Take A Deep Breath: Some Perspective On The Financial Crisis

TechDirt has a very long article on the current financial crisis, explaining how we got into this financial mess in the first place. The article is worth a read, and I encourage you to read the entire article on their site - TechDirt. First off: this situation is complicated. The deeper you dig into it, the more you can begin to sketch out a picture of what's really happening, but no one (no one!) can accurately understand all the different variables at play here. Anyone claiming to have all the answers is wrong. They're either ignorant or lying. Also, the blame game isn't just pointless, wrong and silly, it's dangerous. I've been seeing too many folks on both sides of the political aisle trying to use this crisis as a political football, and all that's doing is making it that much more difficult to come up with real solutions. If you see anyone focus on playing the "blame game," ignore them. They're not worth listening to and they'll only be misleading. Finally, any explanation you read that isn't multiple-book-length will probably be greatly simplified -- including this one. But I'm hoping that it at least kicks off an interesting discussion. So, what happened? The basic summary is that a chain of events all resulted in more and more money being put into riskier and riskier mortgages, where much of the risk was hidden away by computer models and the repackaging of those risky mortgages in bulk. Normally speaking, the idea of bundling up a bunch of risky projects into one actually does make some sense -- because you're figuring that while some will fail, the successes will greatly outweigh the failures. And, in many cases, that's true (it's basic diversification). But the problem was that very few, if any, of the models seemed to take into account the fact that these weren't independently risky items, but that many were very dependent on each other. Thus, rather than a small group of risky deals going south, outweighed by the success stories, people started to realize that you could have a domino effect, where a large portion of the risky stuff going bad could actually lead to even more of it going bad. That's just what you get for creating bad models that don't take dependencies into account. What made this even worse, however, is that a bunch of the risk was eventually pawned off to the least knowledgeable investor: the public markets. We had a long chain of players, who effectively kept "laundering" the risk through various ways until it ended up being held by people who simply had no clue how risky the products were that they owned. Then, once stuff started to go bad, the dependencies started to snowball and make everything worse -- and the confusion over how bad and how risky things were made those who actually had money on hand reasonably afraid to keep lending it to those who couldn't accurately express the risk. That resulted in a lack of liquidity -- effectively the oil in the economy's engine. Without liquidity, a lot of stuff freezes up pretty quickly and dangerously. That's what caused Treasury boss Paulson and Fed chair Bernanke to ask for the "bailout" plan. Why are we "bailing out" those who created this mess? Actually, while almost everyone is calling it a "bailout," it's not quite a true bailout, and it's not clear that it really "rewards" those who created the mess. Like everything else, it's quite complicated. Personally, I like Fred Wilson's use of the phrase "The Splurge" to describe it, because in many ways it's more accurate than a bailout. Basically, the government is asking for $700 billion to try to buy up distressed assets. The details suggest that it's starting out with $350 billion, with another $350 billion to be handed out later, if necessary. There are plenty who believe that $700 billion is just the tip of the iceberg, and eventually that number will grow to be much higher. So, why isn't this a full "bailout"? Well, because the government would be getting equity back as well, and there are plenty of smart folks who believe that this could lead to the government making a profit. Indeed, buying up distressed assets historically isn't a bad way to make a profit -- if you know what you're doing. Lots of folks tend to shy away from distressed assets, and a good fund manager can buy up distressed assets for pennies on the dollar and figure out ways to sell them down the road for nickels or dimes on the dollar. It's a perfectly reasonable business proposition, and historically, there are plenty of stories of folks who made out like bandits buying distressed assets following bursting bubbles. So, if the government can drive a hard bargain and buy up these assets at a reasonable price, it could work. So, the good news is that there's a chance that the "splurge" could result in a best case scenario: it pumps liquidity into the market, stabilizes things, gets the economy moving again and lets the government profit. But that's the best case scenario. Others are a lot less sure, noting that the upside pales compared to the downside risk, and even if an upside scenario may seem a lot more likely, the cost of the downside is much, much bigger (at least $700 billion at this point, and perhaps more). In fact, there are those who suggest that a poorly done splurge will almost certainly make things even worse. And, plenty are pointing out that the smart money seems to be betting that the government is entering the game as the "last sucker" we were discussing earlier. Given that there's still confusion over how the gov't will value these assets, it seems reasonable to worry. But isn't this just about Wall Street? There's a common refrain among many, many people, that this is just the result of greedy Wall Street bankers, and the proper thing to do here is to just let them all fail. It's not that easy. The ripple effects here would be pretty serious -- and while I don't think the economy would fully seize up, it would be really painful across the board. The lack of liquidity in the commercial paper world (short term lending, mostly) would impact a lot of businesses that you might not think have such exposure to Wall Street. And that, in turn, could create an ongoing spiral. It would stop somewhere, but where is anybody's guess at this point, and it may be pretty far down a hole, with a pretty massive destruction of wealth in the meantime. Some may believe this is the best way to get through things (the rip the band-aid off quickly belief), but the overall damage could be significant, and not so easy to come back from. Ripping the band-aid off quickly doesn't always yield the best result if it rips the scab with it, causing more damage. So, simply letting everything fail, while an option, could have serious long term consequences. To sum it all up It is a huge mess, no doubt. The splurge is quite risky -- and while I can appreciate the upside potential, if done right, that "if" scares me a lot. I'd be much more comfortable with it if it wasn't being pushed through in its entirely in such a quick manner, with partisan players on both sides going on the news yelling at the other side each night. Instead, focus on a smaller initial package and spend a bit more time working out the bigger deal later, with a lot more input. In the short term, there's still going to be a fair amount of bloodshed, and the downside will impact companies outside of the financial sector, but for those in tech, the good news is that we're probably more isolated than other industries, though certainly not completely isolated. And, since everything is changing so rapidly, you never know what shoe might drop next.