Edited: 01 Mar 2010 

Understanding the Credit Crisis

The credit crisis is a complicated issue.  There is much misinformation circulating about it; there are many conflicts within it; and thus there is much disagreement about what ought to be done about it.  Here we shall try to distill the situation in terms understandable to most people, without absurdly oversimplifying it.

The crisis is (at present) mostly restricted to credit and real estate markets.  It is not (yet) a stock market crisis, despite that the stock market is influenced by credit factors, and often reacts wildly to news regarding credit availability.  (The stock market often reacts wildly to just about any kind of news, yet such disturbances usually amount to very little over time.)  However, the credit crisis is real.  If it is ignored or mishandled, its effects will spread to other sectors of the economy.  The credit crisis involves two distinct problems: insolvency and illiquidity.

Insolvency is a problem for borrowers, but affects lenders, too: Some borrowers simply owe more than they can pay, and their loans go into default.  They lose whatever collateral they have supplied, and may have to file for bankruptcy.  This puts severe limits on their future purchasing power and borrowing options, but it also leaves their creditors on the hook for whatever part of the debt the collateral does not cover.

Illiquidity is a problem for lenders, but affects everyone else, too: It is not that the credit industry has no assets of value, but that the assets it has have become "illiquid."  This is because the value of all the loans that have been bought, sold, renegotiated, foreclosed, transferred, packaged, divided, and repackaged has been obscured by that process, and cannot now be accurately determined.  And assets of unknown value cannot be used to advance further credit.

"Illiquidity" is a term unfamiliar to most, but it is easily explained.  Most people have heard of "liquidity," which is the ease with which assets and liabilities can be transferred or exchanged for other things in an open market.

• A liquid asset is something that can be freely exchanged for something else.
  Cash is perhaps the most familiar example of a liquid asset.

• An illiquid asset is something that cannot be freely exchanged for something else.
  Cars, homes, businesses, and 401(k) retirement accounts are examples of illiquid assets.

Credit illiquidity is more complex, but can be understandably outlined in just a few steps.  Let's start with something familiar.

1. Most Americans are well acquainted with home mortgages and equity loans, auto loans, and credit card debt.  And most have at least heard of corporate and government bonds.  These are all forms of loans, money that is owed and must eventually be paid to someone else.  Loans thus count as "liabilities" on home and business ledgers.

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2. On a bank ledger, however, loans appear as "assets," because they represent money that must eventually be paid back to the bank by borrowers.  (Or if it is not, the bank will recover the loss by selling whatever collateral was provided by the borrower to obtain the loan.)  Correspondingly, a bank considers deposits as liabilities, money it has "borrowed" from depositors and must ultimately be repaid to them.

A block diagram makes it easy to see how money flows in this system.  Initially, local banks use depositor funds to make loans:

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3. To a bank, as we have already noted, a loan—which represents money that the bank will ultimately receive—is an asset.  A loan in good standing with a known value is a liquid asset, and can be exchanged like any other liquid asset.  When local deposits run too low to cover demand for loans or withdrawals, local banks can sell their existing loans to larger banks, whose resources include deposits by large businesses.  This enables the local banks to raise cash, in order to make more loans and cover withdrawals:

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4. The larger banks, in turn, may combine several loans into a package, and sell that package (as a unit) to a still larger bank, or to an investment bank, which pays for these assets with funds from sales of shares to the investing public:

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5. In addition, at any stage of this process, several such packages may be carved up and recombined in order to diversify assets and spread risk.  (Note that this is not a matter of neatly separating and regrouping individual loans.  The carving process applies to the package as a whole, with each slice of it effectively containing a portion of every loan in that package):

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If this is beginning to seem a bit confusing, that's because it is.  (So don't even bother trying to make sense of all the arrows!)  We need only understand that in the real world of banking, with its millions of loans, the shuffling is vastly more complicated than in our simple little example.

A "sausage" analogy is appropriate: It is impossible to tell exactly which particular parts of which particular animals ended up in which particular package of hot dogs.  Because each asset package is treated as a unit, all of the subsequent "slicing and dicing" (as it's called) blurs distinctions about precisely which bits and pieces of any original loan end up in any final package.  What complicates things even further is that changes occur to the loans in these packages.  Some of the original loans have remained good and will be repaid, while others have been renegotiated, and still others (about 3%,⁽¹⁾ as of September 2008) have gone into default.  So the values of the original loans have changed, even as all this slicing and dicing has been going on.

Now, all of these assets and investments have some dollar value, to be sure.  But at this point it is extremely difficult to determine exactly what that value is.  Since their current cash value is undetermined, these assets can no longer be used to back more loans and credit.  They are no longer "liquid" assets, but have become "illiquid" ("frozen").  That is, they cannot easily be used in routine transactions.  And that is the problem, because ordinarily these assets would be used to back further lending activity downstream.
So it's just a credit crisis—for the time being.

