There is no doubt that I am in a bad mood... probably caused by reading Forbes Magazine before dropping off to sleep.

In the April 7th edition of Forbes Magazine, Steve Forbes, Editor-in-Chief, presidential aspirant and a member of one of Wall Street's prominent and influential families, writes in his "Fact and Comment" column titled, "Here's How to End the Panic,

"THE BUSH ADMINISTRATION MUST TAKE TWO STEPS IMMEDIATELY to quickly halt the unending, enervating credit crisis: shore up the anemic dollar and, for the time being, suspend "marking to market" those new financial instruments, such as packages of "subprime mortgages."

Bypassing Forbes' comments on the dollar, Steve goes on to say...

"The other measure: The Treasury Department and the Fed should get together with the SEC, the Comptroller of the Currency and other bank regulators and announce that financial institutions for the next 12 months will no longer write down the value of exotic financial instruments (primarily packages of subprime mortgages)."

"Instead, writedowns will occur only when there have been actual losses on those assets. If a mortgage defaults, a bank will then -- and only then -- recognize the loss."

"It is preposterous to try to guess what these new instruments are worth in a time of panic. Such assets are being marked down to increasingly arbitrary low levels. But when a bank books such a loss, it must replenish depleted capital, even though cash flows for most financial firms are still positive.  Worse, when forced by panicky regulators and lawsuit-fearing accountants to write down the value of these securities, institutions will dump assets in a market where there are temporarily few or no buyers. The result is a spiraling disaster. So let's have a time out on markdowns until we actually have real experience in what kind of losses are actually going to occur."

"Those two steps would quickly end the panic. Until that happens, expect more trouble."

Great, Steve! Just continue to stick your head in the sand, reward Wall Street for creating an abomination and buy time by bandaging the patient to prevent anyone from seeing the unsightly wounds.

Papering over Wall Street's misdeeds...

According to Wikipedia, the "flight to liquidity" is defined as:

"A flight-to-liquidity, is a stock market phenomenon occurring when investors sell what they perceive to be less liquid or higher risk investments and purchase more liquid investments instead, such as US Treasuries. Usually, flight-to-liquidity quickly results in panic leading to a crisis."

The root of our present crisis lies in the financial engineering performed by the Wall Street Wizards. Wizards who, in their rush to generate outrageous commissions and even more outrageous personal bonuses, decided to create products for sale where none existed before.

By taking debt collateralized by mortgages, they pooled similar mortgages together and sold them to investors as Mortgage Backed Securities (MBS).

Had there been a one-to-one relationship between the mortgage (collateral) and the debt instrument, there would be no problem in valuing the paper, collecting a major portion (over 50%) of the loan's value in a foreclosure and booking either a profit or loss.

But Wall Street recognized that some loans were made to flaky borrowers with crappy (a technical term) credit or under conditions (no doc, stated income, teaser rate, payment option adjustable rates, interest only, negative amortizing) which allowed a person with little or no real credit capacity to purchase a home in an over-inflated speculative real estate market.

Non-existent insurance...

So Wall Street performed some wizardry... they executed "repurchase" agreements with originators who were contractually obligated to "buy back" or replace non-performing loans that experienced either a "first payment" or "early payment" default. Nobody, it seems in some cases, recognized that the total value of the loans originated greatly exceeded the originator's ability to repurchase a significant portion of the generated loan portfolio should borrower defaults exceed a certain mutually agreed-upon level. This was exacerbated by originators who allowed the borrower to keep re-financing their non-performing loan in order to keep the shell game going.

Those that noticed potential problems with loan pools sought a greater degree of protection by using a form of mortgage insurance which guaranteed that the lender would be made whole if the unthinkable (a foreclosure) occurred. The insurers knew that some money would be recovered and thought that they correctly understood the risk. Again, nobody, it seems in some cases, recognized that the insurer's ability to handle and increasing number of loans exceeded their balance sheets and other re-insurance arrangements. And for those who wanted an even greater amount of "insurance," there were sophisticated hedges where a "counterparty" agreed to cover a certain degree of value shortfall in return for a healthy premium.

Then GREED happened.

Originators, pushed by Wall Street's demand for product, dipped lower and lower into the borrower pool to originate even more risky mortgages. Wall Street's wizards started playing with their computerized risk models and sliced-and-diced various levels of risk into new synthetic securities (derivatives) where there was only a tenuous connection between the paper and its underlying collateral. More and more paper was generated without regard to the fundamental stability of the underlying collateral.

Nobody, apparently, noticed that some originators were engaging in fraud by creating documents out of the thin air, by inflating appraisals and by simply overriding their fraud detection systems. After all, the risk was being transferred from the originator to the secondary market and the greatest exposure period for the originator only lasted for a few months.

Fairy dust sprinkled by the ratings agencies...

Of course, investors would have never purchased such speculative securities if they had really known that the access to the underlying collateral was legally tenuous or next to impossible.  Enter the ratings agencies who listened to their own clients as they explained "how safe" these securities were with their multiple protections against defaults. So the ratings agencies, to earn their thirty pieces of silver, waved their magic wand and "certified" these deeply flawed securities as being of "investment grade." All based on the "warantees and representations" of management.

