Joined: Oct 04, 2004 Posts: 2498 Location: Ye Olde Englande
Posted: Tue Aug 14, 2007 10:00 am Post subject: Economics 101
I noticed this forum was lacking an overall guide to economics for dummies such as myself who have no idea what derivatives or hedge funds are.
I therefore decided to start this thread in the hope that it will be able to be used as reference for people who are trying to get a proper understanding of the current sub-prime crisis or how the mechanics of a dollar collapse would work.
I would really appreciate anyone who wishes to give their time to provide information or links that would help.
It can be really frustrating reading articles on economics and then finding out that the crisis is linked to CDO's etc and not being able to understand it.
With that in mind I thought I would start with the current crisis involving the sub-primes. Here's how I currently understand it.
Following the collapse of the dotcom boom and the events of 9/11 governments round the world slashed interest rates in order to prevent serious damage to the global economy. In Japan rates went to 0% and in America to 50 year lows of 1%.
These interest rate cuts sparked a boom in credit lending throughout the Western world leading to booming housing markets and lots of people being able to get loans and credit cards.
However over the last few years interest rates have been going up again. This is mainly to combat excessive spending and also to control inflation which has been rising due to the high demand for commodities which have pushed up raw material costs.
In the United States, during this housing boom, many unscrupulous lenders gave mortgages to lots of people with questionable credit ratings known as Sub-Prime Mortgages. With each interest rate rise these peoples budgets were stretched further and further to the point that they foreclosed on their mortgage and lost their home.
Now here's the part I don't get.
A lot of these sub-prime mortgages were actually owned by banks and other major companies who were expecting a return on these mortgages at some point. As foreclosures increased banks realised that they would not get the return they hoped for and so tried to bail out. This caused stocks to plummet and central banks to intervene which brings us to where we are now.
I guess that in order to properly understand economics you just have to follow the money. Or then again it may not be as simple as that. This brings me to the first few questions that I have.
1. If central banks are intervening by injecting money where does this money come from? Other banks that are also in trouble? Doesn't make sense.
2. Surely this money has to be paid back sometime?
3. How did these companies come to have these sub-primes as an important part of their long term profits and surely the risks on these "investments" would be extremly high?
Thanks in advance for anyone who answers. _________________ "The age of excess is over. The age of entropy has begun"
Posted: Tue Aug 14, 2007 12:16 pm Post subject: Re: Economics 101
What you aren't getting is that a lot of the subprime mortgages have been packaged by investment banks into securities and sold on the bond market. It's the holders of these bonds that are exposed to the risk of mortgage defaults and bankruptcies. I believe that the Bear Sterns hedge funds that imploded had high exposure to this type of paper for example.
Joined: Mar 18, 2005 Posts: 2570 Location: Minnesota
Posted: Tue Aug 14, 2007 1:55 pm Post subject: Re: Economics 101
I'm just learning this myself, But i find it fascinating.
The subprime mortgages were not very riskey because house prices kept going up (for the last several years), and access to refinancing your home-loan was so easy & available. And even if there was a foreclosure, the bank/fund could recoup any loss my selling the house.
All of a sudden, house prices started to fall and (starting with the Bear Stearns hedge funds collapse)... TPTB realized that they were not recouping their losses when selling a house after a foreclosure.
Now this set off a panic, & everybody (Hedge fund managers, Big banks, and the little guy as well) are all rushing for the exits on anything to do with mortgages, especially subprime & ALT-A...all of a sudden there's no money to lend for mortgages...everybody is stuffing their money into US Treasury bonds to avoid loosing their money. (Really not much different than a bank run).
So the Fed steps in & says We'll borrow you half a zillion & you borrow us those CDO's...that will put cash back into the system & things will start working again...it will build confidence in the system & people will start putting their money back into CDO's.
My understaning of it, it that the money (liquidity) they pumped into the markets was simply created out of thin air...Sure wish I had that ability
I'm just learing this stuff myself (& I don't claim to be an expert) so anybody feel free to correct me if i've gotten anything wrong).
You also have the CDO thing...now it used to be that a bank would hold your loan...so before giving you that loan they had good reason to check out your credit history & deny you if anything looked bad. But now, The bank/lender gives you the loan, packages it up in bundles of loans (Collateralized Debt Obligations) and sells it to investors on wall street...Who then use that as collateral so they can borrow more money from said bank to buy EVEN MORE CDO's (this is where we start getting into that complicated thingy called derivatives I believe). This removes the responsibilty of checking out the borrower from the original lender (bad idea).
I'll try to write more later, but first I'd like to see if anybody is gonna tell me I got it all wrong _________________ Quis custodiet ipsos custodes.
Posted: Tue Aug 14, 2007 4:40 pm Post subject: Re: Economics 101
stu wrote:
1. If central banks are intervening by injecting money where does this money come from? Other banks that are also in trouble? Doesn't make sense.
