The current economic crisis was not caused by houses or barrels of oil. It was caused by the trade in pieces of paper. Mostly virtual pieces of paper, at that. These pages will give you a simple explanation - with simple examples - of a relatively complex situation.
We will start with a lot of definitions and short explanations. Why? Without them, you are less likely to understand the bottom line, when you read it. And it is important to understand the not quite standard way we use some terms for the sake of simplicity.
What are these pieces of paper?
The pieces of paper in question are often called "instruments", such as "financial instruments". They are things like stocks, bonds, Treasury Notes, Certificates of Deposit, commodities, and the like. They are (in theory) documents which represent something of value.
What are virtual pieces of paper?
In most cases these days, the pieces of paper described above never become physical pieces of paper. Instead, they exist as information on a bunch of computers. They have serial numbers and the like to give them their own identities, but they never make it to paper. For instance, few of the people who own stocks bother to get physical "stock certificates" for the stocks any more.
Some pieces of paper are more likely to "get physical" than others. Things like "Bearer Bonds", checks, Savings Bonds, mortgage agreements, and the like are in that category. Others, like stocks, bonds, etc., sometimes become physical pieces of paper.
What can you do with these pieces of paper?
Basically, you can buy them, hold them, and sell them. Usually, you can also create them, create other pieces of paper based on them, or convert them into something else. Some of them have limits (usually laws, regulations, and/or contract terms) which restrict what you can do with them.
What do you mean, you can buy them?
Depending on the kind of paper it is, you can either buy it directly from the current owner, buy it through an exchange, or buy it from the issuer (most often a financial institution or the government). You might be able to pay full price for it or even barter for it. Depending on the limits described above, you might be able to buy them using leverage, buy long, or even buy an option to buy them later.
What is an exchange?
An organization that exists to handle the buying and selling of specific kinds of pieces of paper. A couple of the best known examples are the New York Stock Exchange (NYSE), which handles stocks, and the New York Merchantile Exchange (NYMEX), which handles commodity contracts.
What is leverage?
This is one of the most important - and dangerous - concepts we will address. Basically, leverage involves borrowing most of the money used to acquire an asset, with the loan payable at the time you sell the asset.
Think of being someone who buys a new car every year or so. You see offers for "Small down payment, no interest or payments until 2010!" and take the seller up on that. You put down your 5%, and get the car. If the value of the car goes up (unlikely, I know) within the next few months, you can sell it for a profit. When you sell it, you have to pay off the 95% you still owe, but all the profit is yours to keep.
When you are buying and selling pieces of paper using leverage, the paperwork is a lot simpler than the auto loan in the example and you don't (generally) face the prospect of making monthly payments on the loan. You just have to pay off the balance when you sell the pieces of paper.
Why is leverage attractive?
When you expect the value of your asset - your pieces of paper - to increase before you sell it, leverage seems almost magical. Instead of getting one $100 piece of paper for $100, you can put down that $100 and get 20 such pieces of paper (assuming a 5% down payment - 20 to 1 leverage). If the price of the pieces of paper goes up by a little bit, you might sell it for a profit. With a 2% increase - bringing the price to $102 - you could sell the one share you bought outright and make a $2 profit. Or you could sell the 20 shares you got with the leverage and make a $40 profit from that same $100 investment. As the leverage ratio gets higher, the down payment gets smaller and the profit multiplier gets larger.
The speculators and institutional investors are not putting down $100 at a time. They are more likely to be using $50,000 to get a million dollars worth of the pieces of paper. That 2% increase becomes $20,000 profit. And with leverage ratios as much as 1 to 30 and 1 to 40 being common in certain markets, that $50,000 investment could produce as much as $40,000 from that same 2% increase. And an additional $20,000 for each percent the price increase goes beyond that 2% before you sell it.
Why is leverage dangerous?
Have you ever heard the common advice "Never gamble with money you can't afford to lose"? If the price of the asset falls, the leverage can be just as powerful when turned against you. In the above examples, a price decrease causes you to lose money. If you just bought the asset, a 2% drop in price would mean you lose $2 when you sell it. With the 1 to 20 leverage, you have lost $40 of your original $100. Bad, but you still have something left.
The real trouble comes when the drop in price is greater than the down payment. A 10% loss in the price of the asset you bought outright just means you lost $10 of your original investment. But with the 1 to 20 leverage, that same 10% loss has wiped out your initial investment and you owe another $100 out of pocket. As the leverage ratio gets higher, the down payment gets smaller and the loss multiplier gets larger. If the leverage ratio was 1 to 40 and the loss was 50%, your $100 investment would leave you $1,800 in the hole. Now imagine the effect of that 50% drop on a $50,000 investment with a 1 to 40 leverage ratio - $900,000 in the hole. And in most cases, even those high rollers do not have an extra $900,000 in cash sitting around.
What is the difference between buying long and buying options?
