humiliated the United States in 1991, we have largely ignored Somalia. That is, until 2006.
By 2006, while the TFG was operating out of Nairobi, a series of Islamic Courts had sprung up throughout the country, bringing the first modicum of stability and regulation to the region in decades. The Courts’ strict adherence to Islamic law prompted much international condemnation, though many Somalis were, for the first time in years, expressing relief for the new security, order, and accountability. To the United States, it did not matter that the capital city, Mogadishu, was safer and more stable, as the administration only saw the red flag of radical Islam, taken to be a synonym for anti-Americanism and terrorism.
Then, in December of 2006, Ethiopia, which is Somalia’s historic enemy, suddenly invaded Somalia to oust the Islamic Courts Union (ICU) and reaffirm the power of the TFG. The ICU leaders fled south into Kenya, and it appeared to be a quick and easy defeat of the de facto authorities. Yet within weeks, the country reverted to a state of disarray, as an ICU Islamist-lead insurgency began fighting the Ethiopian troops. A few weeks after the initial foray into Somalia, it became clear that the US had played a substantial role in the conflict: We gave Ethiopia (one of our allies in the War on Terror in the Horn of Africa) a green light to invade, and supplemented its attacks with our own air strikes against the fleeing ICU leaders. With increased attention paid to the War on Terror in the Horn of Africa, US interest in the conflict has returned.
In the past two years since the Ethiopian invasion, Somalia (particularly the area around Mogadishu) has become the worst humanitarian crisis in Africa—even worse than Darfur. The country has seen a resurgence of tribal and clan-based warfare, a multi-faceted insurgency, regional destabilization, an increase in offshore piracy, and a seemingly futile future for the Transitional Federal Government. Yet, US official policy has been to continue to support the TFG and an African Union peacekeeping mission (AMISOM), with the goal of preventing Somalia from becoming a safe-haven for terrorists, as it was, the administration says, under the ICU. Whether the ICU would have become an international threat to the United States is debatable, but what is certain is that by fomenting the current instability that is destroying Somalia, terrorism is much more likely.
Even though the recent economic crisis and upcoming elections are consuming most of our attention, we cannot forget Somalia. This first negotiation between an insurgent group and the TFG is significant, as it shows the willingness of the TFG to solve this crisis and end Ethiopian military control—both of which the Somali people desperately want. Now is the time for the United States and other global actors to show that we want peace in Somalia, and to put pressure on other insurgent groups and the TFG for further negotiations. In addition to strong diplomatic actions, greater focus must be placed on humanitarian aid, and giving tactical or financial support for peacekeepers. It is crucial that attention be directed to the needs of the Somalis as a whole, not just to individual clans and tribal leaders as in the 1990s, if the international community hopes to gain any legitimacy with the people. As we have seen time and time again in Iraq, Afghanistan, and elsewhere, terrorism is much more likely when it can feed off of unstable and devastated areas. If the United States hopes to be taken seriously in the future on our international commitments to human rights, democracy promotion, and fighting terror, we must jump at this rare occasion for diplomacy, before it all falls apart again.
Friday, October 31, 2008
Wednesday, October 29, 2008
Will You Make Extracting Coal Clean too, Mr. President?
Surprise, surprise—the Bush administration is, again, attempting to enact environmentally devastating legislation. The proposal would rewrite a law from 1983 that prohibits coal mining companies from disposing mine tailings (waste from mountaintop removal) into “valley fills” within 100 feet of any intermittent or perennial stream if the dumping impacts the quality and quantity of those water sources. In the new proposal, companies must “minimize the debris they dump,” but are allowed to dump within 100 feet of the water source if it is impossible to avoid. This last piece is not only vague—what constitutes the inability to abide by requirements?—but also gets to the heart of just how far protective environmental policy has been gutted to support lucrative corporate policy. And obviously, coal is not the only example where this is the case. I decided to bring this up, though, because with all of the talk about “clean coal,” not one politician has mentioned how they plan to make coal’s extraction process “clean.” And if you are wondering why, the answer is that it cannot be made clean, especially when the mining companies use mountaintop removal to obtain the coal.
