Wednesday, September 17, 2008

An introduction to the economic crisis: part 3

You'll remember from parts 1 and 2 that we've covered banks lending to people who can't pay and insurance companies encouraging them.

In part 3, we're going to talk about banks that aren't banks trying to do bank-ish things. This hasn't caused any big banks to go bust, but does explain why no one trusts them. Which is why, if you remember, we are all f****d.

No one down, but many scared

One of the services that commercial banks provide is converting short-term lending (you deposit money in your bank account and can draw it out instantly) to fund long-term lending (you don't have to pay your mortgage back for 25 years).

Since short-term interest rates are lower than long-term interest rates, this is usually profitable. It's also rather dangerous because, if everyone wants their money back at the same time, all your money is tied up in mortgages so you can't pay them.

This happened to Northern Rock.

SIVs: not just the monkey form of the AIDS virus

Since banking is dangerous, commercial banks are heavily regulated. But some clever people realised that if you set up something that looked and quacked like a bank, but wasn't legally a bank, you could take more risks than the regulators would allow a bank to take. This meant that you could make more money.

SIVs and Conduits are 'brass plate companies' controlled by commercial banks. A brass plate company, you will remember from CDOs, is a company that doesn't have any employees and isn't legally owned by anyone. It's called a 'brass plate company' because it's only real asset is a brass plate with its name on it.

These companies borrowed money by issueing very short-term bonds. If you remember, a bond is something like a loan or a mortgage. Whereas a normal mortgage takes 25 years to pay back, a very short-term bond might need to be paid in a fortnight.

They invested the money they borrowed in low-risk, but long-term, assets. This meant they could make a profit from the difference between the low interest rates on short-term bonds and the higher interest rates on long-term assets.

So they needed to find a low-risk, long-term asset that paid a high interest rate. You may know what I'm about to say. Yep, it's the return of our old favourite - the 'low-risk' CDO.

When investors realised that SIVs were full of dodgy CDOs, they stopped buying the short-term bonds. Unfortunately, because the long-term assets took so long to give them their money back, the only way the SIV or Conduit could pay back the short-term bonds was to issue a new set of short-term bonds every fortnight.

The commercial banks that controlled the SIVs and Conduits didn't want everyone to realise that they had been aiding and abetting unlicenced banks. Therefore, they had to buy the dodgy CDO bonds to give the SIVs the money to pay back the short-term bonds no one wanted anymore.

This means that the large commercial banks own lots of dodgy CDOs. This is why no one trusts large commercial banks. And this, in short, is why we are f***d.


  • At 10:17 am , Anonymous Innocent Abroad said...

    Utterly brilliant. Should be compulsory reading in every sixth form in the land. Unfortunately, as I have been too idle to seize absolute power, it won't be.


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