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Leveraged Failure, Taxpayer Bailout September 23, 2008

Posted by frewon9 in News.
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Via the Wall Street Journal:

Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace….Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.

The Wall Street Journal is right about one thing: the massive deleveraging of the whole global financial system is at the core of our present crisis.

What is leveraging? Investing with borrowed money.

When you’ve gotten those “Low Introductory Rate!” credit card offers, maybe you’ve been tempted to get the card, max out the cash advance, take that money and put it somewhere safe. Say the card has a 3% interest rate. You put the money in a 5% a year high-yield savings account. When the credit card rate is about to jump up, you take the money out of the savings account, pay off the card and pocket the difference. That’s leveraging.

If you’re mid-scheme, and the card’s rate unexpectedly jumped, you’d be doomed. Particularly if those low rate card offers are much harder to find. That’s deleveraging.

Over at Dearscience.org, with another shitty cartoon, I attempt to walk through why the highly leveraged investment banks on Wall Street imploded so thoroughly this month.

In the meantime, our wallets are being raided, to the tune of about a trillion dollars. To put this in perspective, the entire economic output of the United States, for one year, is about ten trillion dollars. One tenth of an entire year’s work is being poured into the crumbling foundations of Wall Street. And, this possibly will be insufficient to do more than temporarily slow the cascading failure.

Can anyone tell me why banks like this deserve to be saved? Why highly leveraged schemes like this are in any way desirable? What social benefit are we receiving from their continued existence?

Thanks to the new, draconian, bankruptcy bill, if we engaged in this sort of reckless get rich quick scheme, we’d be ruined when it unraveled. Why should we be ruined—for getting sick without health insurance, for buying a house at the peak of a bubble—but Wall Street saved?



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