Economic "Crisis"

I for one am relieved that economics and policy issues have returned to center stage in this debate (despite a few jabs from both sides). From Black Monday (or Sunday) to today, much has been said about the status and the fate of our economy. Obama has said we’re in crisis. Biden has criticized McCain for not saying we’re in crisis to emphasize the crisis. McCain has seen the light and said we are in crisis after he said the economy was fundamentally strong, by which he actually meant the workers – it’s easy to get the economy and the American workers confused, I know. And Palin has said, oh wait, she’s not allowed to talk to reporters.

The bailouts of Bear Stearns, Fannie Mae, Freddie Mac, and now AIG, however ugly they might be, are I think, necessary. The collapse of these financial institutions would have meant the collapse of the lives of many (think bye-bye retirement plan, etc.). Worse yet, the problems of these banks are exposing the problems of the entire system which is beginning to resemble the illegitimate lovechild of the Gordian knot and a house of cards.

All loans are backed by some form of collateral, which in the case of these financial institutions tended to be in some type of securities or equities (i.e. shares of stock). If those stock prices fall, so does the collateral. Consider the stock prices of Lehman brothers which are now around a whopping 20 cents*. As your collateral disappears or is devalued, you now have less capital to leverage your old loans, let alone any future lending. You also risk a shockwave of bad news for others as a default on your own loans, now without collateral, leaves them holding the bag.

Ultimately the Federal Reserve has been bailing everyone out, mainly through a variety of loans. My favorite is a 40-85 billion dollar bridge loan to AIG, which is kind of like helping them out until next month’s paycheck arrives. As an added incentive, the Fed levied a 12% interest rate to push AIG to sell off parts of its company quickly. Now with all these loans, can you guess what the collateral is? That’s right, equities of those very same companies. There is nothing like giving loans to shaky companies with the same shaky companies as collateral – did I mention house of cards?

For Bear Stearns these equities included assets believed to be tied up in the sub-prime mortgage debacles and for AIG, this entails the wonderful world of CDSs, or credit default swaps, basically an insurance policy for a loan**. Luckily for AIG and the Fed there haven’t been many bad loans lately, oh wait . . .

However ugly this may be, I think the alternative would likely have been far worse. With the fate of these corporations being knotted to everything else, it’s far better to untangle the knot before you start cutting out pieces of rope.

Are we in crisis? I think the answer is yes, but I’d rather say we’re on the precipice of true crisis. I think the next few weeks will give us a better indication. More on the economy to come . . .

*The 52 week high was over $67.
**A third party, like AIG, agrees to insure a loan for someone else in return for a quarterly fee. If the loan goes bad, AIG covers the losses of the lender.