Okay, so my recent attempt at explaining retail economics has been riddled full of holes by would-be Warren Buffetts. To get someone more knowledgable to explain to me why my reasoning was off, I emailed a friend of mine, Tom, who is an attorney. He provided what must be considered the Unified Field Theory of Economics as he not only discussed how credit works in the business world but also included an explanation of the current Wall Street meltdown. So in a way, I tie in two of my previous posts (“The Truth About Christian Bookstores” and “Jefty Economics and the Least of These“).

What follows is a fascinating overview. (As to some of the political commentary in the response below, it’s integral to the piece. Cerulean Sanctum toes no party line and never will, so I offer the following with that caveat.)

The world runs on credit. Merchants don’t purchase their inventory, they borrow it for sale. In some cases they use a business credit line from a conventional bank to get the money to buy inventory for sale. Certainly, a very small business has to do that because they can’t get credit from suppliers. The smallest businesses use credit card financing—they buy with a credit card and use proceeds to pay the credit card bill. If you pay the balance at the end of each month you never have interest charge—and you get 30-60 days of money for free.

In more established businesses, the manufacturer supplies inventory on a net-30 or net-60 term which means in essence that the manufacturer is loaning the inventory. Auto dealers work through a financing arm of their manufacturer to get inventory on the shelves without paying for it, or at least paying very low interest on its value.

Wal-Mart’s model is to pay quickly but sell more quickly. They typically get cash terms from suppliers, i.e., no finance charge, pay 30-60 days after delivery. But they sell merchandise before the payment for that merchandise is due to the manufacturer. Wal-Mart will roll prices down to cost, just to make sure that they get the inventory sold before it is paid for. If you make this scheme large enough you have billions of merchandise sold and later paid for , and millions if not billions of dollars continuously in Wal-Mart’s pocket. Money earned from sales and not yet paid to suppliers, money that is constantly flowing in and out but which has a steady positive value—which Wal-Mart is free to invest in stores or put in the money markets to make interest. Without even profiting on the product sales (!), Wal-Mart can make money on “float”. It is brilliant.

If you contemplate this, you can see why the big box, Wal-Mart style stores rule retail. They can survive on very tight margins because they can roll inventory through their store that they never effectively pay for. Consumers love the selection and the store has a volume of transactions that can generate a sufficient profit even as the actual margin per transaction is very low. The old mom and pop store that actually owns its inventory is dead and will never come back (outside of highly niched businesses).

This explanation says a lot for why a credit crunch is extremely hazardous to our economic system. Our economy uses credit so systematically and it is so much at the core of our economic effectiveness, that to constrain it just the littlest bit sends shock waves throughout the whole system. The businesses that are right on the edge—the ones that need to borrow money even for a day or two to cover the cost of inventory and make payments to manufacturers before inventory is sold—are in a very precarious position. If they can’t get credit they’ll get caught between paying for inventory and paying for payroll, for example. That’s a tough spot…if you don’t pay for the inventory on time you get no more and you’re out of business. If you don’t pay the employees, they all quit and/or the news gets out and your suppliers dry up. Any way, you’re out of business.

Banks make short term loans mainly in the form of business lines of credit. The banks use their own money for such loans, or borrow money in short term credit markets. Banks make margin on the interest rate difference. (Obviously, a bank can borrow short term money at a lower rate than a business can borrow short term money.)

It is not just the odd business that runs on short term credit—essentially all of them do. And not just retail. Manufacturers operate on credit. Obviously, they want to get paid for what they make, but they don’t get paid as fast as they like (thanks to Wal-Mart and its friends). Manufacturers have costs to cover and need money to keep the plant rolling.

Businesses around the world thus play in the short term credit market, some directly, most indirectly. They give IOU’s to cover their costs while they wait for receivables to come in, and they pay back as they can. Most businesses do this through a bank but some large companies play in the markets directly.

Bank and large company IOUs are the cash of the macro economy. They are where mutual funds put their money, and where banks park every dime of excess cash that they have, to make sure they make money on their money, rather than have it sit around. (Banks have a minimum of cash on hand they have to maintain – every dime above that minimum is parked somewhere it can make money, and this is done on a daily basis.)

When the short term credit market dries up and short term lenders like banks and mutual funds don’t want your company’s short term IOU’s, you’re dead. Again—missed payrolls, crisis selloffs, etc. GE is a perfect example of a company that couldn’t get enough cash and wound up having to mortgage itself to Warren Buffet. The auto makers are moving toward the same spot and that is why everyone is now saying they’ll get a government loan too. There are many small business examples.