2. Surely this money has to be paid back sometime?
3. How did these companies come to have these sub-primes as an important part of their long term profits and surely the risks on these "investments" would be extremly high?
Thanks in advance for anyone who answers.
1. The money comes from (at the moment) central bank reserves, what they're doing (now I'm just talking the Fed here on in for simplicity) is Repo operations. Basically they offer to buy debt, that could be treasury bonds, GSE debt (government sponsored entitys) like Freddie Mac and Fannie Mae or even MBS (mortgage backed securities) which are just a bunch of mortgages packaged into a 'bond', although these things get complicated with 'interest only' and 'principal only' and all kinds of crap.
So what they do is a REPO, which is they buy this stuff/crap for cash and the seller is obliged to pay back the cash after a certain amount of time. For the Fed this is usually overnight and 14 day Repos. The idea is that a bank can hardly lend out their government bond or pay obligations with it but if it's replaced by cash you DO have more cash on hand to lend out, so when they do this on a large scale the amount of cash should drive down interbank lending rates and thus the 'price of money' ie interest rates across the board. So yes they want that money back and sharpish.
As that covers question 2, question number 3:
Pension funds, mutual funds, commercial banks and any other investment vehicle you can think of have all been chasing a yield in this environment (since Q1 2004) where spreads (the difference between 'risk free' that is government bonds of first world countries and any other more risky debt) have contracted, the investment banks piled this crap out of the door and these 'investors' were reassured by the structured finance of CDO's, which is to turn an MBS into tranches; That one get's paid out before the other. This is how these first tranches got "investment grade" ratings by the rating agencies. Unfortunately for the Fark that bought this stuff they didn't respect the centurys old truism Caveat Emptor. Now they are getting burned because:
1. Hedge funds have used these securities as margin for borrowing and as they are leveraged if they have to sell they have to sell regardless of price as this happens the CDO's are valued less by the banks who are providing that credit which means they must put up more margin which means they have to sell more assets etc etc.
2. The valuations of these securities are marked to model, which means they are based on expected default rates based on previous history, obviously previous history doesn't take in to account the absurd lending practices that got us here.
3. Most 'investors' (AKA the morons holding the bag) hadn't got a clue what they were buying, they were buying this crap because it had a AAA rating from S&P or whoever and they were desperate for yield.
Posted: Tue Aug 14, 2007 7:35 pm Post subject: Re: Economics 101
stu wrote:
1. If central banks are intervening by injecting money where does this money come from? Other banks that are also in trouble? Doesn't make sense.
The money effectively comes from nothing. The central bank buys securities from dealers who agree to buy them back within a set period of time. The central bank buys the securities with freshly created bank reserves, which are created as a central bank liability for the purpose of the transaction. The central bank is left with a new asset (securities) together with an offsetting liability (new bank reserves), both of which disappear from the balance sheet when the repo transaction is completed.
This process provides a (temporary) increase in bank reserves. But essentially, it's accounting jiggery-pokery. _________________ "Who knows what the Second Law of Thermodynamics will be like in a hundred years?" - Economist speaking during planning for World Population Conference in early 1970s
Joined: Oct 04, 2004 Posts: 2498 Location: Ye Olde Englande
Posted: Wed Aug 15, 2007 7:12 am Post subject: Re: Economics 101
I'm beginning to get the gist of this.
The central banks intervene by buying the debt and replacing it with fresh money (apologies if that is oversimplifying things). These banks that are getting hit now have to pay back ECB, FRB, BofJ etc.
In order to understand this part of economics more I believe it really helps to understand the process involved in the creation and distribution of money. In a way it's just like trying to dig to the roots in order to understand how the tree came about.
From what I know money was first created as a form of IOU. Essentially people held their assets in the form of gold and because gold was either too heavy to constantly carry round or you could get mugged on the street carrying the stuff the best thing was to leave it in a building in exchange for a piece of paper which told you how much you owned. Apparently that is how the first banks came to be. Please feel free to correct me as I go on.
Nowadays it seems there are two ways of creating money. The first is the stuff that comes out of thin air and the second is the actual paper stuff. I believe the amount of money in circulation is dependant on various things such as inflation, interest rates, currency exchange etc.
This leads to me to my next few questions:
1. What are the main reasons for the creation of a) paper money and b) digital money.
2. What are the main factors that determine the amount of money needed to be in circulation?
3. If central banks are bailing out the investment banks by taking on their debts and injecting fresh money into the system then surely the repayment of this debt back to central banks is dependant on a growing economy? Considering Western economies are 70-80% dependant on the housing market and consumer spending surely there is the possibility that these debts will never be repaid as all central banks are doing is delaying the inevitable?