But let me backtrack for a minute and explain what mountaintop removal (MTR) is, and how it works: Mountaintop removal is a relatively new, cheaper, and far more destructive way to mine coal. Traditionally, coal mining was a labor-intensive process, where workers entered into coal depositories through tunnels and shafts, and used tools to break off and move coal (think “Zoolander”). But in MTR, forests are first clear-cut on the mountain, then extraordinarily powerful explosives are used to blow-off its top. Next, the loose soil, rocks, and other refuse is hauled off in trucks, or pushed into the valley below. A dragline is then used to dig deeper and expose the coal, so that other giant machines can extract it. Supposedly, the mining companies are mandated to “reclaim the land,” remaking the mountain’s ecosystem. Not only is this idea nearly impossible—the destroyed ecosystems were thousands of years old and extremely complex—but a meaningful attempt at reclamation is rare.
What usually happens is that the mining company attempts to stabilize the loose rocks, and the tailings (leftover material after the coal has been removed) are pushed into the valley where they block rivers and streams. It is estimated that over 1200 miles of streams in the Appalachian Mountains has been damned, slowed, or polluted by MTR. Erosion is a huge problem, as is the tendency for non-native species to invade and proliferate. Further, the processing of coal creates “slurry,” or “coal sludge,” which is either pumped back into the hollow mountain (where it inevitably escapes) or stored in “sludge pools” at the base of the mountain. What was once a thriving and healthy ecosystem is transformed into a wasteland.
The impacts from MTR are felt in the areas around the mountain too: sludge often leaks into local water systems, and the ponds can burst, flooding and poisoning local areas. MTR destroys important animal and plant habitats, and has extremely detrimental health implications for those living in the area, as people suffer from airborne dust and debris, flash floods from erosion, and toxic water supplies. MTR, contrary to coal company rhetoric, does not create jobs—it actually eliminates jobs because it is far less labor-intensive than traditional mining techniques.
MTR is already a horrible environmental and human rights problem, and the Bush administration’s new proposed legislation will only facilitate further damage. But what is most significant, I believe, is not the egregious behavior of the current administration (I doubt anyone is surprised by this proposal), or the lack of discussion about mining coal (clearly no politician mentions it because removing coal from mountains, by definition, cannot circumvent human and environmental damages), but the failure to mention the necessary lifestyle changes we must make as a country. Finding better ways to mine and burn coal is not the answer; the way we live, and the amount of energy we use has to change. Because I am not running for political office, I can say this outright: no amount of clean or alternative energy will solve our energy problems in the long run; we have to change the way we live.
At the end of the day, this proposal will not change much: dumping mine tailings 100 feet away from water sources still causes huge problems, and mining companies already breech the 100-foot buffer zones regularly. What must change, though, is our perception about the quality of our environment, and the role we play in it.
But let me backtrack for a minute and explain what mountaintop removal (MTR) is, and how it works: Mountaintop removal is a relatively new, cheaper, and far more destructive way to mine coal. Traditionally, coal mining was a labor-intensive process, where workers entered into coal depositories through tunnels and shafts, and used tools to break off and move coal (think “Zoolander”). But in MTR, forests are first clear-cut on the mountain, then extraordinarily powerful explosives are used to blow-off its top. Next, the loose soil, rocks, and other refuse is hauled off in trucks, or pushed into the valley below. A dragline is then used to dig deeper and expose the coal, so that other giant machines can extract it. Supposedly, the mining companies are mandated to “reclaim the land,” remaking the mountain’s ecosystem. Not only is this idea nearly impossible—the destroyed ecosystems were thousands of years old and extremely complex—but a meaningful attempt at reclamation is rare.
What usually happens is that the mining company attempts to stabilize the loose rocks, and the tailings (leftover material after the coal has been removed) are pushed into the valley where they block rivers and streams. It is estimated that over 1200 miles of streams in the Appalachian Mountains has been damned, slowed, or polluted by MTR. Erosion is a huge problem, as is the tendency for non-native species to invade and proliferate. Further, the processing of coal creates “slurry,” or “coal sludge,” which is either pumped back into the hollow mountain (where it inevitably escapes) or stored in “sludge pools” at the base of the mountain. What was once a thriving and healthy ecosystem is transformed into a wasteland.
The impacts from MTR are felt in the areas around the mountain too: sludge often leaks into local water systems, and the ponds can burst, flooding and poisoning local areas. MTR destroys important animal and plant habitats, and has extremely detrimental health implications for those living in the area, as people suffer from airborne dust and debris, flash floods from erosion, and toxic water supplies. MTR, contrary to coal company rhetoric, does not create jobs—it actually eliminates jobs because it is far less labor-intensive than traditional mining techniques.