The short answer is that buying long is a contract that you will pay a set amount of money for a set amount and type of pieces of paper on a particular date, and an option is a piece of paper that gives you the right (but not the obligation) to buy such paper at such a price on that date.
Buying long is like custom ordering a car. You pay a little of the money up front, and the rest of the money when the car is delivered on the agreed on date. The car company is obligated to produce and deliver the car on that date, and you are obligated to pay the balance of the price on delivery.
Buying an option is like getting a supermarket rain check. It gives you a limited right to buy a limited amount of a particular product from that store for a specified price within a specific time. The obligation is one way; they are obliged to sell you that product at that price (if you so choose), but you are not obliged to buy any of it. If you want to, you can just let the rain check quietly expire.
What do you mean, hold them?
While most such pieces of paper are virtual these days, and therefore physically impossible to hold as such, the time between your acquisition of them and your disposal of them (usually by selling them) is still considered time spent holding them. Some of these pieces of paper actually pay you to hold them. Some, like bonds, Certificates of Deposit (CDs), and Treasury Notes (Savings Bonds, T-Bills, etc.), pay you interest for however long you hold them. Others, such as some stocks, pay dividends at certain times in the fiscal year.
How do you sell them?
Your options for selling your pieces of paper are pretty much the mirror of your options to buy them. Depending on the kind of paper it is, you can either sell it directly to the buyer, sell it through an exchange, or sell it back to the issuer (most often a financial institution or the government). You might be able to get full price for it or even barter for it. Depending on the limits described above, you might be able to sell them using leverage, sell short, or even sell an option to buy them later.
What does "selling short" mean?
You sell a stock short when you are sure the price will be going down in the near future. It is making an agreement (which becomes another piece of paper in its own right) to sell a piece of paper that you do not yet have to the buyer on a particular date and at a particular price. Sometime between the time you sell the short contract and the date specified, you have to buy that piece of paper, so you can honor the contract. Sometimes, if the price drops enough, the buyer will sell the contract back to you for less than you were paid. If that happens (and you don't sell the contract again), you don't have to buy the other piece of paper after all.
What are Bubbles?
Sometimes, the process of money chasing money runs away to the point that a sort of irrational exuberance takes over. The prices for the items in question - often, but not always, pieces of paper - increase well beyond any realistic value for the items, and then keep going up. Those involved seem to lose track of the nature of the items themselves,and just concentrate on the price and the flow of money. A sort of hysteria takes hold, sucking more and more people in, more and more deeply. This phase can last a long time, but sooner or later it reaches a point where even those dynamics can't sustain it and the market collapses. The bubble "pops". The prices fall rapidly, with money chasing money out of the market, until they level out at a more sustainable, realistic level.
Vast fortunes have been wiped out when such bubbles popped, especially when overeager speculators had been using leverage to increase their effective investment.
Such bubbles have been happening for hundreds of years. One of the best known of the early bubbles was the Tulip Bubble of 1636. Almost as famous was the Mississippi Bubble of 1719 - one of the early bubbles built around pieces of paper. More recently, there have been a number of real estate bubbles, stock bubbles (such as the Dotcom Bubble), and a number of bubbles built around other pieces of paper.
What does "Money Chasing Money" mean?
It's a common part of human psychology. When people see others making a lot of money doing something relatively easy, they want to do the same thing. And when they see the people they regard as "in the know" getting out of something, they want to follow. That is the essence of money chasing money. It can cover entire areas of investment (real estate, currency trading, commodities, etc.), or narrow down to a specific element (eg. a specific stock), or fall somewhere in between (dotcom stocks, porkbelly futures, etc.). When they see people making money by buying those things, holding them, then selling them for a profit, they do the same thing - their money "follows" that earlier (and presumably more knowledgable) money. And when they see "the money" getting out of that area, or especially selling short, they follow it out as well. Often, the people doing the following neither understand nor care about the specifics of the pieces of paper they are buying and selling.
What are mortgage derivatives?
Mortgage derivatives are pieces of paper which are created based on mortgages, or based on other pieces of paper which are directly or indirectly based on mortgages. This article gives a good explanation of several kinds of mortgage derivatives.
What does unregulated mean?
The trade in various kinds of pieces of paper are controlled, or "regulated" by particular "Regulatory Agencies", which are a part of the Executive Branch of government. For instance, the SEC regulates trade in stocks, bonds, and other "securities". They do this by issuing and enforcing a set of rules ("regulations"). Unregulated means that
either there is no agency with jurisdiction over the thing in question, or there is such an agency and it has chosen not to issue or enforce such rules.
What does under-regulated mean?
Sometimes, there is an agency with jurisdiction over the thing in question, but the rules or the enforcement (or both) are too weak to produce the necessary effect. We say then that the thing is under-regulated.
What does OTC mean?
Over The Counter. Effectively, buying it like you would goods at a store or from a web site.