The consequences of inaction, or of action that comes too late, are not pretty.  If we allow a pervasive credit freeze to set in, we can soon expect a "domino" effect.  This is because the credit market as a whole is not just home mortgages, auto loans, and credit cards.  It is systemically interlinked with the rest of the economy of production and consumption.

• The crisis already affects the real estate and construction industries, since these are almost entirely tied to credit transactions.

• Next, it will disrupt lending to businesses and individuals, resulting in a significant drop in capital investment and consumer purchases.  (Already AT&T has encountered difficulty in obtaining short-term financing for monthly expenses.)

• Then, businesses will have to react by cutting back production, laying off workers, and cutting stock dividends.  As of September 2008, recent job losses have already run into the hundreds of thousands; a protracted credit freeze would result in millions.

If and when the crisis reaches this point, our economy will have entered a true recession.  Recovery will then be much more difficult, because that will require halting and reversing the downward inertia, not only of credit institutions, but of the entire economy.  Even individuals who fancy themselves independent—self-employed, debt-free, and dealing only in cash—will ultimately feel the crunch when consumer demand evaporates.  It will then be too late to complain about what should have been done earlier to deal with the crisis when it affected only the credit market.  Indeed, it now seems the question is no longer whether there will be a recession, but rather how severe the recession will be and how long it will last.

So if we wish to avoid a severe and prolonged recession, we must decide now what to do.  Even though the options currently on the table are not very attractive, it could take months to develop something better, and we clearly do not have that luxury of time before the economy turns sour.  Better an ugly solution in time to avert catastrophe, than a pretty one that's simply too late.

Who is to blame for this mess?  There is plenty of blame to go around: gullible borrowers, predatory lenders, "creative" accountants, scheming executives, rubber-stamping corporate boards, heedless investors, and leaders of both major political parties for at least the past two or three decades.  It can even be argued that the whole process began with the best of intentions—to make the American dream of home ownership accessible to more people.  But one thing is for certain: Irresponsible deregulation has allowed predation and untempered greed to gain control.  That is why the public is rightly outraged about excessive bonuses and retirement packages given to executives whose firms failed because of their reckless schemes.  Why should anyone receive millions as a reward for incompetence or malfeasance, while their customers lose their savings, investments, and homes, and their employees lose their jobs and retirement benefits?  If thieving scoundrels are rewarded, that will simply encourage others to become thieving scoundrels!

This is why we must take steps to hold the miscreants accountable.

• The villains must know there is a price to be paid for negligence and wrongdoing.  When others must suffer for their knavery, they must be punished for it if possible, and denied reward for it at the very least.  The problem here is that, technically, many of them have done nothing illegal.  Some legislation or judgment might be needed in order to pursue reparations by means of lawsuits. 

• We must reestablish prudent government regulation and responsible oversight in an industry that evidently offers too many temptations and opportunities for abuse.  And we must ensure that no administration can arbitrarily relax these controls, either to serve personal interests or as favors to business cronies.

• Finally, we must maintain intense surveillance upon those charged with solving the problem.  A blank check for $700 billion from taxpayers, without adequate safeguards and diligent oversight, is unthinkable.  We have ample reason to mistrust an administration that has persistently lied to us—not just to the point that we are uncertain whether or not to believe it, but well beyond that, to the point that we must now regard any claim it makes as probably false unless proved otherwise—not to mention a congress that has merrily rubber-stamped that administration's schemes and whims for six of the last eight years.

As for ourselves, we must resolve to live wisely and within our means.

• As consumers, we should avoid what is extravagant and wasteful, and opt instead for what is practical and efficient.

• As borrowers, we must avoid taking on more debt than we can reliably and comfortably handle.  Above all, resist the temptation to borrow for anything that isn't a true necessity.

• As investors, well, we're already in the soup.  We need to liquidate enough to keep ourselves solvent for perhaps a couple of years or more, and ride out the dip as best we can.

• As individuals and families, we need to take responsibility for our own well-being, and avoid becoming a burden upon others.

• As neighbors, we need to be willing and ready to help each other when necessary, but not so overeager we let ourselves be suckered.

Come to think of it, most of these ideas are solid advice regardless of economic conditions.

Hope for the best, but prepare for the worst.  There is no need to panic, provided we now soberly assess our situation and thoughtfully prepare for economic hard times.  If the recession turns out to be as severe as anticipated, we can survive it with a little caution and foresight.  If, on the other hand, it turns out milder than expected, we can all party when it's over.

=SAJ=

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Footnotes:

(1) A three-percent loan default rate might not seem like much, until we consider that the normal default rate is only a fraction of a percent.