MTR is already a horrible environmental and human rights problem, and the Bush administration’s new proposed legislation will only facilitate further damage. But what is most significant, I believe, is not the egregious behavior of the current administration (I doubt anyone is surprised by this proposal), or the lack of discussion about mining coal (clearly no politician mentions it because removing coal from mountains, by definition, cannot circumvent human and environmental damages), but the failure to mention the necessary lifestyle changes we must make as a country. Finding better ways to mine and burn coal is not the answer; the way we live, and the amount of energy we use has to change. Because I am not running for political office, I can say this outright: no amount of clean or alternative energy will solve our energy problems in the long run; we have to change the way we live.
At the end of the day, this proposal will not change much: dumping mine tailings 100 feet away from water sources still causes huge problems, and mining companies already breech the 100-foot buffer zones regularly. What must change, though, is our perception about the quality of our environment, and the role we play in it.
Saturday, October 4, 2008
The Financial Crisis 101
Published in the Connecticut College Voice
We are in a huge financial crisis. But what exactly does this mean? Is the world collapsing around us? Should we take to the hills and hunker-down? I know a lot of us are confused about what happened, and what is happening now. I think this is partly the case because the economic lexicon is rather inaccessible to the majority, and because it is hard to find a good, clear explanation—we need some sort of Financial Crisis 101. So it was with the non-economist in mind that I interviewed Professor McKenna in the Economics department, and set out to write a basic explanation of this crisis. I hope this is helpful, because in a calamity this size, in order to make informed decisions, everyone must understand the situation and the options.
In early 2000, the Federal Reserve had set very low interest rates because the economy was doing well and there was no immediate threat of inflation. In addition, the huge trade imbalance in the US (we import more capital/goods and services than we export) meant that in effect, the rest of the world was giving us goods and services in exchange for US dollars, and then using those US dollars to buy US Treasury bills. This increased the demand for Treasury bills, which is essentially an increase in the supply of willing buyers. The effect of this is that interest rates are driven down, because when supply goes up, prices go down; the interest rate represents the price being charged for the Treasury bills. (It is in the US national interest to sell our debt at the lowest possible interest rate, so that when we pay back those who loaned us money, we are paying them less.) This was directly linked to the highly competitive and robust housing market; low interest rates encourage individuals to take out loans, and more people can therefore afford to buy homes or take out mortgages. (Low interest rates also allow businesses to borrow money for entrepreneurship, financing inventories or for investment.) So with low interest rates, banks were able to offer a huge number of mortgages to homeowners and buyers. And because many banks were trying to sell the same product, they had to offer special deals to borrowers in order to remain competitive. Because the banks wanted to make these loans, they were not as careful as they had been in the past, and relaxed traditional borrowing requirements/safety requirements. They ended up lending money to people who could not pay it back—banks issued sub-prime mortgages (mortgage loans that carry a higher risk to lenders because they are given to people with financial problems).
Economists and critics warned about sub-prime mortgages for years, and what we have seen recently is the materializing of their concerns: banks gave mortgages (loans) to many people who could not afford to pay them back, and the banks were forced to foreclose on those mortgages (take away mortgages because payments have not been made) and seize their homes. This happened over and over again, resulting in a great number of empty homes. The law of supply and demand kicked in, which meant that the excess in the supply of homes drove down the price; i.e., houses were suddenly worth less than the mortgage loans homeowners received a few years earlier. This meant that when homeowners with sub-prime mortgages defaulted, the banks lost money because they seized property that was worth less than the value of the loan they had issued. This is one aspect of the current financial crisis.
Another aspect of the mortgage problem has to do with mortgage-backed securities (a security is essentially a contract that can be assigned a value and traded; in this case, the mortgage/house is used as collateral, a means of securing the transaction). Banks want to give loans because they make a profit on the interest they charge, so when they give mortgage loans, they often then package a group of mortgages and sell them to another institution or investors. The bank then takes the money it received from the sale of those packaged mortgages and offers more loans or mortgages to other buyers. When the bank packages mortgages, they sell them to another financial institution—a sort of middle-man company. This middle-man company then asks other financial institutions to loan them money, using the money homeowners pay for their mortgages as proof that they, the middle-man company, have incoming revenue and will be able to pay back the new loan. Investors are willing to buy them because they are backed by mortgages; they feel confident in their purchases because a house is a solid, physical asset. The new loan is the new security that is backed by mortgages, and those who buy these securities receive income when the homeowners make their mortgage payments. What follows after the buying and selling of these securities is a complicated, and largely non-transparent process of buying and selling similar to the stock market. The connection to the financial crisis is that when people stopped paying their mortgages, there was a severe drop in confidence in mortgage-backed securities, which then caused a crash in their value. This is the heart of the current crisis: there has been a drop in the value of all types of assets as people have lost confidence in the system.
