Default Social Security but not China?

A company was founded that used bonds for its financing rather than stocks.  It issued bonds for various lengths of time: short term to smooth cash flow, medium term for starting new projects, and long term for capital improvements such as office buildings and factories.

When it began hiring a large number of people, it started a retirement and disability insurance fund for its employees.  It paid half of the premiums and collected the other half from the employees.  All the premiums purchased short-term bonds of the company.  Essentially, the company used the premiums to smooth its cash flow.

This went on for several decades.  Some employees never collected because they died before retirement.  Others collected for a few decades after retirement.  Few complained about the arrangement.

Then the company hired a new CEO.  He looked at the retirement fund and decided that instead of paying interest on the bonds of the fund, he could use that money to increase his own salary.  He also found a loophole in the decades-old contracts that allowed him to not pay the principle on the bonds.  He could apply it to his own salary.

There was a big hue and cry from current retirees about having their retirement checks reduced, but the votes of the bonds were controlled by the company, not the retirees.

Meanwhile,the holders of the higher interest bonds, the big banks and the foreign governments, including China, were assured that the company would meet its regular interest payments and pay the bonds in full on maturity.

The House of Cards came tumbling down

The newspapers and the blogosphere are filled with commentary pointing blame for the credit crunch all over the place - Federal government forcing banks to loan to high-risk people, greedy investment bankers who gave themselves big bonuses for just moving money around, house buyers signing for loans they couldn't pay in the end, the media, the conservatives, the liberals, and...

I think that, yes, blame can be spread far and wide, but all of these malefactors had the same basic premise: loaned money can be bought and sold.

The beginning premise sounds simple. A local bank lends money to someone for some purpose. At a certain point, the bank has no more money to lend except for what dribbles back in as loan payments. To raise more money, the bank sells its loans to a larger entity. But the larger entity can only do this far so long. In order to buy more loans, it has to raise more money. So it sells its loan to a larger entity. Where does it end?

If house prices keep going up, it never ends. But prices will not keep going up. Either everyone who wants a house has one, or prices go so high that fewer people are willing to buy houses. So, prices go down, sometimes very rapidly.

Sometimes prices drop so rapidly that people would rather stop paying their loans than pay more than their house is worth. Of course, if they walk away from one house, they will have a hard time buying a house of much less worth. That further reduces the number of qualified buyers further reducing the prices of houses.

Tulips, Florida real estate, houses, when will they ever learn?

Free market is a construct, not reality

Some write that there should be no bail-out of borrowers who are defaulting on their loans. These commentators write that the borrowers willingly entered into a contract and should accept the consequences of their inability to pay. These commentators also say the lenders shouldn't get any help as the lenders also willingly entered into a contract.

Like "there ain't no such thing as a free lunch" there ain't no such thing as a free market. Those who preach about a free market also forget about the detail of externalities. Few transactions are between a willing buyer and a willing seller with no effect on anybody else. If a dealer sells a car to a buyer who knows the brakes are bad, it may be a third party who suffers damage to life, limb, or property when that car doesn't stop. If a factory belching smoke sells its products far away, it is the people who live nearby who suffer the effects of pollution.

Similarly, a large number of defaults can affect more people than the borrowers and the lenders. More conservative lenders are going to take even more care choosing their borrowers. This in turn will drive up interest rates for more solid borrowers. There are already stories about the "credit crunch".

Defaults of home mortgages are going to put more houses on the market. A larger supply of houses is going to depress prices for those who would like to willingly sell their houses. The depressed prices may be good for potential buyers, but the increased mortgage rates and decreased availability of money to lend could offset the low price benefit. This could lead to fewer buyers which would lead to even lower prices.

Low demand for houses also affects realtors and builders. The lower earnings for these two groups could also lead to less spending by them in other areas, like autos and appliances and many other goods and services.

Fewer purchases by more people leads to a slower economy. Couple this with rising fuel costs, is it any wonder the stock market is in turmoil?