Jon's Thoughts on the Causes of the Financial Crisis

Everyone, or just about everyone, has heard about the credit crunch and potential major problem with the global economy. If you've listened to or read the news this week, the rejection of the first bailout by the House was partly blamed on John and Jane Q. Public's failure to understand that the unresolved credit crunch can affect individual families and "Main Street" as well as bankers and "Wall Street."

This evening while driving to dinner (side bar: supposedly the best pizza in Birmingham...okay but not great. Sauce tasted like sugar water. Toppings and whole wheat crust were excellent.), NPR was trying to put a "Mom and Pop" flavor on the financial crisis by interviewing small business owners. These owners cannot get $20,000 to $50,000 lines of credit from any bank to cover gaps created by the lag between accounts receivable and payable. As a result, the owners are 1) laying off employees or 2) not hiring new employees even though they want to.

This story was the latest one I've heard or read in the last week trying to convince the public of the need for a bailout.

I, for one, still am not convinced of the need for the bailout. I have been following the story, mainly through Baron's but also from radio and newspaper reports. I understand banks may have leveraged themselves $30 to $1 (i.e., the bank may actually have only $1, but they owe $30). But if you look back at oil and commodities prices over the last 12 to 18 months, you can see a picture as to why this occurred and why inflation is around 5%.

The simple answer is: GREED!. Artificially cheap credit drove a housing bubble that raised home prices and fueled NYSE growth. The Fed raised interest rates a few years ago to slow the ecomony to keep inflation low. ARMs readjusted at a higher rate, and a few mortgage defaults started.

At the time, I don't think anyone but the bankers knew their dollars were highly leveraged and they couldn't pay off debts. However instead of coming clean then, they looked for another investment to 1) cover their debts and 2) keep the financial growth rate elevated. Whether the banks acted jointly (criminal charges should be filed if this is proven) or one started and the others quickly deciphered their plan (most likely, IMHO), banks are guilty of the spike in oil and commodity (corn, wheat, soybean, metals, etc) prices.

Whenever, the media hyperbolized the effect of "insert natural disaster du jour or War on Terror development here" on oil or commodity prices (as appropriate), bankers artificially drove up the price of that commodity as their excuse to make more profits. The excessive volatility we have seen is the effect of bankers selling large positions in these markets to obtain cash to pay off short term debt, resulting from the housing mess, that had come due. Gullible John and Jane Q. Public accepted these price increases and volatility as 1) the new economy, 2) China's and India's fault, 3) no one knew what was happening, or 4) any other somewhat rational reason you can imagine.

Eventually, the inflation caused by the higher oil and commodities slowed the economy because John and Jane finally decreased their driving and stopped spending. "Uh Oh" say the bankers (and nephew Kendal, but he'll be a scientist or engineer when he grows up....not a banker) as oil and commodity prices fall dramatically because oil stockpiles are at record levels and the 2008 corn/wheat/soybean crop will be excellent.

With oil back at $100 per barrell (vs. $148) and corn at $4.80 per bushel (vs. $8), these bubbles have popped and bankers no longer have a mechanism to pay off their short-term debt. Hence, major defaults, bankrupt banks, and the "need" for a bailout. Note, the bankers could "short-sell" stocks, but the SEC banned short-selling recently.

So, what does bankers greed and the bailout have to do with John and Jane Q. Public's inability to get credit? In my opinion, ABSOLUTELY NOTHING.

Imagine the bailout does not occur and the economy returns to where it was in 2000 (as some experts predict). Yes, many companies will go bankrupt. Banks will not have the cash reserved to pay off their highly leveraged debt. Companies with receivables from the banks will go bankrupt because they will not get paid. I favor this type of free market cleansing of old ideas and mistakes (call it Darwinism). However, will all credit vanish? No! Because back in 2000 we easily obtained a mortgage at an obscenely low fixed rate and were able to get a loan to buy a car.

If credit and loans were easy to obtain in 2000, banks should not punish John and Jane Q. Public now by withholding credit in an effort to save themselves. If anything, banks should be giving these loans. How else do they make money than through interest on loans (okay, annoying service charges and fees don't count). Or the Feds can give the bailout money to small businesses. $700 billion dollars would give 1 million small businesses a $100,000 loan to cover expenses. Some politicians constantly preach that small businesses are the U.S. economy. Besides, the $50,000 some businesses need probably is a small fraction of the annual bonus some of these bankers received while creating this mess.

The only possible reason for the bailout is that sovereign nations (China, Thailand, etc.) will be upset because they purchased the CDOs from the banks thinking they were safe investments. That would be bad because these countries also finance our huge budget deficitis. We don't want to make them mad and they'd withhold their money. Then we'd really be in a serious mess. Who would bailout the U.S.?