Following the Crisis

Finding funding for Indie-Arcade has me watching the current financial crisis daily. The situation can be confusing, with arcane financial terms and complex transactions. So I want to share some of what I’ve learned and provide some resources for anyone else trying to find their bearings.

What’s Going On

The origins are complicated but have two primary sources. The first is the subprime mortgage crisis that began in 2007.

After the turn of the millennium, following the dot-com bust, massive amounts of money was pumped into the global financial markets. This money came from a variety of places such as the US Federal Reserve (by keeping interest rates low) as well as emerging Asian economies including China. Investors found themselves with a lot of cash and needed a place to put it. Much of this went into traditionally safe US home mortgages. But as more money poured in, increasingly “creative” ways to turn a buck were invented. This risky behavior ranged from providing mortgages to those who could not afford them (subprime mortgages) to creating complex financial products based on sliced and diced mortgages. Ultimately, the speculation caught up with the markets in 2007, putting many banks and other financial firms in dire straights as home owners defaulted on their loans.

But subprime mortgages aren’t the only culprit. Other complex financial products added to the mess. Chief of these are credit default swaps. You can think of CDS as something like insurance. If I hold a corporate bond and I’m concerned the company may someday go bankrupt, I can pay a financial firm a fee so that in the case of an actual bankruptcy I’ll at least get my money back from the bond. These CDS, which have been completely unregulated, were primarily used as a form of hedging. However, eventually, they became speculative.

Imagine a perverse form of life insurance. Suppose I could buy life insurance on my neighbor. Since he’s healthy right now, the cost of the insurance is pretty low. But then one day, he gets deathly ill. More and more people now also want to buy life insurance on this poor guy, but the cost of the insurance has gone up (since the likelihood of his death has increased). Since I bought the insurance when he was healthy, I’m still paying the lower fees. So I go out and sell insurance myself at the higher rates, hedging my bet. However, when my unfortunate neighbor finally kicks the bucket, everyone now starts owing everyone else money, much of which no one actually has. If that sounds ridiculous, you now understand the credit default swap market.

Breaking the Camel’s Back

With that backdrop, we flash forward to last month. The whole market was sick with the subprime mortgage mess. Uncertainly about who owned what and who owed who, had firms hesitant to lend to one another. Then came Lehman Brothers.

Lehman Brothers went bankrupt on September 15th largely due to exposure to subprime mortages. On September 16th, AIG had to be bailed out due to its exposure to both the subprime mortgage and credit default swaps. On September 17th, the Reserve Primary Fund broke the buck due largely to exposure to Lehman Brothers. This is where we went from crisis to meltdown.

The Reserve Primary Fund is a huge money market fund where safety, as opposed to earnings, is the chief concern. Breaking the buck means that the $1.00 you put into the fund is now worth $0.97. Imagine how you’d feel if that happened to your savings account. This set off a sort of panic in the money market funds. The funds in turn tightened their investments and exposure, leading to a freeze in the corporate paper market. The corporate paper market is where companies go to get short term loans to manage cash flow. It’s where they get the money to pay for new expansion or even payroll while they wait for their customers to pay their bills. When the corporate paper market freezes, the economy freezes.

A Crisis of Trust (or why you should ignore the DOW)

The downfall of Lehman and AIG set off a crisis of trust throughout the financial system. The complex web of credit default swaps and other derivatives has had banks and firms unwilling to lend to one another. Without that lending, companies face cash flow problems leading to cutting back on expansion and jobs. The subprime mortgage crisis has turned into a credit crisis which will affect the larger economy.

To give you an idea of just how bad it is, the figure to watch isn’t the DOW Jones or even the S&P 500. It’s the TED spread. The TED spread shows the difference between the interest rate on a 3 month treasury bond and the interest rate banks charge one another for short term 3 month loans. Banks often have to do these sorts of interbank loans and so typically the difference between these two rates is very small, less than half of one percent. Well, here’s what the spread has looked like over the last three years:

That’s right, it’s now above 4%. That’s a measure of how banks see lending money other banks as more risky than lending money to the US government. Four percent may not sound like much, but it’s over 800% higher than it’s traditional value. Banks are over 800% more scared than normal to lend to other banks. That’s a credit crisis.

Learning more

This article is already going a bit long, so I’ll save discussing the bailout for another post. In the meantime, if you’re interested in learning more, here are some resources I highly recommend. You’ll find that much of my article here is just a summary of the material below:

Radio and Podcasts

• This American Life: The Giant Pool of Money. Start here for an excellent primer on the subprime mortgage crisis.
• This American Life: Another Frightening Show About the Economy. Then get up to speed with the credit crisis.
• NPR Planet Money Podcast. Follow the daily developments here.

Blogs and Articles

• NPR Planet Money Blog further updates online.
• Baseline Scenario distills the latest financial crisis news.
• Baseline Scenario’s Financial Crisis for Beginners goes into more detail than I have here.
• Bloomburg TED Spread Index. Monitor the situation.
• For tech startups, read up on what Sequoia has to say.

What’s Next

The prevailing wisdom is that it’s going to get worse before it gets better. What you might need to do will depend heavily on your personal situation. That said, I don’t necessarily recommend following Jim Cramer’s advice to pull out of the market. In the long term, you’re likely better off to keep money in the market. Pulling out now is a recipe for selling low and buying high. So don’t abandon your 401K. If you really need that money within the next 5 years, then the stock market is risky place, crisis or no crisis.

As for my own startup, the situation is mixed. Raising capital could become increasingly difficult, requiring us to focus on positive cash flow and potentially putting off hiring staff. At the same time, raising small amounts via bridge loans and angels could actually be easier as people look for somewhere other than the stock market to put their money. All of a sudden, a small tech startup doesn’t look all that risky compared to everything else.

Still, it’s going to be an interesting ride ahead.