Greed certainly played a role, as bad mortgages were sold and investors made very risky investments in an effort to get higher yields. But greed has always been prevalent in our economic system. What is of greater concern, is the lack of transparency, oversight, and regulation in the financial system. One example concerns derivatives (a way of investing in a particular product or security without owning the assets behind it, such as purchasing mortgage-backed securities—remember, a security is a something assigned a value and traded). The variety of derivative mortgage-backed securities issued is huge, and the structures they take are so complex that only the people who deal with them on a day-to-day basis can really understand how they operate—it is hard for the government or some oversight body to regulate something that they do not understand. Also, many transactions are private, and not recorded the way stock transactions are, which makes oversight and regulation impossible. Without knowing the derivative structures and transaction records, no one can be very certain what the extent of these assets are, who is holding them, and the level of interdependence.
O.K., I hope you are still with me: the impact of the housing crisis was both caused and felt by the relevant financial institutions. And this, in conjunction with poor regulatory and oversight standards, became increasingly visible this past summer and into the fall.
One of the first public signs of this crisis was the trouble faced by Fannie Mae and Freddie Mac this September. Fannie Mae and Freddie Mac were created by the US Congress to provide funds to the housing market so that more Americans could take out mortgages and buy their homes. They are, however, shareholder-owned, private companies, and there are two of them so that there is some competition in the market. Fannie Mae and Freddie Mac do not loan money directly to homeowners, but rather buy pooled mortgages from approved lenders (like banks), and then sell those mortgages to investors; part of what the firms do is similar to the middle-man company described earlier. In purchasing pooled mortgages from a lender (Bank A), the two provide more money for it to use and give out as loans/mortgages. They also insure mortgages, providing the confidence mortgage lenders need in order to make additional loans. The two firms own about half of the US mortgage market, and almost all US mortgage lenders rely upon them. By providing the bridge between mortgage lenders and investors willing to buy mortgages, Fannie and Freddie ensure the availability of sufficient money in this sector.
What happened in early September was a direct result of the housing crisis; just as we saw earlier, mortgage defaults caused a drop in housing prices, and in the success of financial institutions, including Fannie Mae and Freddie Mac. The US government decided to step in and help the two institutions by allowing the US Treasury to buy shares in the company and expand their access to credit, which gives the company the ability to borrow as much money as they need to cover any short-term cash crunches and long-term obligations, and only have to pay interest on the money when they use it. The government will also create new management, guarantee their debts (so the entities to which they owe money will be confident that they will receive their money), and provide them with more liquidity. (Liquidity refers to the ability to convert assets, which is property to which a value can be assigned, into cash. The more liquid something is, the more easily it can be converted to cash.) Mortgage-backed securities is one form of assets owned by Fannie and Freddie, and when the value of those assets decreased, it meant that other financial institutions would be less willing to loan them money, or would loan them less money. If they could sell their bad assets, however, they would have the money required to back more loans, and keep business running. So the purpose of the US bailout to the two firms was for the US to buy their bad loans, hoping that as demand for the loans increased, so too would the value of the assets. Another way to think of this is that the US bought the product of the firms (loans), which increased demand, and increased the value/price of the product. And the increase in product/asset value would mean that Fannie Mae and Freddie Mac would have the collateral they needed for future business. The bailout of Fannie Mae and Freddie Mac is projected to cost taxpayers about $25 billion.
As the financial crisis widened, and before the end of September, the investment bank Lehman Brothers filed for bankruptcy and failed; the investment firm Merrill Lynch was bought by Bank of America; the country’s largest savings bank, Washington Mutual, was purchased by JPMorgan Chase; and the insurance giant, American International Group (AIG), announced it too was in trouble. AIG is a major insurance corporation that issues another type of derivative, loan insurance. To explain what they do, assume Bank A loans money, or gives a mortgage, to an individual, with the expectation of being repaid. If that individual cannot pay back their loan, Bank A loses money. This is where AIG stepped into the picture: they offered loan insurance to banks like Bank A, guaranteeing that, for a set periodic fee, if loans were not paid back, AIG would give Bank A the lost money. This is just like car insurance: I pay a monthly fee, and should I damage my car, the insurance company pays for the repairs. AIG, and car insurance companies, are willing to offer insurance because they assume that the revenue from the fees they charge will offset any money they have to pay out. But part of the reason AIG almost went under was that too many people could not pay off their loans (sub-prime mortgages, for example), and AIG was forced to pay out more money than they were receiving from the regular fee payments.
