A Clear Cut Explanation For Global Financial Mess

One Congressional report provides an excellent primer for non-specialists who wish to know precisely what factors have created the current economic meltdown. A Clear-Cut Explanation For Global Financial MessBy Cliff Montgomery – Dec. 5th, 2008A Congressional Research Service report issued on Oct 31st provides an excellent primer for non-specialists who wish to know precisely what factors have created the current economic meltdown. provides some key quotes from the study, below. We’ve also decided to emphasize an essential factor: This crisis began because people at or near the bottom of the economic scale could no longer afford their mortgage payments.This ship cracked at the bottom, not at the top. However one tries to spin it, this truth confirms that we are affected as much by the needs of the poor and middle classes as we are of the wealthy. Thus as long as we chiefly spend taxpayers’ time and money to prop up the rich, we will never fix the real problem–and are doing little more than re-arranging the chairs on the Titanic.“Starting in the 1980s, non-bank lenders [have created programs which increase] shares of U.S. mortgages. These non-bank lenders obtained their own funds through the conversion of mortgages into marketable securities (securitization), rather than by accepting consumer deposits as in the traditional banking model.”In most cases, once a mortgage was made, the entity that originated the loan sold it to another institution, which then pooled a large number of these loans together. From this pool of loans, the institution then issued securities whose returns were based on the payments made on the underlying mortgages in the pool.”For a variety of market and regulatory reasons, these mortgage-backed securities (MBS) became widely held by most financial institutions in the United States and by many institutions worldwide.”In addition to the securities directly backed by mortgages, financial institutions created numerous other complex securities and derivatives based on the initial MBS. These secondary products, such as collateralized debt obligations (CDO) and credit default swaps (CDS) were also very widely held.”In 2006 and 2007, the rates of default and non-payment by mortgage holders increased significantly [Emphasis added]. This, in turn, ultimately caused the securities and derivatives based on these mortgages to lose value. In some cases, securities thought to be low risk were completely wiped out.”These losses have rippled through the financial system, causing problems for institutions in a number of unexpected ways as well as stress to the general financial system. The failures of large financial institutions, including Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG, were part of this turmoil.”Due largely to the uncertainty about what future mortgage default rates will be, what institutions are exposed to mortgage-related assets, and whether more institutions may fail unexpectedly, financial markets have nearly frozen at various points in time since August 2007.”Difficulties for individual financial institutions, and for financial systems as a whole, can often usefully be distinguished as problems of liquidity or of capital adequacy.”A firm suffering from liquidity problems has assets whose values significantly outweigh liabilities, but is unable to liquidate these assets fast enough to meet short-term obligations.”A firm suffering from capital adequacy problems has an inadequate buffer between its assets and its liabilities; if its asset values fall or liability values rise unexpectedly, the firm may be unable to meet its liabilities even if its assets can be liquidated quickly. Insolvency could result.”The classical prescription for addressing liquidity problems is for a lender of last resort (such asthe Federal Reserve) to lend freely, but at high enough interest rates so that institutions do not take too many risks.”[But] Capital adequacy problems, particularly when widespread, can be more difficult to address. In past crises, steps have included directly bolstering firms’ capital and sweeping insolvent, or near insolvent, firms out of the system. […]”Beginning in early 2008, multiple failures in large financial institutions prompted case-by-case government interventions to address these failures. Dissatisfaction with these ad hoc responses was cited by the Treasury in proposing a broader response focusing on government purchase of troubled mortgage-related assets, hoping to stem uncertainty and fear by removing these assets from the financial system.”In early October 2008, Congress passed, and the President signed, the Emergency Economic Stabilization Act of 2008, creating the Troubled Assets Relief Program (TARP).”TARP includes two primary programs: a troubled asset purchase program and a troubled asset insurance program. Troubled assets under the program are first defined as mortgages and mortgage-related assets, but the Treasury is also authorized to purchase any assets if so doing promotes financial stability.”The total amount of assets to be purchased or insured is limited to $700 billion, with a possible congressional resolution of disapproval when the amount exceeds $350 billion. Taxpayers are to be at least partially protected from losses through the provision of equity or debt considerations and through insurance premiums from the financial institutions participating in TARP.”Participating institutions are also required to abide by certain limits on executive compensation. In addition to aiding financial institutions, TARP aims to aid homeowners directly through provisions promoting mortgage restructuring and extending tax relief for homeowners who have mortgage debt forgiven.”On October 14, following enactment of EESA, Treasury announced the creation of a voluntary Capital Purchase Program. Under this program, up to $250 billion will be injected into financial institutions through government purchases of preferred shares.”This program is substantially different from the original Treasury proposal, which focused on removing mortgage-related assets from the financial system rather than directly bolstering financial institutions’ capital reserves. It is being undertaken under the broad authority provided in the law to make any asset purchases that promote financial stability.”Like what you’re reading so far? Then why not order a full year (52 issues) of thee-newsletter for only $15? A major article covering an story not being told in the Corporate Press will be delivered to your email every Monday morning for a full year, for less than 30 cents an issue. Order Now! Wait, why does an independent news source run advertisements? The Spark answers in its advertising policy. * Please check out our ads–they help keep this news site running. Thanks!