Thursday, September 25, 2008

How We Got Here and Where We Are Going

The government is trying to do their best to create a plan to get us out of the mess that they put us in.  Still, nothing is passed yet so there may yet still be hope that they do the right thing which would be to do nothing.  I just find it very ironic that just six months ago, both Bush and Paulson told the American People we had no problems, and now we are suddenly on the precipice look straight at Doomsday.  It was a lie six months ago and its a lie today.  At least they are consistent.

The saddest part of the whole thing is that they obviously didn't see it coming.  I mean seriously, how could you not.  They created this mess through their own actions.  Let us look back and see exactly how this happened.

In 1999, the government decides that  it would be a great idea if everyone could afford to buy a home.  This is an idiotic notion but it sounds good politically so the American people eat it up.  To enable this "plan" the government allows Freddie and Fannie to lend money to people with less than worthy credit.  Isn't that nice?  Isn't it great that we can enable the "American Dream" by allowing people to own things they can't really afford?  This of course masks an even bigger problem.  These are Govermented Sponsored Enterprises.  This gives them an implicit backing of the government making people believe the government won't let them fail.  Even worse, people get jobs there by political appointment, further insulating them from scrutiny.  But this is only one of many idiotic things that the government does.

In 2001, we have 9/11.  Fearing a massive recession, the government takes it upon itself to shore up confidence and lower interest rates to an insanely low level.  Rates basically go to 0 percent making the cost of captial very very cheap.  People can now get very low percentage mortgages.   Add this to the above, and you get people who shouldn't be getting loans able to take how huge loans for very cheap.

Innovation now takes hold.  Financial engineering allowed financial institutions to take all these mortgages, package them up, and sell them off as securities.  They supposedly are able to create very "safe" assets by slicing and dicing them in a myriad of ways.  Of course, this also makes the security very hard to understand and greatly obscures who really owns what.  But becasue banks can do this, they no longer really care about making good loans.  There motives now move from making good loans, because they will eventually have to collect on these loans, to making as many loans as possible so that they can make these new fangled securities.  They don't care if the payer never pays the money back becasue they already sold off the mortgage.  Of course this isn't the governments fault, so I'll give them a pass on this one.

Now the SEC gets involved.  There have historically been regulations that only allow banks to take on so much debt when compared to assets.  This limits their ability to use too much leverage.  Of course you remember how leverage works.   It allows you to greatly multiply your gains AND losses.  Of course, when it seems like housing prices can only go straight up, and people are making money hand over fist, the banks lobby to be allowed to use more leverage so they can make insane amounts of money.  Of course when things go south, they go south in a hurry too, which is exactly what we are seeing.  These banks were able to take huge positions on assets they don't have, and thus make a situation that threatens the entire financial market.

So there you have it.  Giving way too much easy and cheap money to people who shouldn't have it and have no accountability for when things go wrong.  Doesn't that sound exactly what Paulson is asking for when he asks for $700 billion with no restrictions, no oversight and no accountability? How on earth does anyone think that will end up OK?  It of course won't.  What will happen is that they will pass some form of bailout.  It won't at all do what they want it to do.  In fact, its pretty easy to see some of the awful effects it will have.

At the very least, the dollar is going to go into the tank.  Inflation is inevitable.  We already owe way too much money to the rest of the world.  Now the government is going to essentially print money to pay for this plan.   This will have very negative effect.  Inflation is one of the worse things that can happen from an economic perspective.  This will also drag out the housing problems we are having now as markets will take longer to correct.  This is just prolonging the pain.  This will increase moral hazard thus creating a crisis even bigger the next time.

How do you play this?  Despite my earlier advice that the dollar was going up in the short term (thanks to a years of getting hammered and the rest of the world also slowing down) the dollar will fall.  Commodities now have a ways to go up, despite their highs.   So sell the dollar, buy commodities, and short the market.


  1. Although the government had a hand in creating the current financial crisis, I don't think the free market can unravel this mess on its own. The government will have to be involved, but to what extent is still to be seen. I don't like what Paulson said about absolute power to fix this problem. $700 billion is a lot of money; A lot of tax payers' money. No one should ever have absolute authority to handle that kind of money without oversight or itemization. However, I can understand (if) once we have a thought out plan, there shouldn't be too much red tape to get actions into place.

  2. Paulson's proposal for no oversight does sound highly suspect. Even just 6 months of total control over $300 billion is too risky. The bill was modified to state that Paulson will report his progress to the president. Even that is not enough! There needs to be more checks and balance. After all, isn't that how this whole mess got started? No more unaccounted money and bad debts. No more of the same ineffective, corrupt regimen.

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