Dominos: How Bear Stearns default threatens the entire world financial system
“When we hear of turmoil in world financial markets, it can be difficult to understand how so much chaos can result from a relatively small number of defaults on individual home mortgages”
Paul Solman, a business and economics correspondent for PBS's NewsHour, explained in Dominos: How Bear Stearns default threatens the entire world financial system in simple words why it is that what started with what looked likes a limited problem in the mortgage sector could cause rip and ripples that can escalate to the point where they "now threaten the entire world financial system."
Solman began by noting that "the money you borrow to buy your home no longer comes from the local bank. It comes from investors from all over the world."”
Big and small players dealing in other people’s debts, buy up the mortgages on lots of houses, combine them into a pool, and sell slices of that pool to investors. With the house bubble still inflating and keeping together this has offered a high rate of return. And since many mortgages are pooled, it has also been considered extremely safe.
Even if one mortgage defaults that will have little effect on the pool – the risk is spread out.
However, the problem was that
“"the more investors got into the act, the greater the pressure to lend."” Lenders were competing with one another to offer more favorable mortgage terms.
Eventually, new buyers had so little actually invested in their homes that if any problems arose, it was easiest to just walk away from both house and mortgage”
“Making things worse, the return on these mortgage pools was so high that the big lenders began investing in them on their own, often using money borrowed at a lower rate from banks like Citicorp and JP Morgan. And the banks were also investing directly in securities backed by mortgages, credit cards, or auto loans. Even more investments went into so-called "derivatives," essentially side bets on these other loans”
So to buy debts, investment firms and security dealers borrowed money from banks which also were relying on the returns from debts they have invested in.
The same market, the housing market, were therefore holding up a huge sector of the total economy.
"The world financial system runs on credit -- on paper promises. If big borrowers and lenders don't make good on those promises, panic can set in, and the biggest financial institutions in the world can find themselves under siege.
Everybody wanted to get in on the action and nobody was using their own money, so the debts quickly multiplied from billions to trillions"
The value of the mortgage taken out by new homeowners on the actual value of his house quadrupled as it branched outwards and upwards, passing through many hands of people who has made borrowing and lending their business.
It is only in the first tier – the actual physical property – that there is something of “real” value.
From then on up, through the layers of people buying and selling these mortgages and people betting on their value, there is only speculative and projected value. Something with no attachment to any reality – no real sum of anything that can be exchanged for goods or services – would be worthless “paper promises” unless kept “alive” by being tossed around on the market and given value by other people’s expectations.
The only thing of real value holding up the whole house of cards were the homes owned by individual buyers.
But when the value of those homes dropped -- as it now has -- and too many of the buyers walk away, the whole structure risk collapsing.
It is like a game of music chairs, where everyone hopes the music will play forever. But how do you opt-out? Almost every part of our lives have been penetrated by the tentacles of global finance and economical interdependence.
The global financial system might seem fair in the sense that allows everyone to compete and participate on equal terms.
But it is created and run by a comparatively mall group of people, let’s call them Masters OF the Game, who writes the rules and stops the music when it wants to.
They hold key positions within the system, and need not compete within it. They regulate the very core processes that determine the conditions to which others must adjust, by setting in motions what becomes great ripple effects through manipulation of one of the pillars underpinning the system.
You may doubt that a small minority of the population within a economic system, has the ability to manipulate it to the point of eliciting a depression.
As the article Wall Street fears for next Great Depression shows – for those able to read between the lines and pick out the few telling facts dispersed throughout the text – it is not only possible, but quite easy
Note how two things are held out in the article as underpinning the system: Trust and Credit - both easily manipulated by efforts requiring a fairly small amount of people
For the rest of us, the most we can ever hope for is to make it WITHIN the game, maybe become Masters IN the Game.