'Subprime' Crisis aka 'what the hell is going on'?
zeromus knows very well how to provoke a reaction from me :) Here is the long answer.
In 1944, while WW2 was still going on, delegates from all the Allied countries met at a place called Bretton Woods, NH. A couple of very important things happened there. This was called the Bretton Woods exchange rate system and this was to stop an economic policy known as 'beggar thy neighbor' where a country devalues its own currency to increase the competitiveness of exports. Countries had to keep their exchange rate within 1% band of convertibility. The World Bank and the IMF were setup and all currencies were pegged to the USD, which was pegged to gold. Hence the phrase 'as good as gold' and 'the almighty dollar'
However, there is a problem with this system, which is that gold reserves cannot grow at the same pace as global exports. This puts an upward pressure on the price of gold. In the normal run of things, this is ok, but the USD was pegged to gold at $35/ounce. Unfortunately, the price of gold depends not on what government thinks it should be, but on how much it takes to mine and process. On the black market, you could buy gold at $40. Guess what started to happen. I'll take my $35 dollars to the Fed, ask for my ounce, which I am entitled to and sell it on the black market for $40. Riskless profit! This is exactly what many governments did to solve internal problems. There was a run on gold and in 1972, Nixon cut the link between the USD and gold and all currencies were floating. This led to the recession of the 1970's and runaway inflation. One of the Fed's jobs is to ensure price stability and Paul Vockler raised interest rates to fight inflation. High interest rates force inefficient businesses to close. This tends to piss a lot of people off as inefficient business usually create more jobs than efficient ones. The Fed Funds rate which Helicopter Ben has cut by 75 basis points to 3.5%, was very high, almost 20% during the early 1980's.
Due to inflation easing, the rate kept getting cut, and cut, and cut. This is why the stock market was on a one way rocket trip from 1983 onwards. Even in 1987 after the big crash, the Dow ended higher at the end of the year. The markets started to joke about the Greenspan put, which says that Greenspan will issue new money and let loose a torrent of liquidity to calm the markets. He did this again and again. Come 1998, an obscure little hedge fund known as Long Term Capital Management (LTCM) goes kaput. LTCM is a long story, but what they did was they bet that Russia wouldn't default on its debt. The old adage "Countries don't go bankrupt" was what they had in mind. Russia forget the rules and defaulted. LTCM was stuck with a useless bunch of paper. However, it didn't just buy rubles, but derivatives on rubles. This is the where world markets turn from being an exchange for buyers and sellers into a casino for very smart people.
A derivative is essentially a one way bet. Lets say zeromus bets MSFT will go up by $1 and hoboscratch bets MSFT will go down by $1 and I know both want to make this bet. What I can do is play off one bet against the other and make a spread, which is literally in pennies. So I pay for one bet with .9999 dollars and buy the other with 1.0001 dollars. I get 0.0002 for doing diddly squat. The people going to lose or make money are zeromus or hoboscratch. Why should I care? Well, a few reasons follow.
1) Multiply the 0.0002 by a trillion. (yes, Trillion with a T)
2) I am doing this transaction with borrowed money.
3) Its not MSFT I'm betting on, but on the interest rate mortgages all over the US
According to the Comptroller of the Currency, the notional value of derivatives in the top 25 banks of the US is 180 Trillion. US GDP is 13 trillon. So the top 25 banks are playing with a pool of fictional money that is 16 times bigger than the real economy. WTF? How is that even possible? This is where the true danger of derivatives lies. As Warren Buffett said, these are 'weapons of financial mass destruction'. The danger is that it costs only $1 to take an exposure of $100 worth of derivatives. So on the MSFT transaction, I only need 30 cents bet on a $30 stock. So if I'm a greedy smarty pants and sure of my computer models and I have $1 billion, guess what I'm going to do. I'm going to go out and buy derivatives worth $100 billion. Now, as the_ironhorse and Jon Bankard would attest, derivatives are modeled on the standard normal distribution which....um...well...doesn't quiet work. Its works about 99% of the times. Its the 1% thats really a bother. And the 1% is a bother because I've found in the real world that because of that 1%, derivatives and their pricing follows a power law distribution NOT a standard normal distribution. Oh crap. To those less mathematically inclined, a simple example.