The recent meltdown is so problematic because it has impacted every one of these short term credit markets. I’ll explain how…

The start of the problem was Fannie and Freddie. They were Government-sponsored home loan clearinghouses that wrote low-income mortgage guarantees. They collapsed due to too many claims against mortgage loan guarantees they wrote. This happened primarily because Fannie and Freddie were undercapitalized and underregulated (not subject, for example, to the reforms put in place after the Enron failure). They were never properly regulated because they were an insider institution—Government created, Government coddled. They were also a PC institution— affordable “subprime” loans for the underqualified was a sacred cow of the Democrats. Not surprisingly, Fannie and Freddie were in the pocket of the Democrats and vice versa, and Fannie and Freddie became havens for Democrat politicos. Fannie and Freddie dumped fortunes of cash into the Democrats to get protection—and poured some into the Republicans as well, to get cover. And Fannie and Freddie also dumped fortunes of cash into the pockets of their own executives, who arranged their compensation to be linked directly to the number of loans underwritten, rather than, for example, profitability or safety and soundness. The Democrats blocked every kind of real reform for years, and that is why that condition continued as long as it did.

Of course, an underregulated, politically connected institution with a penchant for guaranteeing risky loans is easy prey for Wall Street. Investment banks took advantage, which is what they live to do. In fact, investment bankers came to DC and completely took over Fannie and Freddie. Together, Fannie/Freddie and Wall Street sharks revolutionized subprime mortgage financing. The key tool was converting subprime mortgages into a different kind of instrument entirely—mortgage pools held together by elaborate “swap” contracts that dynamically grouped the loans into tiers. The top tier loans were whichever ones are being paid on or paid off, and the bottom tiers were whichever ones are not paid on or paid off. Obviously, the higher tiers have the lowest risk and bottom tiers have the highest risk. The mortgage pool pays the owners of the top tier securities the lowest interest rates return and pays the bottom tier security holders the highest interest rate return.

The subprime-mortgage-backed derivative securities were guaranteed by Fannie and Freddie, because the mortgages themselves were so guaranteed. Wall Street also arranged for the top tier securities to be reinsured by commercial insurers such as AIG. Those top tiers now looked really safe—they looked at lot like the short term paper Banks deal in fluidly. When you consider that any pool of subprime loans will include plenty of “house flippers” and refinancers, you’ll see that buyers of top tier securities would, at least until recently, be quite sure to get their money back very soon after putting it in. Only bottom tier people bore a risk of waiting for money to come back like a conventional mortgage lender. Of course, you can see the assumptions there—houses will hold value, people will continue to be able to flip real estate and refinance, etc.

The bottom tier securities mostly went to investment banks and investors ready to take a risk. Things turned out badly for those people, hence Lehman Brothers is no more…but that is not the big problem.

The big problem is that top tier mortgage backed securities entered the market for short term paper, previously occupied only by very safe borrowers such as banks and manufacturers, and very safe lenders such as money market mutual funds. Indeed, I understand that top tier mortgage backed securities were traded as freely as short term paper until the bottom fell out. If you want to lend some money, you can lend it to a bank, or a money market mutual fund, and now you had a third option: buy some mortgage-backed top-tier securities. If you need some cash, you borrow from a bank, or a money-market mutual fund, or you sell some of your mortgage-backed top-tier securities. Basically, mortgage-backed top-tier securities traded just like cash in the world markets.

Of course, the world market for cash demands certainty. Banks will only give short term IOUs to people they are absolutely sure will pay them back. Otherwise, since the bank has put every extra penny into the money market, if it does not get paid back the bank immediately falls below its reserve requirements. It will then get regulatory warnings, the balance sheet will show losses, and the stock will plummet. If it gets bad enough depositors get spooked and start to pull assets, making the bank more unsound, and the death spiral is unleashed.

Banks and other investors across the country put short term cash into mortgage-backed securities, and a lot of it. The SEC and various state bank regulators should have blocked this or at least limited it, but they didn’t. I hope the cause of their failure was naivete or stupidity, rather than corruption. We’ll find out.

The bomb went off with the housing bust. Borrowers stopped flipping homes and refinancing, and instead started going bankrupt and into foreclosure. Fannie and Freddie started taking hits on their loan guarantees. Fannie/Freddie were undercapitalized and had been so for years. When they dried out, which didn’t take too long, Fannie and Freddie died, and so did their loan guarantees to backed up subprime mortgage debts, and the securitized versions of them. The holders of lower tier subprime-based securities saw them become nearly worthless. Lehman Brothers died.

