Sunday, September 28, 2008

For Sparcam, other Lurkers, and Friends,

Several times over the past week I have been asked to explain the financial mess we are currently in, given my past experience on Wall Street.  Here is my attempt to make it as simple as I can, not to talk down to you, but to recognize that much of what you hear on TV either makes no sense, is hopelessly filled with Wall Steet jargon, or has a distinct political bias to it.

First, this problem is very serious.  The US economy does not run on cash; it runs on credit.  Our annual Gross Domestic Product is over $13 Trillion (the value of all goods and services produced by the economy); the amount of cash and checking accounts funding that is only about $1.5 Trillion.

The difference is made up by banks lending to each other, lending to small businesses to make payroll and to farmers to buy seed and rent equipment, you and I willing to lend money to corporations in terms of buying bonds or buying into those corporations by purchasing their stock, etc.  In other words, the free flow of credit is the backbone of our economy.

But, in order for the credit markets to work, the lender must be able to value the collateral put up by the borrower.  That's where the now-famous sub-prime mortgages enter the picture - they cannot currently be valued by the market.  How did this happen?

In 1977, the Carter Administration proposed the Community Reinvestment Act which became law.  The purpose of the law was to get banks to make more loans to those on the lower end of the financial spectrum so that they too could enjoy the American Dream.  Banks were pressured to create easier loans for those otherwise unqualified to get them.  The old notions of 20% down, not more than 25% of  your income going to housing, a sterling credit record, and even proof of income, employment and current low debt all started disappearing from the normal demands of mortgage lenders.

In 1993, the Clinton Administration wanted even more such loans to be issued, many with adjustable rates, interest only payments, other gimmicks and expectations of easy refinancing.  Attoney General Janet Reno actually went on record threatening banks who declined to increase their portfolios of risky loans with refusals to allow mergers, increased regulation and DOJ investigations.  One can only presume that the Democrats were especially interested in these loans because they were going to likely Democratic voters, including a large number of illegal immigrants.

In 1995, Republicans in Congress, to include John McCain,  saw a danger in this lending process and proposed much more stringent regulation of banks lending practices.  The bill never got out of committee, with complete Democratic opposition which they said, "would dry up affordable housing opportunities for millions of Americans."

To address the banks' growing concerns of the risk of the assets they held, Fannie Mae and Freddy Mac agreed to buy up their sub-prime mortgages.  The more mortgages held by these Government Sponsored Enterprises (GSE) the more their profits - and bigger their bonuses.

The GSE's then "sliced and diced" these mortgages into a "fruit salad" of many mortgages and sold the salad packages as securities known as"Collateralized Debt Obligations" (CDO's).  Those mortgage backed securities were bought in great quantities by pension funds, investment banks, commercial banks, foreign governments, and mutual funds, to name but a few investors.  In each CDO there were good mortgages, mediocre mortgages and some real rotten ones, but - these were all backed by Freddy and Fannie, so the US Government stood behind them, right?  Wrong.

The GSE's were chartered by Congress to provide mortgage lending, but their products were never insured by the "full faith and credit of the US", such as are Treasury bonds.

But home builders loved the program as much as the GSE's and Democrats.  Everyone could now afford a home, even if they couldn't...  And home prices were rising every year, so many looked upon house buying not just as a place to live, but as a quick road to easy riches.  This led builders to build as fast as they could to take advantage of increased demand and higher prices.

This is now known as "the housing bubble."  Soon, supply of homes exceeded demand, home prices began to fall and adjustable rate mortgages started adjusting.  Many of those less affluent folks who had been talked into buying much more home than they could actually afford discovered that the value of their home had suddenly dropped below the amount of their mortgage.  They were now "upside down" and defaulted on their loans.

The CDO securities spread throughout the economy were now deemed "toxic."  The value of those fruit salad securities, the collateral which many put up to secure new lending, could no longer be valued.  Credit began to dry up and the economy would soon grind to a halt unless those securities were removed from the system.

To think of it in simplest and gross terms, the lending markets became constipated and needed an enema fast, before the whole body shut down.  Enter "The Loan Arranger", Hank Paulson, SEC TREAS, and his sidekick, Ben Tonto Bernanke, FED Chairman,  with a proposal to have the Government buy up all the suspect CDO's to clear the system of that which could not be valued, then hold onto most of them, believing that most owners would continue to pay their mortgages, and the Government may eventually make most of its CDO outlay back.

But $700 BILLION isn't chump change, so the Congress has now jumped into the act to propose giving the Treasury one Milk of Magnesia tablet at a time, holding continuous hearings on how the credit market patient is doing, and claiming that they are watching out for the American taxpayer.

Problem is, if the credit markets don't get rid of the toxic mortgage CDO's quickly, then the markets will continue to parcel out needed continuous credit in little packets, a sure recipe for rapid economic slowdown, increased unemployment, further devaluation of the US dollar and lack of confidence that the US Government has the courage to take strong and immediate action.  What is need is a "high colonic enema," not Congressionally administered Milk of Mag tablets one small dollar amount at a time.

So, was this all about greed?  To a degree.  There were the "needy greedy" who wanted more home than they could afford and wanted it now.  There were the "politically greedy" who saw the chance to create a new government prograsm which would buy them votes and make the government more responsible for everything.  There were the " lending greedy" whose purchase of suspect mortgages created more volume for them and bigger paychecks.  There were the "building greedy" who slapped up houses like crazy and loved the increased demand and easy mortgages which made them rich.  And there were the "Wall Street greedy" who trafficked in CDO's and even built "insurance derivatives" called "Credit Default Swaps" which were designed to insure investors against their CDO's going bad by swapping out part of their portfolio risk for other risks in different investment areas - all for a hefty price, of course.  These were the demise of AIG, the world's largest insurance company.

So, there you have it.  It's a big problem requiring a big solution, not tentative measures.  But, knowing our Congress, they will never take any of the blame for the "failed social engineering" of the "affordable housing laws."  Instead, they will administer small doses of medicine and wonder why the patient isn't getting better.  And, of course, they will point their fingers at anyone except in the mirror.

Hope this makes some sense out of what is a very complex subject...


Suzanne C said...

You are awesome! Thanks for making a very murky subject much more clear. I've been racking my brain trying to figure out who to ask about this and I remembered you. Thank you so much!

ps: tell your wife I'm very jealous of the Vince Gill picture!

Apis Melliflora said...

This was an excellent blog! Thank you oh Master Teacher! I especially liked the clever food/body analogy. Hard to forget!

Keeper said...

Great Job!

You have a gift for taking a very murky and indigestible subject and distilling it into a clear and palatable story. I could take a month trying to accomplish that and would still not do half the job you did. Thanks Ken

Anderson Zoo Keepers said...

Thanks for the analysis. But here's another question.

Why is the name of the bail-out:
"To amend the Internal Revenue Code of 1986 to provide earnings assistance and
tax relief to members of the uniformed services, volunteer firefighters, and Peace Corps volunteers,
and for other purposes"

And what "earnings assistance" are we going to see here exactly? Isn't the entire point of this bill the "for other purposes" part?

Unknown said...

Sir ... Thank you for helping me to understand what no college course I ever took taught.

I was raised by parents who said work hard, invest wisely, and live within your means. So I did ...

I work in social services. I work with people who believed they were entitled to home ownership. I can't reparent them ... I can only help them try to find their own way.

Again ... thanks!

Granny Lin said...

Ken, thanks for taking the time to explain a complex subject to those like me who have limited understanding. It makes more sense now. Thanks again.