If you round up 10,000 people in Seattle and weigh everyone, the weight would follow a standard normal distribution. 2/3 of the population would be clustered along the mean weight, say 180 pounds. If we took people only over 18, 90% would lie between 100 and 300 pounds and 100% would lie between 0 and 1000 pounds.
Now, say you also took people's networth along with the weight. Now say 1% of them (the same 1% for the derivatives trader) turn out to be Bill Gates and the top 100 people at MSFT. What distribution would networth follow? It would follow a power law distribution with the top 1% holding 95%+ of the total wealth in the room. If the average networth was $1,000,000, Bill would be way, way ahead with 50,000,000,000. If you compare that with weight, it would mean that a person would have to weigh 9,000,000 pounds. Not gonna happen.
So whats this got to do with Subprime, interest rate cuts and tax relief? Well, we just hit the 1% and all of a sudden power law distribution applies. Why do you think Citibank, Merrill, and all the other banks are writing off billions of dollars of bet that were supposedly 'risk free'?
This mess has been caused by cheap money and printing more cheap money isn't going to solve the issue. The Fed is sticking its head in the sand and saying there isn't a problem when there is one. Recessions are a necessary and essential part of any functioning economy. There are needed. The price of not having a recession is inflation and the currency being debauched, which is being felt by everyone in America. So whats the bottom line, what the hell is going on? What's happening is that there is too much money and too little goods and services. Two things need to happen. Either money gets taken out of the system or more stuff gets made, or a combination of both. Ben is trying to get companies to make more stuff by making money cheaper, but that trick has worn out. There is nowhere to put the money except in actually producing stuff, which noone is going to do because they know noone is going to buy. So companies are going to hold on to the money or put it to work overseas.
Bite the bullet, Ben! Raise interest rates. Makes money worth something again.
In 1944, while WW2 was still going on, delegates from all the Allied countries met at a place called Bretton Woods, NH. A couple of very important things happened there. This was called the Bretton Woods exchange rate system and this was to stop an economic policy known as 'beggar thy neighbor' where a country devalues its own currency to increase the competitiveness of exports. Countries had to keep their exchange rate within 1% band of convertibility. The World Bank and the IMF were setup and all currencies were pegged to the USD, which was pegged to gold. Hence the phrase 'as good as gold' and 'the almighty dollar'
However, there is a problem with this system, which is that gold reserves cannot grow at the same pace as global exports. This puts an upward pressure on the price of gold. In the normal run of things, this is ok, but the USD was pegged to gold at $35/ounce. Unfortunately, the price of gold depends not on what government thinks it should be, but on how much it takes to mine and process. On the black market, you could buy gold at $40. Guess what started to happen. I'll take my $35 dollars to the Fed, ask for my ounce, which I am entitled to and sell it on the black market for $40. Riskless profit! This is exactly what many governments did to solve internal problems. There was a run on gold and in 1972, Nixon cut the link between the USD and gold and all currencies were floating. This led to the recession of the 1970's and runaway inflation. One of the Fed's jobs is to ensure price stability and Paul Vockler raised interest rates to fight inflation. High interest rates force inefficient businesses to close. This tends to piss a lot of people off as inefficient business usually create more jobs than efficient ones. The Fed Funds rate which Helicopter Ben has cut by 75 basis points to 3.5%, was very high, almost 20% during the early 1980's.