So what happened?
The international economic problem was caused by the interactions of two classic bubbles involving money chasing money in unregulated and under-regulated pieces of paper. Each caused widespread effects, although the reasons differed.
The one that directly involved more institutions, and caused the more spectacular crash, centered on mortgage derivatives. These pieces of paper, often separated by several degrees from the mortgages themselves, were mostly unregulated. In the Lassez Faire environment promoted by the agencies of the Bush Administration, there was nothing to slow the heavily leveraged speculation and investment in these pieces of paper - even among supposedly regulated investors like banks. Money chased money, with little regard for the realities of the mortgages behind (often way behind) the pieces of paper, and the bubble swelled and spread. Even after a number of sources sounded alarms about those mortgages, the bubble continued to swell.
While that bubble was growing, a regulatory decision set another bubble on the fast track. In January, 2006, oil derivitives slipped their leash. These pieces of paper, already volatile due to events in the Middle East, the Gulf Hurricanes, and growing demand elsewhere benefitted from a ruling by the Bush administration’s Commodity Futures Trading Commission (CFTC).
Up until that time, the primary exchange for trading those "paper barrels of oil" was the New York Merchantile Exchange (NYMEX). But NYMEX traders must keep records of all trades and report large trades to the CFTC, along with daily trading data noting price and volume information. In theory, the CFTC uses that data to track speculation and price manipulation.
The January 2006 CFTC ruling let the London Exchange (ICE) use its trading terminals in the United States to trade US crude oil futures on the ICE futures exchange in London. The traders on such unregulated OTC electronic exchanges don’t have to keep the records required of NYMEX traders or file the “Large Trader Reports” with the CFTC, and such trades are exempt from routine CFTC oversight. On top of that, the CFTC issued another ruling that had the effect of allowing (in the words of Business Week) ”unlimited speculation through a swaps loophole that exempted Wall Street investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors to the oil derivative traders on Wall Street vis a vis the ‘swaps’ exemption.” Money chased money, and the bubble was off and growing.
But this paper chase was a little different. Some of the oil related pieces of paper actually had the effect of setting the price per barrel of oil, and the frantic trade in the suddenly unencumbered and very profitable pieces of paper sent the price of oil (and oil derived products such as gasoline) skyrocketing.
By June of 2006, a committee of the US Senate issued a report outlining the situation and sounding an alarm about the effects of such speculation. The higher fuel prices quickly started to spread to other areas, such as food prices. As the bubble continued to grow, the effects became more severe. The rising costs and the (related) cutbacks in purchasing caused drops in employment. Families - even seemingly well to do families - who were already on the margin found themselves with little or no real income, and they started to default on their mortgages.
When the rate of mortgage defaults became high enough to catch the attention of the speculators and investors in the mortgage derivatives, that bubble popped. For each one of those mortgage defaults, as many as 20 different people and/or organizations had some sort of derivative pieces of paper that would be affected by the default. Concerned about that effect, they started trying to sell those pieces of paper. That drove their value down even more. People and organizations with political agendas started to point fingers at "predatory lenders", the CRA, and Fannie Mae/Freddie Mac, making often fallacious claims about their contributions to the problem, thereby increasing investor anxiety about anything related to mortgages.
By December of 2007, the side effects of the two bubbles drove the US into a recession. People cut back on optional purchases (such as new cars). By Fall of 2008, the oil bubble had started to deflate a little. The speculation-driven oil price had dropped from a high of about $160 per barrel to about $120 per barrel. The fuel prices, and the prices they drove up, were slower to drop.
Then the floor dropped out, and everything seemed to happen at once. Once solid financial organizations started to fail, due to their large investments in heavily leveraged mortgage derivatives. The banks among them stopped making most kinds of loans. Automobile companies, and others that depended on such loans for their customers, suffered massive losses as sales continued to drop.
When the first attempts by the (US) Federal government failed to stem the tide, the Administration proposed a massive bailout. It would get money from Congress to buy up a lot of the "bad" pieces of paper from the failing financial organizations (at a discount), and free the banks to start lending again. The failure of Congress to pass the bill that would fund that "bailout" caused a panic in financial circles, and a resounding crash in the markets for pieces of paper. Speculators and heavily leveraged investors, facing the dark downside of leverage, liquidated their investments to limit the damage and pay for their leveraged losses. The stock market plummeted, wiping out trillions of dollars of investments in days. The prices of "paper barrels of oil" dropped $20 per barrel in two days, then settled into a somewhat shallower long term decline (ultimately losing $100 per barrel from their earlier peak). The general public, hearing dire news and predictions from the political sources and the media, started to panic. Financial institutions faced bankruptcy.
A somewhat modified version of the "bailout" package passed the Congress and was signed by President Bush. But by then the damage was done. Tens of thousands more people were losing their jobs throughout the country, and the package was too little too late to stop it.