Wednesday, October 1, 2008

Wall Street Crisis: I don't get it

I admit it. I don’t get the Wall Street crisis. I’ve been trying to get my head around it for a couple of weeks now, and I just don’t understand it. I realize that doesn’t make me any different from most Americans—and sadly, most of our leaders in Washington—but that still doesn’t make me feel any better about it. I don’t like not understanding what’s going on around me.

I keep hearing that our entire financial system is on the brink of meltdown because of tightening in the credit markets. It’s much harder to borrow money now than it was a month or a year or a decade ago. That part I get. What I don’t get is why that is a killer to the financial system. I keep reading and hearing sentiment like this and I have a hard time understanding:

And the cost of borrowing in dollars overnight rose the most on record after Congress rejected the bailout plan, putting a chokehold on the global financial system. The ability to borrow is critical for businesses to maintain daily operations, such as payroll, or finance inventory purchases.
The part I’ve highlighted both scares and befuddles me. I have always thought that payroll was sacrosanct. It seems to me that a company that is healthy to begin with should never have to borrow money to meet payroll. Why would any business conduct its affairs so close to the margins that it needs to borrow money just to pay its workers? How creditworthy is an organization that needs to tap into credit just to meet its most basic obligations? It seems to me that lending money to businesses to meet payroll is just putting off inevitable failure.

I need someone to explain to me why spending hundreds of billions of dollars so that failing banks can prop up failing companies is a good thing for the economy. Wouldn’t we be better off in the long run if we allowed credit to tighten and forced business back onto a solid footing of capital instead of credit?

Where the Boston Globe piece above looks at the effect of the crisis on businesses, I’ve also seen some analysis of the effect the credit crunch is starting to have on consumers. Time magazine broke it down in a number of ways:

There are cracks on Main Street, but whether or not you see them largely depends on where you stand. Just ask anyone who wants to buy a house with a subprime mortgage — they're not all evil, but these days they are exceedingly rare — or with a jumbo loan, which now carries an average rate 1.2 percentage points above a regular mortgage.
This isn’t indicative of a crisis to me. Part of the reason we are in this mess (and I think it’s a smaller part of the reason than some would have you believe) is that lenders were giving loans that were too big to people who didn’t have the means or the credit history to pay them. I don’t see that a tightening of the subprime market as a problem, it’s a correction.

So a jumbo mortgage is running somewhere around 7.5%. If a home buyer wants to purchase a house valued at $540,000 (assuming 20% down), they are going to have pay a higher rate. But historically, those buyers are still paying low interest rates. Assuming that the writer is correct that a jumbo usually runs .25% higher than a conventional loan, the average jumbo rate would have been above 7.5% every year from 1972 (when Freddie Mac began tracking conventional mortgage rates) until 2000. From April 1973 to March 1993, the average conventional mortgage rate was at or above 7.5% for 240 consecutive months.

The problem isn’t that credit isn’t available; it’s that people with bad credit can’t get it and that people with lots of money can’t get it cheaply. Just because the mortgage market has been loose on one end and cheap on the other doesn’t mean that a change in the market is a crisis. It’s just a change in the way we’ve been doing business since the end of the millennium. If you had told someone in 1998 or 1988 or 1978 (especially ’88 or ’78) that we would be in a crisis because people who couldn’t afford loans couldn’t get them and that jumbo loan rates were creeping above 7.5%, they’d have passed out from laughing at your definition of “crisis.”

The Time article continues:

Now, about those credit card offers. You may not feel it, but there are fewer of them going out — 1.1 million during the second quarter, down 17% from the same time last year, according to Synovate, a research firm that tracks direct mail. Who's being ignored? Well, subprime borrowers (no surprise there), but also anyone who doesn't make a lot of money: 52% of households with an annual income of less than $50,000 received at least one offer in the second quarter, compared with 66% of such households during the same period last year.
Again, this seems like the definition of better business. So people who have bad credit or have low incomes are less likely to get credit cards? This is not a crisis. Besides, over half of those sub-$50,000 earners are still being offered credit. It doesn’t appear that the credit card industry is tightening its belt too much. Perhaps the third quarter numbers will show sharper declines. Even so, offering less credit to people who can’t afford it isn’t a bad thing.

Finally, a note on car loans, again from Time:

…you're probably not going to get [an auto loan] unless your FICO score is north of 700, whereas six months or a year ago, a score as low as 620 would have gotten you behind the wheel. "Some of this just represents moving back to standards that were in place five or six years ago," says Paul Taylor, chief economist at the National Automobile Dealers Association. "But if you're a customer, not getting credit you could've gotten a year before looks like a credit crunch to you."
And that’s the point. The credit markets are moving back to where they were, when there was at least a shred of responsibility. The credit crunch isn’t a “crisis,” it’s a “correction.” It only appears to be a crisis because America has become addicted to easy credit at all levels.

Somehow we’ve come to the place where our financial system is entirely dependent on borrowing money we don’t have to buy things we can’t pay for from businesses who have borrowed money to stock their shelves and pay their workers from banks that are failing because they have lent too much money to people who can’t pay them back.

And now we want the government to borrow $700 billion to lend to those banks to prop up this system for who knows how long until it fails again.

Do you see why I don’t get it?

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