Due to inflation easing, the rate kept getting cut, and cut, and cut. This is why the stock market was on a one way rocket trip from 1983 onwards. Even in 1987 after the big crash, the Dow ended higher at the end of the year. The markets started to joke about the Greenspan put, which says that Greenspan will issue new money and let loose a torrent of liquidity to calm the markets. He did this again and again. Come 1998, an obscure little hedge fund known as Long Term Capital Management (LTCM) goes kaput. LTCM is a long story, but what they did was they bet that Russia wouldn't default on its debt. The old adage "Countries don't go bankrupt" was what they had in mind. Russia forget the rules and defaulted. LTCM was stuck with a useless bunch of paper. However, it didn't just buy rubles, but derivatives on rubles. This is the where world markets turn from being an exchange for buyers and sellers into a casino for very smart people.
A derivative is essentially a one way bet. Lets say zeromus bets MSFT will go up by $1 and hoboscratch bets MSFT will go down by $1 and I know both want to make this bet. What I can do is play off one bet against the other and make a spread, which is literally in pennies. So I pay for one bet with .9999 dollars and buy the other with 1.0001 dollars. I get 0.0002 for doing diddly squat. The people going to lose or make money are zeromus or hoboscratch. Why should I care? Well, a few reasons follow.
1) Multiply the 0.0002 by a trillion. (yes, Trillion with a T)
2) I am doing this transaction with borrowed money.
3) Its not MSFT I'm betting on, but on the interest rate mortgages all over the US
According to the Comptroller of the Currency, the notional value of derivatives in the top 25 banks of the US is 180 Trillion. US GDP is 13 trillon. So the top 25 banks are playing with a pool of fictional money that is 16 times bigger than the real economy. WTF? How is that even possible? This is where the true danger of derivatives lies. As Warren Buffett said, these are 'weapons of financial mass destruction'. The danger is that it costs only $1 to take an exposure of $100 worth of derivatives. So on the MSFT transaction, I only need 30 cents bet on a $30 stock. So if I'm a greedy smarty pants and sure of my computer models and I have $1 billion, guess what I'm going to do. I'm going to go out and buy derivatives worth $100 billion. Now, as the_ironhorse and Jon Bankard would attest, derivatives are modeled on the standard normal distribution which....um...well...doesn't quiet work. Its works about 99% of the times. Its the 1% thats really a bother. And the 1% is a bother because I've found in the real world that because of that 1%, derivatives and their pricing follows a power law distribution NOT a standard normal distribution. Oh crap. To those less mathematically inclined, a simple example.
If you round up 10,000 people in Seattle and weigh everyone, the weight would follow a standard normal distribution. 2/3 of the population would be clustered along the mean weight, say 180 pounds. If we took people only over 18, 90% would lie between 100 and 300 pounds and 100% would lie between 0 and 1000 pounds.
Now, say you also took people's networth along with the weight. Now say 1% of them (the same 1% for the derivatives trader) turn out to be Bill Gates and the top 100 people at MSFT. What distribution would networth follow? It would follow a power law distribution with the top 1% holding 95%+ of the total wealth in the room. If the average networth was $1,000,000, Bill would be way, way ahead with 50,000,000,000. If you compare that with weight, it would mean that a person would have to weigh 9,000,000 pounds. Not gonna happen.
So whats this got to do with Subprime, interest rate cuts and tax relief? Well, we just hit the 1% and all of a sudden power law distribution applies. Why do you think Citibank, Merrill, and all the other banks are writing off billions of dollars of bet that were supposedly 'risk free'?
This mess has been caused by cheap money and printing more cheap money isn't going to solve the issue. The Fed is sticking its head in the sand and saying there isn't a problem when there is one. Recessions are a necessary and essential part of any functioning economy. There are needed. The price of not having a recession is inflation and the currency being debauched, which is being felt by everyone in America. So whats the bottom line, what the hell is going on? What's happening is that there is too much money and too little goods and services. Two things need to happen. Either money gets taken out of the system or more stuff gets made, or a combination of both. Ben is trying to get companies to make more stuff by making money cheaper, but that trick has worn out. There is nowhere to put the money except in actually producing stuff, which noone is going to do because they know noone is going to buy. So companies are going to hold on to the money or put it to work overseas.
Bite the bullet, Ben! Raise interest rates. Makes money worth something again.