Monopoly Money

If you've been playing along at home you've seen in the past weeks Freddie and Fannie get bailed out, Lehman Brothers declare bankruptcy, A.I.G. get a largely ineffectual bailout, and today a $180B cash injection from the Federal Reserve. If you don't know what I'm talking about, stop and go read a newspaper, for real.

The papers seem to be writing a whole lot about 'How could this happen?' and in my oh so humble opinion failing utterly to explain in lehman's terms (pun intended) what is going on, so here is my attempt to do so. Partially, I'm writing this cause I've had to explain it verbally so many times in the past few days that I figure I can hone my rhetoric by writing it down.

I'm sharing it for any of my friends who are having issues and concerns with this right now. I can't promised I'm unbiased, as anyone who has heard me rant about economics and the credit market before. I also, will strive to be accurate, but am not an economist, so corrections are *welcome* in the comments. And finally, I've tried to simplify it as much as I can so feel free to skip past things if they seem rudimentary.

First, it is important to understand that what is happening today is not rooted in the past few weeks or few months even. It is the result of years of poor practices in the financial markets.

The second thing to realize is that money is not imaginary, and should not be treated as such. As much as these huge numbers being thrown around may seem daunting and impossibly large, we can trace down through them and see the process that has gotten us to where we are today. Let us start with a simple transaction.

Joe Fatsquatch wants to buy a house. The house costs $575,000 (these are hypothetical numbers, not imaginary numbers) and Joe has $75,000. He needs to get a mortgage to pay the remaining $500,000.

Joe goes to the bank and gets a pproved for a mortgage in which he agrees to pay the bank $500,000 plus 5% (again, hypothetically selected for easy mathematics) interest over the next 30 years. The bank then pays the seller of the house the $500,000, and takes as collateral the house Joe plans to live in.

Over the course of 30 years the bank is going to be paid back much more than the 500,000, and Joe will have paid much more than the initial asking price. In effect what Joe is paying for is the house, plus the luxury of thirty years to pay off the debt, while having possession of the property. Obviously, Joe would have been happier had he not needed a mortgage at all, or not needed to finance quite so much.

What does the bank have? The bank now has a piece of paper that is worth $2,058,067, if they wait 30 years. Now, obviously that is a hypothetical interest rate, and amount to be financed, but you can see the high price of having the luxury of credit.

The bank doesn't want to wait 30 years to see that money. They just don't, it's better to use it now, surely there is some way to monetize this immediately. And along comes Fannie Mae. She is a giant institution that buys and sells mortgages by the thousands. The Bank Joe got his mortgage from sells Fannie Mae that piece of paper, along with 49 other pieces of paper and receives slightly less than the price it would be worth had the bank just waited thirty years for it, but that is OK cause they now have significant chunk of cash available *now*.

Fannie Mae isn't naive, she also values these 50 pieces of paper a little less because she knows that she is accepting the risk of Joe or one of his 49 buddies defaulting on the mortgage. At which point the piece of paper is back to being worth $575,000, not $2,058,067 as there is no longer the interest rate attached to it. Funny how paper can change value like that based on outside circumstances, eh?

Now, if we take those 50 pieces of paper collectively, Fannie has paper worth 102,903,389.88 and physical property value worth 28,750,000. In order to obtain the larger of those two values Joe and his 49 buddies need to pay their mortgages, and in order to do that they need jobs. Indeed, vetting the employment and employability was one of the chief things the original bank did in order to give Joe a mortgage.

Fannie Mae wants to raise capital in order to buy more of these bundles of mortgages as they are obviously a good investment. Fannie Mae issues stock, and sets the price fairly high. Higher in fact, than the value she could actually deliver were all those mortgages to foreclose. Naturally we assume *all* the mortgages won't foreclose so this is probably a safe bet. However, Fannie is a little greedy. She knows she is the big kid on the block, and was put there by the government. And while no one has ever overtly said anything, there is an implicit knowledge that should Fannie Mae not be able to cover her issued stocks the government would step in and cover those stocks for her.

