I’m sorry to interject something mundane here, but I’ve just got to ask this simple question which everyone seems to be ignoring –
Where have the $2–$3 trillion in funds that governments around the world have pumped into the financial markets gone? We certainly haven’t received them, have we? And the banks are still failing.
So where exactly has all this money gone?
I’m genuinely baffled.
This is the money that was used to pay (1) all the sellers of over-priced houses during the housing bubble, (2) everyone who refinanced a mortgage at a higher home valuation and pocketed the difference, and (3) all the fees and bonuses paid to the financial intermediaries who used their derivatives magic to move this money through time and space.
If you want to “follow the money,” it starts with the mortgage lender who loans money to the subprime borrowers. The money ends up in the pocket of the home seller or the person refinancing. The mortgage lender has an IOU from the subprime borrower. This IOU then gets sold to Fanny Mae or Freddy Mac, or other financial institution. Other institutions buy these, bundle them and slice and dice them into financial derivatives. These derivatives get bought and held by other financial institutions (like Lehman brothers). Worse, they borrow money from other institutions to buy these derivatives and huge leverage, inflating their returns and increasing their risk of default thus infecting financial institutions that are not engaged in the subprime business. To try to hedge their risk, some institutions take out credit default insurance with insurance companies (like AIG), which moves the risk into the insurance industry. In each of these steps, someone is pocketing some of the cash.
Everything is fine so long as the subprime borrowers make their payments, refinance, or sell their houses at a value that can pay off the mortgage, flowing the money back up the chain. The problem with this pyramid scheme is that at some point the borrowers start defaulting, the housing market stops going up, and refinancing is no longer possible. Then the music stops, and the house of cards falls in on itself.
The theory behind all the derivatives is that the risk of default gets spread around many more investors, thus allowing more money to flow into mortgages (and encouraging home ownership). The flip side is that when the bubble bursts, the damage hits everyone. And when the psychology of a bubble gets reversed into a panic, the fear is that a crisis of confidence will collapse the economy and plunge the world into the next great depression.
Financial institutions are supposed to be skilled in judging risk how much they can take. They hire “quant jocks” from top business schools to create mathematical models the economy to calculate what risk exposure they should take. So much for the “Masters of the Universe.” They seemed to fail to realize that the foundation of this scheme was subprime mortgages that were being given out without consideration of the borrowers ability to repay.
So the net of all this is that the government bailout money is being used to cover for the payments the subprime borrowers are not making, which ultimately ended up in the pockets of the 3 groups named above.
BRILLIANT Robert, thanks very much for an excellently clear explanation.
So basically we as tax payers are now paying the financial institutions (via massive govt grants/loans) the money they should be getting from the mortgage defaulters (subprime or otherwise) via a myriad middlemen who’re still taking commissions along the way? Amazing.
Doesn’t seem very fair, does it? :-)
that WAS good!
When the government borrowed these trillions of dollars they spent it all in the military industrial complex.
A simple javelin missile (used to destroy tanks, etc) costs over $80,000 per missile.
So the U.S. borrows it, pays it to Haliburton, Boeing, etc for the fighter jets, missiles, etc.
Then the companies use that money to make the product, so the profit is where the money is now.
Good job, Robert.
I couldn’t have said it any better.