Companies like Bank A and AIG expect a revenue flow from their underlying assets, which leads them to enter into new deals and derivative revenue flows. To explain this another way, they expect to make money off the first transaction (mortgage payments with interest, for instance), which allows and entices them to engage in a second, or third transaction (mortgage-backed securities or insurance, for instance). As long as money flows through the system regularly (people make their mortgage payments and banks like AIG do not have to issue more in insurance repayments than they take in) everything is fine. But when something goes wrong (people cannot repay their sub-prime mortgages) everything else is affected. People lost confidence in AIG, and no one was willing to buy new shares or buy the company, which further decreased confidence in it. It is crucial to remember how influential market psychology is to this sector of the financial system. The problem we have right now is not that there is a lack of money to buy shares, or essentially loan money to the failing banks, but that because of a crisis of confidence in the overall system, no one is willing to do so, even at high interest rates. The US government again stepped in to help AIG, and announced an $85 billion rescue plan, which included a stipulation that 80% of the institution would be owned by the US government.
The US is known as the ultimate insurer; by backing institutions it is tacitly saying that the institution will be okay. The just-passed Congressional bill to buy up to $700 billion (funded by the selling of bonds and Treasury notes) of bad loans at a lower-than-usual market price is intended to increase confidence in the financial sector. The $700 billion will be used to buy bad loans from banks (essentially buying the product of the bank), and holding on to them until the housing market improves (which the government expects will occur). If the value of the loans and assets increases, the US is hoping to sell off the loans to investors at a higher price, and make a profit for US taxpayers. Some of these loans will probably be defaulted on, but the hope is that when the market improves, there will be a willingness on the part of buyers to pay higher prices for homes, and the government will get the money back. (Think of the government as owning and selling homes). If the price the government resells it for is less than they paid (if the government loses money), then the bill stipulates that somehow the banking or financial system will be forced to pay the difference—the bill does not stipulate how this will be done, but is to be determined in the future. The bill also says that the government will receive warrants (the ability to acquire stocks in the future) from these banks. What this means is that should the loans not be paid off in the future, the government will make up the lost money by becoming a partial shareholder of the company (owning stock). As a shareholder, they would be entitled to some of the bank’s profits. The goal of the bill is to increase confidence in the financial system, though it is complicated by the inevitable uncertainty of the future.
There also has been a tremendous failure on the part of our country’s leaders to explain, in layman's terms, what is happening to the system, and why this crisis is not just about bailing out rich people on Wall Street. Any proposed bill will help “the fat cats” on Wall Street, but it will also be an attempt to save "Main Street," or everyone who participates in the real economy (the production of output and jobs). Its effects will also be felt in the global economic system. In a crisis of confidence, as we currently have, failure to pass a “bailout” will only exacerbate feelings of low confidence. This is exactly what happened when the House of Representative did not pass the originally-proposed bill on Monday, September 29th; one could literally watch the price of stocks decreasing in record-breaking drops. Times of stock volatility are evidence of uncertainty, which again, decreases overall confidence; it becomes a downward spiral. In the absence of confidence, credit dries up (no one is willing to make loans/buy stock), which decreases investment in the economy. What can follow from that situation is a decrease in both supply and demand for all sorts of goods and services, creating the great potential for a prolonged recession and a loss of many jobs throughout the economy. The same thing is true in the international economy: if the rest of the world loses confidence in the US system, they stop buying bonds (which finance a great deal of government expenditures). And as I explained earlier, if bonds stop being purchased, interest rates go up, and with higher interest rates, firms are less likely to borrow money, and overall investment decreases. With less money invested in the system and in businesses, we slip into a deep recession.
There is great danger in the common sentiment that any Congressional proposal is only “a bailout for Wall Street,” as public outcry sways the opinion of Congressional representatives; public outcry should sway political representatives in a democracy, but the public must also be informed. What happened, and is still happening on Wall Street has a direct impact on all aspects of the economy: it impacts public goods like Federal and State-funded infrastructures, the ability of students to take out loans for college, and it poses a great challenge to the myriad of businesses that provide jobs, goods and services. That being said, the specifics of the bill that was passed will make a huge difference in how this crisis is handled and in the prospects for the future.
