Saturday, September 20, 2008

Do I Have This Right?

Later on, I'll run it past the professor. But here's my understanding of the problems that led to the chaos we're seeing on Wall Street. Below, Krugman and Reich say why they're down on the bailout, which is one piece. Underneath the bailout, though, is the fundamental problem which needs to be fixed in the long term. Based on what I've read, these were the problems.
  1. No Money in the Bank. Financial companies are not required to secure their debt with any assets, as FDIC-insured banks are. I believe the assets-to-debt ratio for banks cannot exceed ten to one (for every ten bucks in debt, they have to have at least a dollar in assets). Financial companies regularly had ratios of 20- and 30-to-1. They were "over-leveraged" and at massive risk.
  2. Lack of Transparency. Financial traders were making deals no one really understood, and as a consequence, no one knew how much debt they were carrying. For financial markets to function, investors need to know how much debt a company has to make sound decisions. Because the finances were buried and byzantine, no one realized just how deeply at risk companies like Lehman and Merrill Lynch were. (And apparently, part of the problem with the bailout is that no one knows what the situation is now, either.)
  3. Too Big To Fail. Normally, the market would punish companies that were insanely overleveraged. If that didn't happen because of a failure of transparency, these companies should suffer the fate of stupidity, like Enron: a quick death. But because these companies had pieces of so much of everyone else's money, letting them fail would send ripples throughout the world.
This was a massive shell game financial companies were playing, regulators were ignoring, and politicians were abetting. I understand that the risk was plain to anyone who wished too look, but of course, when the money's that good, who bothers looking?

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