Thanks again. _________________ "The age of excess is over. The age of entropy has begun"
Posted: Wed Aug 15, 2007 10:27 am Post subject: Re: Economics 101
stu wrote:
1. What are the main reasons for the creation of a) paper money and b) digital money.
Currency in general was created in order to store surplus labor and life energy. See Adam Smith's The Wealth of Nations. As far as paper currency specifically that was created by governments in order to tax and enslave future generations of corporations and individuals. Digital is simply the modernization of paper. _________________ The Lies Of Richard Heinberg
Posted: Mon Aug 20, 2007 5:06 pm Post subject: Re: Economics 101
stu wrote:
I'm beginning to get the gist of this.
The central banks intervene by buying the debt and replacing it with fresh money (apologies if that is oversimplifying things). These banks that are getting hit now have to pay back ECB, FRB, BofJ etc.
In order to understand this part of economics more I believe it really helps to understand the process involved in the creation and distribution of money. In a way it's just like trying to dig to the roots in order to understand how the tree came about.
From what I know money was first created as a form of IOU. Essentially people held their assets in the form of gold and because gold was either too heavy to constantly carry round or you could get mugged on the street carrying the stuff the best thing was to leave it in a building in exchange for a piece of paper which told you how much you owned. Apparently that is how the first banks came to be. Please feel free to correct me as I go on.
Nowadays it seems there are two ways of creating money. The first is the stuff that comes out of thin air and the second is the actual paper stuff. I believe the amount of money in circulation is dependant on various things such as inflation, interest rates, currency exchange etc.
This leads to me to my next few questions:
1. What are the main reasons for the creation of a) paper money and b) digital money.
2. What are the main factors that determine the amount of money needed to be in circulation?
3. If central banks are bailing out the investment banks by taking on their debts and injecting fresh money into the system then surely the repayment of this debt back to central banks is dependant on a growing economy? Considering Western economies are 70-80% dependant on the housing market and consumer spending surely there is the possibility that these debts will never be repaid as all central banks are doing is delaying the inevitable?
Thanks again.
1. The main reason is that major govenments bankrupted themselves with foreign "adventures", the economic reason (per economists) is that Gold Etc is not expandable thus they can't provide stimulus to the economy.
2. For the USA, the mandate for the FED is maximum growth with low inflation.
3. I was hoping someone would call me on this, but they have'nt. Basically the fed can monetize all kinds of debt, now in a normal situation they wont, but let's say today MBS are not touched with a bargepole (which is true)? Well by law they can monetize all kinds of crap (which means they can "buy" an asset like a mortgage backed security and credit cash out of nowhere to the MBS holders account) the implications of this stuff are yours to figure out....
Posted: Mon Aug 20, 2007 5:20 pm Post subject: Re: Economics 101
So you need to understand one thing and that is that when a repo takes place the "money" or the bid from the Fed comes from nowhere, it doesn't exist but is still credited to the account of the holder of the security. BUT WAIT! This is not all bad, there is a good reason to have a system like this despite what the tin-foil hat wearers claim. But let's be clear this is inflationary, money has been created out of nothing. This is not an criticism of "hard money" nuts, nor an endorsment of fiat money folks, fiat money has a sound "theoretical implementation" but does it work? Do "hard money" systems? This is a rather more complex discussion...
Posted: Mon Aug 20, 2007 5:29 pm Post subject: Re: Economics 101
CrudeAwakening wrote:
stu wrote:
1. If central banks are intervening by injecting money where does this money come from? Other banks that are also in trouble? Doesn't make sense.
The money effectively comes from nothing. The central bank buys securities from dealers who agree to buy them back within a set period of time. The central bank buys the securities with freshly created bank reserves, which are created as a central bank liability for the purpose of the transaction. The central bank is left with a new asset (securities) together with an offsetting liability (new bank reserves), both of which disappear from the balance sheet when the repo transaction is completed.
This process provides a (temporary) increase in bank reserves. But essentially, it's accounting jiggery-pokery.
You're right, but seriously, people find this hard to comprehend whoever they are, it confuses when you explain it like that. And then there's the ever widening assets that can be monetized by LAW by the fed, all checkable...
Posted: Mon Aug 20, 2007 5:29 pm Post subject: Re: Economics 101
http://www.peakoil.com/fortopic30856.html _________________ Just look at us. Everything is backwards; everything is upside down. Doctors destory health, lawyers destroy justice, universities destroy knowledge, governments destroy freedom, the major media destroy information and religions destroy spirituality.
You cannot post new topics in this forum You cannot reply to topics in this forum You cannot edit your posts in this forum You cannot delete your posts in this forum You cannot vote in polls in this forum
News
Discussions
Resources
Members
Forum FAQ
Search
Usergroups
Profile
Log in to check your private messages
Log in
for cash and the seller is obliged to pay back the cash after a certain amount of time. For the Fed this is usually overnight and 14 day Repos. The idea is that a bank can hardly lend out their government bond or pay obligations with it but if it's replaced by cash you DO have more cash on hand to lend out, so when they do this on a large scale the amount of cash should drive down interbank lending rates and thus the 'price of money' ie interest rates across the board. So yes they want that money back and sharpish. 