No one can know what the future will look like, or even the impact of bank consolidation, but we have a better chance of preventing problems down the road with new regulation. The financial world changes very rapidly, and we need a new array of regulation and oversight to keep up with changes, and to modify accordingly. It is not simply that we need more regulation; we need a different kind of regulation.
I hope this article was helpful, and that we all continue to make an effort to follow the political and economic developments of this financial crisis. This is likely to be one of the most defining events of our lifetime, and it is essential that we remain informed.
We are in a huge financial crisis. But what exactly does this mean? Is the world collapsing around us? Should we take to the hills and hunker-down? I know a lot of us are confused about what happened, and what is happening now. I think this is partly the case because the economic lexicon is rather inaccessible to the majority, and because it is hard to find a good, clear explanation—we need some sort of Financial Crisis 101. So it was with the non-economist in mind that I interviewed Professor McKenna in the Economics department, and set out to write a basic explanation of this crisis. I hope this is helpful, because in a calamity this size, in order to make informed decisions, everyone must understand the situation and the options.
In early 2000, the Federal Reserve had set very low interest rates because the economy was doing well and there was no immediate threat of inflation. In addition, the huge trade imbalance in the US (we import more capital/goods and services than we export) meant that in effect, the rest of the world was giving us goods and services in exchange for US dollars, and then using those US dollars to buy US Treasury bills. This increased the demand for Treasury bills, which is essentially an increase in the supply of willing buyers. The effect of this is that interest rates are driven down, because when supply goes up, prices go down; the interest rate represents the price being charged for the Treasury bills. (It is in the US national interest to sell our debt at the lowest possible interest rate, so that when we pay back those who loaned us money, we are paying them less.) This was directly linked to the highly competitive and robust housing market; low interest rates encourage individuals to take out loans, and more people can therefore afford to buy homes or take out mortgages. (Low interest rates also allow businesses to borrow money for entrepreneurship, financing inventories or for investment.) So with low interest rates, banks were able to offer a huge number of mortgages to homeowners and buyers. And because many banks were trying to sell the same product, they had to offer special deals to borrowers in order to remain competitive. Because the banks wanted to make these loans, they were not as careful as they had been in the past, and relaxed traditional borrowing requirements/safety requirements. They ended up lending money to people who could not pay it back—banks issued sub-prime mortgages (mortgage loans that carry a higher risk to lenders because they are given to people with financial problems).
Economists and critics warned about sub-prime mortgages for years, and what we have seen recently is the materializing of their concerns: banks gave mortgages (loans) to many people who could not afford to pay them back, and the banks were forced to foreclose on those mortgages (take away mortgages because payments have not been made) and seize their homes. This happened over and over again, resulting in a great number of empty homes. The law of supply and demand kicked in, which meant that the excess in the supply of homes drove down the price; i.e., houses were suddenly worth less than the mortgage loans homeowners received a few years earlier. This meant that when homeowners with sub-prime mortgages defaulted, the banks lost money because they seized property that was worth less than the value of the loan they had issued. This is one aspect of the current financial crisis.
Another aspect of the mortgage problem has to do with mortgage-backed securities (a security is essentially a contract that can be assigned a value and traded; in this case, the mortgage/house is used as collateral, a means of securing the transaction). Banks want to give loans because they make a profit on the interest they charge, so when they give mortgage loans, they often then package a group of mortgages and sell them to another institution or investors. The bank then takes the money it received from the sale of those packaged mortgages and offers more loans or mortgages to other buyers. When the bank packages mortgages, they sell them to another financial institution—a sort of middle-man company. This middle-man company then asks other financial institutions to loan them money, using the money homeowners pay for their mortgages as proof that they, the middle-man company, have incoming revenue and will be able to pay back the new loan. Investors are willing to buy them because they are backed by mortgages; they feel confident in their purchases because a house is a solid, physical asset. The new loan is the new security that is backed by mortgages, and those who buy these securities receive income when the homeowners make their mortgage payments. What follows after the buying and selling of these securities is a complicated, and largely non-transparent process of buying and selling similar to the stock market. The connection to the financial crisis is that when people stopped paying their mortgages, there was a severe drop in confidence in mortgage-backed securities, which then caused a crash in their value. This is the heart of the current crisis: there has been a drop in the value of all types of assets as people have lost confidence in the system.
