Special: What’s With the Economy.

I’m a philosopher of science, not an economist. So I decided to write a story that explains what’s with the economy, using small words and Disney characters. The first 5 parts explain the background. The last two parts explain what’s actually going on. So here it goes.

PART 1: SECURITIES. There’s a hamburger joint on your street called BurgerBee, and they do pretty good business. But they need some extra cash up front (say, to get a new grill). You have cash up front. So the two of you strike a deal: you will give BurgerBee some money (say, 1000 bucks or so). In return, BurgerBee will give you a little certificate, which says that every day, you get 1% of the money that BurgerBee makes. That sounds pretty good to you, because eventually, the money that BurgerBee gives you will add up to much more than 1000 bucks.

The certificate that BurgerBee gave you is called a security. It is a promise that you will get some money, although you will generally get it over an extended time period.

PART 2: MORTGAGES. Every month, BurgerBee (or anyone else who owns a building or a home) pays an expense called a mortgage. The reason for this goes back to when BurgerBee first became a restaurant. They wanted to buy a building to make and sell burgers in. The wealthy Scrooge McDuck had enough money to buy buildings. So they struck the following deal.

McDuck gave BurgerBee the money to buy a building for their burger joint (say, 100,000 dollars). In return, BurgerBee gave McDuck a little certificate, which says that BurgerBee will pay McDuck MUCH MORE than the original amount (say, 200,000 dollars). But the payments are made in small amounts, every month, over the course of 30 years. (Actually, the extra amount paid is interest, but let’s not complicate this story.)

That payment is called a mortgage.

PART 3: PRE-PAYMENTS & FORECLOSURES. In order for the deal with McDuck to be fair, there’s one exception about those mortgage payments. Imagine that, one week after McDuck gave BurgerBee the money for the restaurant building, BurgerBee came into 100,000 bucks all by themselves. (Let’s say they owned another store elsewhere, and were able to sell it.) BurgerBee wants to pay back McDuck. But should they really have to pay him back the entire 200,000 dollars, after only 1 week? That doesn’t seem fair! That extra money was meant to compensate for the fact that it would take 30 years to make the payment.

So BurgerBee and McDuck added the following exception to their deal: if BurgerBee pays McDuck back EARLY, then they don’t have to pay as much. So after a week, they might only have to pay back 100,001 dollars. And after 15 years, they might only have to pay 150,000 dollars. And so on. (Again, what really happens is that each payment has interest added to it, but we’re setting aside that complication.)

And it is exactly the same situation if the burger business goes bad, and BurgerBee can’t keep making the mortgage payments to McDuck. In that situation, the two agree that McDuck takes the building away from BurgerBee as a payment. But remember, the building is only worth 100,000. So McDuck won’t get his full 200,000 in that case either.

If BurgerBee completes their mortgage early, it is called a pre-payment.
If BurgerBee stops making payments and McDuck takes the building, it is called a foreclosure.

PART 4: MORTGAGE-BACKED SECURITIES. Now, McDuck is a pretty clever investor. So he decides to use his mortgage certificate to get some immediate cash. Suppose that McDuck does mortgages for a lot more people besides just BurgerBee. In total, let’s say that he gave away 2 million for people to build restaurants. McDuck feels pretty good about this, because he expects to eventually get 4 million in return — he just won’t see all of it for 30 years.

But now imagine that McDuck needs some cash up front. (Let’s say he wants 3 million to build a skyscraper.) The Bank has 3 million up front. So the two decide to strike a deal. The Bank will give McDuck the money for his skyscraper. In return, McDuck will give the Bank all of his mortgage certificates. These certificates are worth! 4 million. But the Bank won’t see all of it for 30 years.

McDuck’s mortgage certificates are called mortgage-backed securities.

PART 5: RISK. The Bank just gave 3 million in cash to McDuck, and received 4 million in mortgage certificates in return. This seems like a pretty good deal: with a little patience, the Bank makes a million bucks. However, there is also a risk involved in the deal. Remember, if BurgerBee pays its mortgage back early — or if it stops making payments — then it won’t pay back the entire 200,000 — it might pay back much less than that. If this happens, then the Bank won’t receive the full 4 million dollars.

Now, the Bank is still generally willing to take that risk. Even if BurgerBee pre-pays or forecloses on its mortgage, the Bank can still make a nice profit — say, 900,000 instead of a million. But if EVERYONE payed back their mortgage too early — or stopped making payments — then the mortgage certificates could actually bring back less than 3 million total. Then the Bank will have gotten screwed: it gave McDuck 3 million, and got back less than 3 million in return. But it’s pretty unlikely that EVERYONE pre-pay or foreclose. So the Bank is generally willing to take that risk, in order to make some money.

PART 6: OUR PROBLEM. The problem is, some of the most important banks and McDucks in the US got screwed in exactly this way. But not out of a million dollars — we’re talking about losing billions each, sometimes over the course of just a few months.

There were a lot of things that led to this. Here’s the basic idea. Consider poor Mickey Mouse, who was struggling to make a living this decade. McDuck decided to lend him some money anyway, to buy a nice house (let’s say, 100,000). This was a very risky idea. After all, poor old Mickey was struggling just to get by, let alone make regular mortgage payments. So to make up for the risk, McDuck asked Mickey to pay MUCH more than the original price of the house — say, 500,000 over the course of 30 years. McDuck was betting that he had a chance to make a lot more money, because 500,000 is a lot more than 100,000. But it was a risky bet.

That kind of risky mortgage is called a sub-prime mortgage.

As it turned out, starting last year, millions of Mickey Mouses around the country stopped making their payments, and their houses were foreclosed. And so thousands of McDucks lost their bets.

This had a kind of domino effect. Think about the skyscraper that McDuck built. He payed the bank in mortgage certificates (mortgage-backed securities). So when all those Mickey Mouses stopped paying, the “unlikely” actually happened — those mortgage certificates lost most of their value, and the banks got screwed.

In the news, they are calling these kind of mortgage certificates bad or toxic mortgage backed securities.

The dominos kept falling, because almost everyone was connected to those bad certificates somehow. For example, the banks also made payments using those certificates. And even worse, they themselves took out new loans ON THE BASIS of those certificates. (This kind of thing is called a derivative, and it gets very complicated.) A good analogy is a tower (i.e., US borrowing practice) with a very risky foundation (i.e., bad mortgage backed securities). So when the foundation fell out, the whole building started to wobble almost uncontrollably.

On Wallstreet, this meant that nobody knew how much anything was worth. It started with all those houses that foreclosed. Nobody’s really sure how much those houses are worth. So lots of banks are invested in lots of houses of questionable value. So nobody’s sure how much the banks are worth — or all the elaborate derivatives — all the way up. Now, when people on Wallstreet don’t know how much something is worth, they often do one of two things: they do nothing, or they sell. They did both last week. And so the stock market fell dramatically.

PART 7: THE PLAN THIS WEEK. The main strategy of the US Government is now to try to restore confidence in those investors, so that the stock market doesn’t fall so badly. Paulson, the Bush administration’s treasury secretary, proposed a plan for the US government to buy up a lot of those bad mortgage backed securities. The idea is to take out the bad foundation, and replace it with a sturdier, cash foundation. Paulson is hoping that this will calm investors on Wallstreet, and get things on the road back to normal.

The question that nobody knows the answer to is: will this work? Or is the tower already on its way down?

Soul Physics is authored by Bryan W. Roberts. Thanks for subscribing.
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