Not "More" Regulation, Not "Less" Regulation, but "Smart" Regulation

I don't know about the rest of you but this whole "Credit Crisis" has really made me take a much harder look at how our economy works and how we got in this mess to begin with. After weeks of research, the only thing I can say for certain is that you can't single out only one factor that led us here. There is plenty of blame to go around on this one. For this post I'm going to take a look at how our investment banks and other financial institutions used credit extremely poorly and how we could regulate it properly.

To begin, we should discuss what it means in the financial world to have "leverage". First we start with the Merriam-Webster definition:

Check out definition number 3 that I circled. Probably all you need to see there, but just in case you want a much more simple example I will reference today's "Planet Money" podcast:

Hmmmm… Sounds kind of like a pyramid scheme to me…

Ok, fine you say, they are all crooks and just want to make a buck the quickest way possible. We already knew this. How did this bleed over into the credit markets?

Well, I'm glad you asked!

Unfortunately, before we can fully understand how the two are related, we first have to understand what the credit crisis is. The biggest piece of the credit crisis is the commercial paper market. To better understand this market, I look to this excellent podcast from "This American Life" for the explanation:

So now that you know what the Commercial Paper market is, you should be able to clearly see how important it is to our economy. There are some businesses/governments that make payroll via commercial paper (see California) due to various reasons. Perhaps, your company is a toy company that does 85% of its business during the holiday season. So, in order to operate year round, you borrow the money you think you will need at the beginning of the year and pay it back after you realize your profits later. You get the point. If companies don't make payroll then people lose jobs. Things can get very ugly.

Ok, I get it you say, this whole thing stinks, but what does it have to do with leverage?

Well, I'm glad you asked!

The answer lies in who facilitates the commercial paper markets. In case you didn't know, the investment banks do. Firms like Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley to name a few. (Although, the latter two are no longer considered "Investment Banks" and were converted to traditional banking institutions due to the credit crisis). I hope I have your attention now. You should recognize these institutions unless you were living under a rock for the last few months. Lehman went belly up due to the various reasons but the main reason was they "leveraged" their facilitation of commercial paper on the behalf of investors to the tune of up to 40-1. Meaning that for every dollar they had they invested $40! And guess what everyone was investing in? CDO's or Collateralized Debt Obligations. Basically they take a bundle of mortgages (mostly bad) and bundle them with even more bundles and in the end you get the CDO that get's "Safe" rating by the credit agencies with regards to risk even though they are not safe.

Ok, so we are talking housing, bad loans, and investment banks now right? What does this have to do with leverage?

Well, I'm glad you asked!

In order to understand this better I once again look to the excellent, This American Life Podcast:

Did you get that? I hope so. If you were like me then you were deeply disturbed by Credit Default Swaps. Everyone is hedging. It's trying to make money on what you don't have… Hmmm.. this seems to be the theme tonight…

Ok, Ok, so I will give you Credit Default Swaps. There is no doubt that this sort of tool hurt our once proud economy. But that wasn't the only reason why we are here. We were talking about the housing crisis right? How does leverage play into housing?

Well, I'm glad you asked!

It's getting late so I will follow up tomorrow with the rest of this blog.