This makes those stocks Very Attractive. Fannie can charge prices completely out of line with the value of the mortgages she owns in fact and does. This is the first point in the chain when we have decoupled the value of what we have to the value of what we pay for. Fannie Mae was issuing stock on imaginary assets and implicit value.

However, the market goes along with it, and because they know Fannie Mae would get backed up in a crisis, almost all the investment banks want a piece of Fannie Mae. Which, of course, makes her that much more expensive. All these investment banks need cash to make purchases. They daily take large loans that are paid back before the end of the business day or week to procure an array of investments and make profit. They are working with a large pool of money that isn't theirs. It is a combination of their investors (people like you and me who have mutual funds, and other group investments) and also these short term loans.

Now, say Investment Bank A borrows 100,000 from Investment Bank B, to be paid back on a set term. Where does Bank B get the money? They have it available in their accounts and Bank B trusts Bank A well enough to lend it to them, with a reasonable assurance that it will get paid back. In fact, this is a common practice Just the other day Bank B borrowed 100,000 from Bank C with the same understanding.

Bank C from Bank D, and Bank D from ... Bank A? Somewhere along the line someone lost track and Bank A has both taken a loan from Bank B and given a loan to Bank D. Something is odd here, each of these Banks now has and can spend 100,000, but only 300,000 exists. Money is not imaginary. And this is the second place we see value decoupled from actual assets.

This model is surprisingly workable as long as the money keeps flowing. It is remarkably similar to our mortgage model in which those pieces of paper have an increased value as long as Joe and his 49 friends continue to pay their mortgages. If the cash in the bank situation above were to stop flowing though, someone would be left with the 'hot potato' and have to bow out of the game. Similarly, if Joe stops paying his mortgage, a value suddenly evaporates.

Well, surely there must be a way to game such a system? One can easily imagine a system where a bank wants to make quick cash to use, and is willing to incur higher risk, feeling confident that if anything went wrong they could stick their neighbor holding the debt.

You could in fact, issue a mortgage to Henry, even though Henry doesn't have a job in which he could pay for such a mortgage. Doing so would be a very poor practice, but Fannie Mae is buying al your mortgages anyway, so who cares? She's big enough to take the hit if Henry defaults.

The Lending Bank issues the bad mortgage, knowing that Henry can keep his head above water for 4 maybe 5 years. Sells it to Fannie who issues stocks with a nod and a wink, backed by the government, And it gets thrown into this buying and selling game where Investment Back start passing it back and forth. Henry defaults.

The mortgage piece of paper loses 75% of its value. Trace that up the chain and go back to the banks lending one another cash, and You have Bank A having just borrowed 100,000 from Bank B, from Bank C from Bank D. We already know we are counting 300,000 as 400,000 as long as the cash keeps flowing and suddenly, because of Henry defaulting, you now only have 225,000 in the 400,000 circle. Poof.

Bank A needs cash and they need it NOW or else Bank A folds, of course, they had no real money to begin with, they were just playing with imaginary money. If for some reason it would be Very Bad for America if Bank A folded it might get an emergency loan from the government, in order to give them time to make good on their assets. This would be called a Bail Out, and we've seen several over the past weeks.

The Fed made $180Billion available for these emergency loans today. And what you are seing is everyone playing with funny money close up shop.

I'd been contemplating this scenario for a while when back in August of 2007 the Federal Reserve and nations around the country injected raw cash into the market to stabilize it. Kind of a 'free loan' day for all the people holding the debt. Think of that maneuver as priming the pump. If Bank A, in the above scenario could get a loan, we could keep the money flowing and sustain the status quo. Over several days the other mortgage payments come in, and that missing 75% gets absorbed into the whole.

But here is the issue, we're still playing with fake money. All the bailouts do is maintain the existing system. Would it be more or less effective to regulate what mortgages can be given? Or how one bank lends to another bank on trust?

I'm still thinking on that one. The one thing I am pretty certain on is that if Bank B knew that Bank A had debt outstanding past the loan requested, they might think twice about lending. Transparency in lending could go a long way towards noturally stabilizing this situation.

That's it. Hope it helps and also hope I'm not dead wrong on how all this works.