Greed certainly played a role, as bad mortgages were sold and investors made very risky investments in an effort to get higher yields. But greed has always been prevalent in our economic system. What is of greater concern, is the lack of transparency, oversight, and regulation in the financial system. One example concerns derivatives (a way of investing in a particular product or security without owning the assets behind it, such as purchasing mortgage-backed securities—remember, a security is a something assigned a value and traded). The variety of derivative mortgage-backed securities issued is huge, and the structures they take are so complex that only the people who deal with them on a day-to-day basis can really understand how they operate—it is hard for the government or some oversight body to regulate something that they do not understand. Also, many transactions are private, and not recorded the way stock transactions are, which makes oversight and regulation impossible. Without knowing the derivative structures and transaction records, no one can be very certain what the extent of these assets are, who is holding them, and the level of interdependence.
O.K., I hope you are still with me: the impact of the housing crisis was both caused and felt by the relevant financial institutions. And this, in conjunction with poor regulatory and oversight standards, became increasingly visible this past summer and into the fall.
One of the first public signs of this crisis was the trouble faced by Fannie Mae and Freddie Mac this September. Fannie Mae and Freddie Mac were created by the US Congress to provide funds to the housing market so that more Americans could take out mortgages and buy their homes. They are, however, shareholder-owned, private companies, and there are two of them so that there is some competition in the market. Fannie Mae and Freddie Mac do not loan money directly to homeowners, but rather buy pooled mortgages from approved lenders (like banks), and then sell those mortgages to investors; part of what the firms do is similar to the middle-man company described earlier. In purchasing pooled mortgages from a lender (Bank A), the two provide more money for it to use and give out as loans/mortgages. They also insure mortgages, providing the confidence mortgage lenders need in order to make additional loans. The two firms own about half of the US mortgage market, and almost all US mortgage lenders rely upon them. By providing the bridge between mortgage lenders and investors willing to buy mortgages, Fannie and Freddie ensure the availability of sufficient money in this sector.
What happened in early September was a direct result of the housing crisis; just as we saw earlier, mortgage defaults caused a drop in housing prices, and in the success of financial institutions, including Fannie Mae and Freddie Mac. The US government decided to step in and help the two institutions by allowing the US Treasury to buy shares in the company and expand their access to credit, which gives the company the ability to borrow as much money as they need to cover any short-term cash crunches and long-term obligations, and only have to pay interest on the money when they use it. The government will also create new management, guarantee their debts (so the entities to which they owe money will be confident that they will receive their money), and provide them with more liquidity. (Liquidity refers to the ability to convert assets, which is property to which a value can be assigned, into cash. The more liquid something is, the more easily it can be converted to cash.) Mortgage-backed securities is one form of assets owned by Fannie and Freddie, and when the value of those assets decreased, it meant that other financial institutions would be less willing to loan them money, or would loan them less money. If they could sell their bad assets, however, they would have the money required to back more loans, and keep business running. So the purpose of the US bailout to the two firms was for the US to buy their bad loans, hoping that as demand for the loans increased, so too would the value of the assets. Another way to think of this is that the US bought the product of the firms (loans), which increased demand, and increased the value/price of the product. And the increase in product/asset value would mean that Fannie Mae and Freddie Mac would have the collateral they needed for future business. The bailout of Fannie Mae and Freddie Mac is projected to cost taxpayers about $25 billion.
As the financial crisis widened, and before the end of September, the investment bank Lehman Brothers filed for bankruptcy and failed; the investment firm Merrill Lynch was bought by Bank of America; the country’s largest savings bank, Washington Mutual, was purchased by JPMorgan Chase; and the insurance giant, American International Group (AIG), announced it too was in trouble. AIG is a major insurance corporation that issues another type of derivative, loan insurance. To explain what they do, assume Bank A loans money, or gives a mortgage, to an individual, with the expectation of being repaid. If that individual cannot pay back their loan, Bank A loses money. This is where AIG stepped into the picture: they offered loan insurance to banks like Bank A, guaranteeing that, for a set periodic fee, if loans were not paid back, AIG would give Bank A the lost money. This is just like car insurance: I pay a monthly fee, and should I damage my car, the insurance company pays for the repairs. AIG, and car insurance companies, are willing to offer insurance because they assume that the revenue from the fees they charge will offset any money they have to pay out. But part of the reason AIG almost went under was that too many people could not pay off their loans (sub-prime mortgages, for example), and AIG was forced to pay out more money than they were receiving from the regular fee payments.
