Understanding the credit mess

I’ve been thrashing about for ideas on how to explain this whole mess, and think I’ve got a decent analogy.  Let’s see how it looks written down.

You have, in your wallet, $20 in cash and a $2000 check for services rendered.  You have $2020 in exchangable notes aka money.

You discover that the check-writer has gone bankrupt before the check cleared.  You have $20 in money, and a piece of paper, the value of which depends on the assets available and total creditors owed (of which your $2000 is part.) If you were planning to pay your bills, you are in deep deep trouble.

The checks are credit.

It’s not just you wanting to pay your bills.  It’s everyone relying on the money that your check represents – and everyone ELSE who had a check that’s now worth, well, nothing.

That’s the situation if credit goes boom  Everybody who was relying on it is now facing hard times if not outright bankruptcy.

Enter the bailout.  Somebody says, “I’ll cover 25% of the check now and give you a post-dated check for the rest.  I’ll help the bankrupt company get back on its feet at which time it will pay off the post-dated check.”

If everyone accepts the post-dating, then they can work out a deal.  A likely working example is that you get $520 in pocket and you sign over the PDC for 80 cents on the dollar for another $1200.  End result, $1720 in your pocket. That’s still a $300 haircut, but it beats having only $20 in your pocket.

The problem with the current situation is that the plan that was tendered sucked.  I think we’ll get a better plan.  Economically, a mediocre plan executed well beats no plan – that leads to total financial melt-down.  (High probability, not guarantee).  See, over 80% of our “money” is credit.  And if the credit is allowed to totally collapse, we hit monstrous deflation.  The only fix for that is dumping so much money into the pool that we have high and even hyper inflation.  Oh, I forgot – the other option is allowing the crash that results.  It’s avoidable – or more accurately, it’s within our power to mitigate the extent.  That is, we’re going to crash at least somewhat, we can control how severe it is.  There are a lot of other issues involved, but this is probably the trigger.

Anyway, that’s the basics, and I hope the model helps people get a handle on it all.

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3 thoughts on “Understanding the credit mess

  1. I was waiting for your analysis on this topic. You analyze things much better than I do (taking the emotion out, which is hard for me to do).

    It sounds as if you believe a bailout is necessary. I’m a little bothered by a capitalist society (or so we say we are) that will bailout rather large failing businesses. I recognize that this is not the same as a bankrupt airline, or bankrupt auto manufacturer. This is the collapse of a financial system – albeit one that exists in 1’s and 0’s in databases somewhere, and has little or no actual trading of real goods. I recognize that the failure of our investing system has more consequences than just lost jobs at those specific companies – but is a bailout necessary? Is this a good use of my tax dollars? Why can’t we let these companies fail, and let the system right itself, or re-create itself?

    just curious on your take if there is no bailout.

  2. Cassidy,

    There are a couple of issues I think need attention here. First is the issue of who (or what) is being “bailed out”. (Bail out is – or should be – the wrong term. I’ll get to that shortly). The balance to be made in letting a business fail is the fact that any failure affects not only itself but all businesses with which it interacts. If I rely on a business and it fails, I need to swiftly find a replacement or face following into failure. This issue is one reason financial institutions have always been so important – and so frequently regulated. Everything is touched by the financial industry by not more than two degrees of separation. For example the Glass-Steagall was intended to keep the financial industry that touches everyone – depository banks – from the higher risk financial industry (investments).

    Add to this commonality of contact the size of the institutions involved, and their failure is a major threat to us all. Were it merely the investment agencies it might not be so significant, but by the fact they’re so intertwined with the banks – the depositories in particular – means their collapse has inevitable impact on us all. A failed bank, without protection, means the failure of a large number of businesses on which it relied.

    As I noted, however, bailout should be the wrong word. I do not like this particular plan, and am glad we seem to be getting something better. Better in that… the old word for the financial industries was “trust”. The people who caused trust to fail should be removed from control of that institution, and it should be placed in other hands believed to be more trustworthy. This is what normally happens with FDIC and OTS takeover of “failed” banks. I’d argue that any plan of recovery should follow the same lines – the reason for the need is similar, after all. Incidentally it hits on a pet focus of mine – undercutting the tendency toward plutocracy. Acting to stabilize the trust we have in the financial system is necessary. “Bailing out” fools who’ve taken stupid risks with that trust should be avoided, not least because it increases the moral hazard.

    We have to patch the system for our own good. But we should do our best to restore and maintain our fiscal and financial trust WITHOUT rewarding those who betrayed it.

  3. But does some “plan” from the government that involves taxpayers picking up the slack do ANYTHING to improve trust in the system? Isn’t that the hardest thing to build? I think the trust is already gone. My mattress looks like a safer place for my money than any of my 401(k) accounts. Some bill passed by the government, to prop up these failing companies isn’t going to make me feel any better.

    The engineer in me wants to see some analysis of the root cause, and something implemented to make it not happen again.

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