It was only days for the rest of the dominos to fall. Only those in the top tier, who were reinsured, remained. But they didn’t last long, because the constriction of financing for home buying deepened the housing slump, and possible claims over top tier securities against AIG and other commercial insurers severely crippled the balance sheet of AIG due to its massive reinsurance exposure. AIG bankrupted, and was immediately loaned huge amounts of cash by the US Government, before we even heard the news. You can see why. AIG was the last guardian of a massive short term credit pool built on mortgage-backed securities.

Now controlled by the US Government, AIG will sell off all of its profitable businesses to cover its reinsurance obligations. Its shareholders, massively diluted by the obligations to the US Government, will be waiting for years for the next dividend, if one ever comes.

AIG was rescued, but the damage was done. Nobody knows if AIG really has enough money to pay off its reinsurance obligations, and in fact, nobody will know for a very long time. The US Government has not said it will guarantee AIG’s reinsurance of mortgage-backed securities, it has only injected cash, become the preferred stockholder, and replaced management. Confidence is lost. Nobody will trade in mortgage-backed securities any more, even the top tier ones. What was being treated as cash is now being treated as worthless. So, the whole system is undermined. The banks that hold the top tier securities, which they bought to park cash, are now stuck with something else entirely: not cash at all, but a long term security for which there is no buyer.

Think about it—nobody knows to what extent these assets are going to pay back. Nobody really analyzed what they were buying and selling in the top tiers before, because they relied on guarantees. That situation is antithetical to short term paper which is supposed to be safe. Short term paper should be only those obligations that are so safe you don’t have to think about whether they’ll get paid back. Top tier mortgage-backed subprime securities are probably OK investments, but clearly, they are not cash.

Banks are obliged by recent reforms to “mark to market”, meaning they must reflect current market price for everything on their balance sheet. When the market for short term mortgage-back securities froze, those rules required the banks to treat those securities as worthless, and write off a huge portion of what had been cash reserve. Suddenly banks across the country were at risk of being unsound for having too little cash. Some were particularly bad —Washington Mutual, Wachovia, etc.—those that were major players in subprime lending.

When these mainstream banks found out those banks were unsound, the collapse accelerated— uninsured depositors at those institutions, such as small businesses with more than $100k on deposit, retirees with their nest eggs in COD’s, etc.—heard about the precarious financial condition of those banks and pulled out. The rest of the cash drained, and the banks failed.

Also, you may have read about a money market mutual fund that failed—it was heavily into mortgage-backed securities. Massive cash withdrawals from that fund forced it to drop below a $1 share price. They were bailed out using a depression-era fund established for just that purpose.

So, a huge amount of short term money was sucked out of the world economy by the failure of mortgage-backed securities. Then the effect spread through failures at very large banks and money market mutual funds. Confidence was lost in each of the three traditional places to park cash: banks, mutual funds and short term securities. Much of the lubricant of the economy spontaneously turned to jell-o.

Treasury moved fast, making money available on short term, propping up AIG, ensuring no depositors lost money, propping up failed money market funds. But there is still the original toxin—mortgage-backed investments that should be cash but are now recognized to be long term, risk-bearing investments. They have to work out of the system, get treated as long-term risky obligations that they are, and get replaced with enough cash to keep things running. This would happen over time, and the market would punish those institutions that bought too much of those investments. But that could be very painful and perhaps not survivable by an economy like ours.

Hence the current answer: the Government buys up to 700 Billion dollars of top-tier, subprime-mortgage-backed securities from the market, replacing them with cash. How much they are worth is unknown—but they are worth something because the homes that secure them are worth something. Maybe 30 cents on the dollar is a fair price … who knows? Any price is better for the system than where we are now, which is them being treated as worthless.

The only entity in the world that can buy these securities out of the market and replace them with solid hard cash is the United States Government, the world’s last and only Warren Buffet. If this does not happen, we’re going down the rabbit hole with no clear idea where it leads.

I find this all morbidly fascinating. However, I remain optimistic that through all of this, we will recover. We will suffer a recession about as bad as that from the dot-com crash, and come back stronger. This is a cautionary tale, something I’m sure we’ll learn from in future generations and hopefully will not repeat. Maybe our addiction to credit will finally be quenched for a few generations. One can hope.

A fine, succinct explanation from a guy much smarter than I am. It pays to have informed friends.