Companies like Bank A and AIG expect a revenue flow from their underlying assets, which leads them to enter into new deals and derivative revenue flows. To explain this another way, they expect to make money off the first transaction (mortgage payments with interest, for instance), which allows and entices them to engage in a second, or third transaction (mortgage-backed securities or insurance, for instance). As long as money flows through the system regularly (people make their mortgage payments and banks like AIG do not have to issue more in insurance repayments than they take in) everything is fine. But when something goes wrong (people cannot repay their sub-prime mortgages) everything else is affected. People lost confidence in AIG, and no one was willing to buy new shares or buy the company, which further decreased confidence in it. It is crucial to remember how influential market psychology is to this sector of the financial system. The problem we have right now is not that there is a lack of money to buy shares, or essentially loan money to the failing banks, but that because of a crisis of confidence in the overall system, no one is willing to do so, even at high interest rates. The US government again stepped in to help AIG, and announced an $85 billion rescue plan, which included a stipulation that 80% of the institution would be owned by the US government.
The US is known as the ultimate insurer; by backing institutions it is tacitly saying that the institution will be okay. The just-passed Congressional bill to buy up to $700 billion (funded by the selling of bonds and Treasury notes) of bad loans at a lower-than-usual market price is intended to increase confidence in the financial sector. The $700 billion will be used to buy bad loans from banks (essentially buying the product of the bank), and holding on to them until the housing market improves (which the government expects will occur). If the value of the loans and assets increases, the US is hoping to sell off the loans to investors at a higher price, and make a profit for US taxpayers. Some of these loans will probably be defaulted on, but the hope is that when the market improves, there will be a willingness on the part of buyers to pay higher prices for homes, and the government will get the money back. (Think of the government as owning and selling homes). If the price the government resells it for is less than they paid (if the government loses money), then the bill stipulates that somehow the banking or financial system will be forced to pay the difference—the bill does not stipulate how this will be done, but is to be determined in the future. The bill also says that the government will receive warrants (the ability to acquire stocks in the future) from these banks. What this means is that should the loans not be paid off in the future, the government will make up the lost money by becoming a partial shareholder of the company (owning stock). As a shareholder, they would be entitled to some of the bank’s profits. The goal of the bill is to increase confidence in the financial system, though it is complicated by the inevitable uncertainty of the future.
There also has been a tremendous failure on the part of our country’s leaders to explain, in layman's terms, what is happening to the system, and why this crisis is not just about bailing out rich people on Wall Street. Any proposed bill will help “the fat cats” on Wall Street, but it will also be an attempt to save "Main Street," or everyone who participates in the real economy (the production of output and jobs). Its effects will also be felt in the global economic system. In a crisis of confidence, as we currently have, failure to pass a “bailout” will only exacerbate feelings of low confidence. This is exactly what happened when the House of Representative did not pass the originally-proposed bill on Monday, September 29th; one could literally watch the price of stocks decreasing in record-breaking drops. Times of stock volatility are evidence of uncertainty, which again, decreases overall confidence; it becomes a downward spiral. In the absence of confidence, credit dries up (no one is willing to make loans/buy stock), which decreases investment in the economy. What can follow from that situation is a decrease in both supply and demand for all sorts of goods and services, creating the great potential for a prolonged recession and a loss of many jobs throughout the economy. The same thing is true in the international economy: if the rest of the world loses confidence in the US system, they stop buying bonds (which finance a great deal of government expenditures). And as I explained earlier, if bonds stop being purchased, interest rates go up, and with higher interest rates, firms are less likely to borrow money, and overall investment decreases. With less money invested in the system and in businesses, we slip into a deep recession.
There is great danger in the common sentiment that any Congressional proposal is only “a bailout for Wall Street,” as public outcry sways the opinion of Congressional representatives; public outcry should sway political representatives in a democracy, but the public must also be informed. What happened, and is still happening on Wall Street has a direct impact on all aspects of the economy: it impacts public goods like Federal and State-funded infrastructures, the ability of students to take out loans for college, and it poses a great challenge to the myriad of businesses that provide jobs, goods and services. That being said, the specifics of the bill that was passed will make a huge difference in how this crisis is handled and in the prospects for the future.
No one can know what the future will look like, or even the impact of bank consolidation, but we have a better chance of preventing problems down the road with new regulation. The financial world changes very rapidly, and we need a new array of regulation and oversight to keep up with changes, and to modify accordingly. It is not simply that we need more regulation; we need a different kind of regulation.
I hope this article was helpful, and that we all continue to make an effort to follow the political and economic developments of this financial crisis. This is likely to be one of the most defining events of our lifetime, and it is essential that we remain informed.
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