Thursday, October 09, 2008

By the Book

Recently, This American Life did a show called Another Frightening Hour About the Economy. It was good. I listened to it pretty much as soon as the podcast was released. But on the way to work today, I decided to listen to it again. Ive discovered that the 2nd listening is different. Its different because Im not just trying to keep up with what theyre talking about. I know where theyre going and (at a high level) I understand what it is that theyre saying. That understanding has freed me up to think about other things presented in the show a bit more critically. And Im struck by how dumb we can be.

Commercial Paper

The first part of the show talks about the commercial paper market. Yeah, I had no idea what that was before that show, either. But it turns out that its essentially a short-term credit card for businesses (both small & large). On a daily basis, businesses earn money. Some days they have a lot of extra money and some days they have a short-fall. It all depends on the timing of when customers pay bills. However, bills to the business tend to come in at a fairly steady rate. So businesses need a way to pay out money every day, even on the days that theyre short. To do that, they use commercial paper. When theyre short, they take a short loan that they pay back on the days that theyve got surplus. A huge number of businesses operate off this market. If lenders to the market freeze up, a huge number of businesses cant operate. If they cant operate, that means that they stop taking in money. And they stop paying employees, vendors, service providers, etc. Commercial paper is a pretty big deal.

But Im really flabbergasted that so many businesses are in this position. As an individual this is roughly akin to using my credit card to pay for things when Im short of cash. Which many people do. However, it is pretty universally derided as a dangerous way to live. A *MUCH* better way to manage shortfalls is to build up an emergency fund. Instead of drawing on credit (which you might not be able to pay back) when youre short, you draw from your emergency fund. Then when youve got surplus, you pay back the emergency fund. This is personal finance 101. Why is this not also business finance 101? The Bible describes the situation: the borrower becomes the lenders slave (Proverbs 22:7). When lenders stop lending, they do not care if those who are enslaved to them cant survive. The lesson from this is that you have a choice about being a slave: dont be one. Build up two types of savings:

  1. Day to day operational savings. This should hold enough money to pay out all the bills that you have in a single day.
  2. Emergency savings: This should hold enough money so that you can survive for 3 months w/out income.

My guess: this behavior would significantly reduce the impact of financial crises like the one were currently seeing.

Money Market Funds

But what caused commercial paper to freeze up in the first place? The reserve fund broke the buck. Part of the way that businesses save money is by investing excess profits into money market mutual funds. One of those funds is the reserve fund. These are hyper-safe funds. The worst theyre ever supposed to do is pay you back your investment. Sometimes they even pay you back some interest. The people who invest in these funds put money there that they cant afford to lose. The reserve fund suddenly had to pay back less than $1 for every dollar that investors had deposited. In other words, investors that were being safe with money they couldnt afford to lose, lost money. Why? Because the reserve fund had invested heavily in commercial paper from Lehman. When Lehman went bankrupt, the reserve fund lost money. Those losses had to be shared by reserve fund investors. Then several other funds started breaking the buck. Suddenly there was a run on mutual money market funds. Investors who couldnt afford to lose money in those funds were losing money and taking what they had left out. Drying up the money available to for loans on the commercial paper market.

But, again, Im flabbergasted. How much position did the reserve fund hold in Lehman? Why werent they better diversified? Again, this is personal finance 101. And its a biblical principle of money management: Give portions to seven, yes to eight, for you do not know what disaster may come Ecclesiastes 11:2. If the reserve fund were better diversified, would it have been better able to withstand Lehmans bankruptcy? Additionally, didnt the credit market rates to Lehman jump sky high indicating a high degree of risk in investing w/them? Why did reserve fund (and other money market funds) lend to Lehman? Wasnt that irresponsible use of extremely low risk money? Two lessons:

  1. Diversify
  2. Do not invest low risk money into high risk investments


Of course, there is a problem that arises from the above observations and result lessons. Why did we get these results? Economists sometimes describe markets as discovery processes. People who enter markets are running an experiment. The market sorts out which ones will work and which ones wont. Over time, bad ideas disappear, and what remains are the good ideas. On a personal level, its pretty darn clear that the above lessons are good ideas. Why didnt they emerge at the business level? Why didnt the market discard what actually happened and leave behind only these good ideas?

I suspect the answer has something to do with moral hazard. Historical government bailouts may have given investors and businesses confidence that any mistakes they make will be backstopped by future government bailouts. So investors and businesses may have taken on more risk than they would if no bailouts existed. I also suspect that government bailouts interfere with the market discovery process by allowing bad ideas to live on. By bailing out those companies and individuals who are in trouble, the government does not allow the consequences of bad ideas to be borne by those who made them. The simpleton goes blindly on and suffers the consequences. Proverbs 22:3. I note also, that our government (in the late 90s) started applying pressure to lenders to increase loans to those with low incomes. The market had already discovered that its a bad idea to lend money to people who dont have much means to pay it back. But the government applied pressure to ignore that lesson in the legislative changes to the Community Reinvestment Act made in the late 90s. These changes put pressure on lenders to increase loans to low income earners.

So whats your point?

Well, this is a blog. A point is required? I guess if I must, the point is that we cant exclude government action as the cause of this problem. True, no one thing that the government did caused it, but the totality of what the government did is a significant contributor. Sure, This American life mentioned how the government failed to regulate. But that's government inaction. When there were distinct and specific actions that the government took that provided a major contribution to this problem. I think that point was missed by This American Life. It was not missed by Russ Roberts (and here), nor Arnold Kling (and here).

1 comment:

dmbsc101 said...

I can think of few things that the government does well and efficiently.

I was in the mortgage industry in the late 90's and I was often regaled by all the glory day tales of the subprime market. Subprime lenders used to get 5 origination points and 9 on the resale. When you're getting this kind of spread you're making some pretty good money and the lenders buying these loans are making decent money as well. Of course they charged these kind of premium prices because the borrowers were considered something of a credit risk. Enter regulation. State attorneys general started a war against "predatory" lenders and created licensing policies for lenders and caps on the amounts they could charge. This naturally led to a shortage of people willing to lend to B and C credit customers. The Clinton administration, applying the rules of the Community Reinvestment Act, got Freddie and Fannie to take up the cause of subprime loans with he implicit (if not explicit) backing of the federal government. Ron Paul predicted that this would take risk out of the market and encourage bad lending and that it would create a housing bubble that would burst and tank the economy. No other politician in this years presidential race spoke about economic policy until it was too late and all they talk about now is in sound bites and socialistic/communistic platitudes.

Post a Comment

I've been getting a lot of friends from facebook starting to read my blog. I'm glad of that. I look forward to comments, critiques, etc. But please do not reference me or any of my family and friends by name. Here's why.