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Friday, January 28, 2011

Understanding Economics 101


One should not have to be an expert in economics, finance or markets in order to have a basic understanding in those fields.  Of course the terminology is purposely set up to be confusing and convoluted so that as few people understand it as possible.  So in order to help readers better grasp the current recession-depression, I will take some commonly used terminology and try to define it in a clear and concise way:

National Deficit, National Debt & Debt Ceiling

The two words deficit and debt get interchanged a lot but they mean distinct things.  The best way to explain is by using an example of an individual using a credit card.

You possess a credit card and owe $1450-  this is your 'Debt'.   You get a bill each month which includes the  minimum payment amount after interest is applied- this is your 'Deficit'.   And if your credit card had a maximum of $1500 in total charges you could apply, that is your 'Debt Limit'.

When politicians talk of lowering the deficit, they mean being able to pay enough toward the debt to lower what the monthly payment will be.  The national debt still expands.  And when Congress votes to expand the debt ceiling, it is like your credit card company telling you that you now have $2000 limit instead of the $1500 you were closely reaching.


Quantitative Easing

This is an academic way of saying 'back door bailout'.  The Federal Reserve creates money (which is actually new debt) which it uses to buy government bonds and other financial assets, in order to increase the money supply.

Now those 'other' financial assets which the Fed is buying is the toxic debt that the various banks are holding on their balance sheets.  The total accumulative debt is in the tens of Trillions.  If the government overtly stated they were going to bailout the banking system for that much money, there'd be literal revolt, so instead the bailout is done quietly and gradually

Think of it this way- your basement is flooded but you don't want to alarm the others in your household which you'd do if you used large buckets and pumps to remove it.  So instead you use styrofoam cups-- a cup of water each trip to the basement as to not startle or panic anyone.

Now currently the Fed is giving the banks $75 billion/month in exchange of buying their toxic assets. The Fed doesn't really want the toxic assets but there must be a legal exchange in order for the Fed to legally give the free money.  This is no different than one person wishing to give $1000 to another but is prevented from overtly giving as a gift, so person instead offers to buy a 2cent tissue for $1000.

Debt is created which is added to the National Debt.  The bank holds the money which they would normally be compelled to lend out to people.  But the Fed does Not want that money circulated.  So they pay the banks not to lend the free money which was given to them.  The banks get reimbursed pennies on the dollar for the toxic asset swap, then make an additional profit simply by holding the money and not lending to needing businesses and individuals.


Commodities

These are tangible goods which are traded on stock exchanges around the world to determine its value in the open market.

Generally, there are two kinds of commodities.. basic resources & agricultural products. These include basic resources and agricultural products such as iron ore, crude oil, coal, salt, sugar, coffee beans, soybeans, aluminium, copper, rice, wheat, gold, silver, palladium, and platinum.  Soft commodities are goods that are grown, while hard commodities are the ones that are extracted through mining.  Electricity is special commodity it itself-- it has the particular characteristic that it is either impossible or uneconomical to store, hence, electricity must be consumed as soon as it is produced.


Securitization

This is where certain types of contractual debt is grouped together or 'pooled' This includes residential or commercial mortgages, auto loans or credit card debt.  This debt is then sold as bonds, or Collateralized mortgage obligation (CMO), to various investors.

(A CMO is essentially a way to create many different kinds of bonds from the same mortgage loan so as to please many different kinds of investors.)

The principal and interest on the debt, which is underlying the security, is paid back to the various investors regularly. There are two kinds of receivables (amounts owed)- Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

(When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.

An ABS is essentially the same thing as a mortgage-backed security, except that the securities backing it are assets such as loans, leases, credit card debt, a company's receivables, royalties and so on, and not mortgage-based securities)

~ In super simple terms, Securitization is a means of lenders ensuring they don't hold any financial risk in case you do not pay your debts, so they sell it off that debt to others or package it in ways that become attractive to investors, and recoup their money that way.

Hope this posting could assist in clarifying some financial terms and concepts, even if gradually, as to make it more understandable to grasp.

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