Thu 2 Oct 2008
How much money is a dollar? To a single person, it’s just a dollar. To the economy, it represents much more. When a dollar passes from person John to Jane in a transaction, Jane now has a chance to spend that dollar. The same dollar may then pass repeatedly to multiple other people. Yep, it still has the same value, but a bunch of people all had their wealth increase by temporarily by a dollar.
In a broad sense, economies are built on the same logic. A tax break crediting $100 to the taxpayer is intended to create a ripple effect of spending that adds a much large amount of wealth to the economy at large. Spending is a chain reaction that brings economic prosperity and higher standards of living to all involved.
This is what I have in mind when I consider the present economic problems caused in large part by risky mortgage investments. Mortgage lenders underwrite mortgages to people and then sell their mortgages upstream to bigger investment banks. These mortgages often pass through the government sponsored enterprises (GSEs) of Freddie Mac and Fannie Mae as part of building a healthy secondary market in mortgages. In other words, the same chain of spending exists as when folks repeatedly spend that same dollar, except it’s on a grander scale.
The mortgage fallout is bad enough that it has hamstrung a lot of large banks, investment and otherwise. Their so-called diversified positions were in fact full of risky toxic waste. Yes, their balance sheets are being crippled by the fallout from being over-leveraged in stinky mortgages.
So, what now? Well, the financial problems of large companies and GSEs will effectively reduce the amount of money in the economy available for borrowing. This will trigger the opposite of the chain reaction described above. For every dollar no longer available for borrowing, the overall pool of money in the economy shrinks to a larger degree. In this sense, the troubles of the larger investment entities can trickle down to smaller companies and individuals.
So what’s the fallout? Well, it’s not a great time to sell a house. Market values are tough to ascertain and buyers are having a harder time getting mortgages at favorable rates. It’s also probably not a great time to look for a job. On the other hand, if you’re an investor with money in his pockets, this is a great time to buy up stocks that have been beaten up badly in the last few weeks. Beyond that, it’s hard to predict the future, especially with the government looking at spend close to a trillion dollar in handouts to keep some of these beaten investment entities afloat.