Wednesday, October 01, 2008

The Big Shitpile

On a discussion board I frequent, a disarmingly honest correspondent wrote:

I work in a technical scientific discipline, but economics kind of baffles me (McCain admitted the same, but he still thinks he is qualified to provide leadership in this area).

I am SO naive that I think that when money got unhooked from its metal backing, the only thing backing it is trust, faith, confidence. When the trust goes, nothing is left. I literally cannot understand WHERE all the wealth that was piling up has suddenly gone -- and so, in my naive way, I think that maybe there never was anything but numbers in an electronic database. Wiping out wealth then just became a matter of pressing the Delete button on those data.

I'm not saying that we should go back to a pure specie-based monetary system, but there has to be SOMETHING more than blind trust going on, else our entire economy has no more rational basis than an enormous chain letter.

One other thing: catboxer worries about explosive inflation, and I agree: an economic depression is very stressful and difficult, because people don't have enough money or means of earning money -- but the money still has value. When money itself has no value, it doesn't matter whether you have a job or not. Working vs non working is then just the difference between having or not having a pile of worthless paper at the end of the day.

I replied: You pose a good question. I'll see if I can answer it briefly without distorting reality too much.

The value of the now worthless derivatives the banks bought and are now stuck with was originally backed by the constantly rising prices of real estate. The thinking was that you could sell a crappy loan to a home buyer, and even if he or she couldn't make the payments, he or she could always sell the place for a profit (because prices were only going up, never down), pay off the loan, and still pocket a profit. Everybody won.

That's what lent value to the securities that were created by slicing and dicing the loans themselves and selling them to banks, pension funds, etc., as collateralized debt obligations, etc. That's also what created the bubble -- the hysteria which expressed itself as "What me worry? Because I'm selling crappy loans to unqualified people? It doesn't matter, because from now on prices will only go up -- never down. So even losers can't lose."

And the people who were making the loans, and creating derivative securities out of those loans, and buying the derivatives are the biggest fools in the universe, because they invariably believed their own B.S. Well, they did and they didn't. It was doublethink, actually.

But what goes up must come down, and when the bubble burst and house prices began their inevitable downward slide, buyers found themselves holding property worth less than what they owed on it. Large numbers of them stopped paying their mortgages, and the situation was universal -- "countrywide" meltdown of the real estate market and of many of the loans. Banks suddenly realized that the paper securities they had bought that were derived from those now-unravelling mortgages were worthless, since they had only been backed by the assumption that real estate prices would continue to increase forever. They had foolishly acquired a big shitpile of worthless paper because they were stupid enough to believe that prices would never reverse direction and start coming down.

The big shitpile is what Paulson proposes we now buy. That's what the 700 billion is for -- to buy worthless paper and bail out people stupid enough to believe their own lies.


Grace Nearing said...

I was so financially naive that I once thought the maximum amount of a home equity loan or line of credit was based on the actual equity the owner had in his home, ie, the amount of principle paid down. Silly me.

Grace Nearing said...

Or maybe that should be the amount of principal paid down.

Rod said...

"to buy worthless paper and bail out people stupid enough to believe their own lies."
Let 'em burn in hell....