Tuesday, November 18, 2008

How Credit Works

The present financial crisis boils down to one fundamental issue – the credit crunch, now gone worldwide. The short explanation of how we got here, is that credit is an easy system to understand and use, yet one where plans are far too often short-sighted. One entity provides a good or service to another, and in lieu of immediate payment terms are set up for delayed payment, usually in a set of payments and with a charge for the credit being extended. The amount of credit charges is usually determined through negotiation and careful attention to necessary goals. For example, the reason almost no one really gives 0% interest rates on credit, is because over time that would unfairly benefit the buyer. Let’s say someone buys a car and gets a deal to pay $25,000 over five years with no interest. If the buyer pays an average of $5,000 a year with no interest, then most of the money for the purchase stays in the buyer’s hands for years, and he gets the use and profit from it. If the seller had received the entire $25,000 at the time of the sale, there is a clear profit compared to receiving the same money but later, so financing or credit terms are designed to make up the money that the seller loses by not demanding full payment up front (not to mention the money lost when someone buys on credit then defaults). It’s all about risk management, accepting the possibility of bad things happening in order to increase the profits from a venture. The credit system works because of two fundamental forces – the buyer is willing to pay more over time for something, in order to be able to make payments instead of paying for it all at once, and the seller is willing to take payments over time and risk a certain amount of default in order to increase overall profitability. That simple rule applies to all credit conditions.

So what went wrong? Greed on both ends, actually. Buyers bought homes they could not afford, while sellers built high-risk ventures into mainstream investment packages, on the theory that diversifying the investments would keep the high-yield aspects while some how mitigating the risk exposure. To make matters worse, high-risk mortgage investments became politically favored in order to offer not just home ownership to low-income families, but also offer high-end properties to people who could not possibly afford them, on the expectation of best-case scenarios, or in a phrase, the absurd belief that nothing but good things will happen in the foreseeable future. ARM loans, balloon-payment mortgages, and interest-only loans came into being in recent years, all of them extremely high in risk by their nature. The culture of saving up for what you want most had long ago been abandoned for the ‘buy now, pay later’ mantra, which itself had been set aside in favor of the even more basic ’Gimme’ culture. I mention this for several reasons. First, you have to understand that in a culture catering to increasing levels of personal greed, expectations of responsible behavior become less and less practical. A generation used to getting whatever it wants in toys and social norms, has now taken control of an economy and government wherein it believes that someone else can be made to pay for whatever these people want. Second, political duty has devolved from stewardship of the nation’s welfare and a duty to those who abide by the rules of order and commonwealth, to a state where any promise necessary to retain office will be made (like ‘lowering’ taxes for 95% of Americans, including those who pay no taxes at all). And third, for the past generation those who work hard and save have been the target of many unscrupulous criminals and congressmen, who see the needs of the lazy as far greater than those of the industrious, since the ratio of honest workers to lazy bums appears to have reached the order of about 1 to 6.

So here we are, the dominoes falling and everyone suddenly realizing they are standing underneath them. What to do? The simple answer is obvious; let the consequences work their way through. But doing that would mean letting a lot of mortgages crash, and with them a lot of banks would fail. Yes, the surviving banks would be much stronger and in the end the total costs would be minimized, but who in Washington has the courage to tell about 2 million families that they would have to lose their homes, and tell three or four dozen small and a couple major banks that they are out of business for their greed and stupidity, especially when this would disproportionately affect minorities? There is simply no such political will, nor am I sure that there ever has been, for what this would require. Instead, the Congress has decided that everyone should suffer a bit in order to prevent a minority from suffering a lot.

There is also some rational basis for the bailout decision. The failure of the stock market in 1929 was a bad thing, but not especially crippling for the country. What brought the recession into a full depression was the collapse of thousands of banks and savings & loans across the country, and these fell in large part due to a collapse of confidence. We see that to some extent in every economic downturn. Bad times hit, a company worries about its condition, they buy fewer supplies, hire no new people and maybe lay off folks, who spend less because they worry about their jobs, and fewer people spending makes things worse for the companies, who lay off more people and the cycle continues until it bottoms out and someone has the nerve to start hiring folks and buying things. When banks get hit, they make fewer loans and offer less interest on deposits and that slows down the economy too. If you can’t get a car or house loan, you won’t buy even if you want to buy. So, Congress does not have reason to worry so much about the investment firms or even the car makers – sorry GM – but they do worry about the banks in general. Loans have to be made to keep the economy from getting worse, and that means liquidity issues have to be addressed.

But you cannot just give money away, or at least you should understand that doing so is extremely stupid. So, there is an argument for spending $700,000,000,000.00 if it is done wisely, but then again we are talking about Congress here. Wisely would mean an investment that offered a reasonable return, not money spent as a giveaway to reward bad behavior and foolish decisions. That’s why the “bailout” money must not be spent directly to pay for bad mortgages, and why – sorry GM – the money may not be spent on the automakers. The money may be spent in any way that is likely to result in an improvement in the economy greater than the amount contributed. That is, just as is done with small matters of credit, the actions taken should be a balance of concessions in the short term granted in order to produce superior long-term results. That is the template which ought to be used in the application of these funds.

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