The truth, of course, was far different. These investment grade derivatives had no apparent value early in their life, could only be valued by complex computer models and were somewhat illiquid - unless you could find a willing buyer to purchase the paper; hopefully for a profit.

Keep 'em coming...

But Wall Street didn't care, they made their commissions buying and selling these collateralized debt instruments. Win, lose or draw -- they pocketed their commissions.

The Wall Street Wizards saw large investors (the hedge funds, pension funds, mutual funds and others) leverage their derrivatives investments by using short term money to purchase longer term securities. Something that is abhorred by those who believe in "old fashioned" banking practices.

The trigger event: the real estate bubble burst...

Aided and abetted by the nation's most optimistic cheerleaders, the National Association of Realtors, real estate agents loudly proclaimed, "It's a great time to buy a house or sell your house in order to 'trade up.'" People were purchasing multiple properties in hot housing markets. Often by lying about their "owner occupied" status to get favorable loan terms. At some point the hot markets became saturated by newly built homes and prices started to drift downward. With appraisal values declining, troubled borrowers could no longer justify their re-financing activities and a downward spiral was exacerbated.

Someone finally shouts "FIRE" in the crowded stock exchange and the panic sets in...

As time went on, as it is wont to do, more and more large investors found that the media was playing up the "toxic" paper story and that their pool money was drying up. Investors, large and small, were not renewing their short-term capital investment in the larger pools after the maturation of their investment. They were taking their money and placing it elsewhere. (Re-read the definition of "flight to liquidity")

With highly leveraged investments, an acceptable 5% loss in a market downturn can turn into an unacceptable 35% loss which encourages investors to demand the return of their investment. Thus faced with an increasing number of redemption requests, pool operators were forced to borrow more money to pay their investors or liquidate "illiquid" securities... and the spiral downward increases.

Full faith and credit...

All of the financial community is based on mutual trust and the understanding that an institution's books fairly represent the financial condition of the enterprise.

Whoa! Not so fast. Here we have the Financial Accounting Standards Board promoting FAS Rule 140 which allows corporations to actually keep their toxic securities hidden in plain sight -- but off their books -- in so-called "Special Purpose Entities SPEs). ENRON-style accounting at its best.

Bottom-line: a major liquidity crisis!

Those with investment capital became wary of all financial institutions. Banks refused to loan money to brokerages simply because they could no longer determine if the firm was profitable, contained sufficient realizable assets to cover its debts and because they were uncertain of the hidden obligations and value of paper held by the institution using the SPEs to hold the risk off the balance sheet. There are no computer models for pricing this risk scenario as no buyers can be found.

Financial institutions are now forced, by "mark-to-market" regulations, to recognize that their "paper" has been significantly de-valued and that they must place a greater amount of their capital into a buckets called "reserve accounts." With much of their capital thus transferred from one balance sheet account to another, the institution's legally  mandated "core capital reserves" may fall to levels that would be judged by the regulators as approaching "insolvency" levels. A very dangerous situation.

Enter the FED...

Bernanke and the boys come to Wall Street's aid... not surprising as the Federal Reserve has always provided a "bail out" plan for depository financial institutions in trouble, and by extension, their Wall Street Associates. So to prevent the insolvency of a major institution or institutions  (remember, the Fed is all about secrecy), the FED starts pumping hundreds of BILLIONS of dollars into the banking system (and now, apparently, directly to the larger Wall Street brokerage) ostensibly to increase systemic liquidity -- but, in reality, to shore up sagging reserves to prevent a catastrophic collapse of a major bank -- with national and world-wide economic repercussions.

Which brings us current...

Now that you understand what is happening, you can appreciate my anger at the lying thieving bastards of Wall Street and their political whores.

Reality: we were failed by our government's financial regulators!

Not only did our financial system's regulators, like the Securities and Exchange commission, fail to protect us from toxic accounting (they signed on to FASB 140) and their non-regulation of ratings agencies and hedge funds; but we were failed by those who regulate both depository (banks, credit unions)  and non-depository (mortgage originators) lending activities when they failed to enforce "proper and appropriate" banking safeguards already on the books.

They looked the other way when accounting irregularities and management malfeasance resulted in BILLIONS of dollars in losses from the GSEs (Government Sponsored Entities) like Fannie Mae, Freddie Mac and others. Fines were levied, accounting controls were improved and the game continued.

They looked the other way when politically-connected law and accounting firms allowed their clients to create works of fiction without raising one note in protest. One need only review the allegations of the chief investigator of New Century financial who openly criticized KPMG for their accounting activities and alleged acquiescence to management's representations and wishes.

Reality: we are still being hosed by the politicians...

The President, members of his Administration (especially Treasury Secretary Henry Paulson), Congress and the presidential candidates are now proposing even more "look good-feel good legislation." Legislation which will further confuse the financial industry with a continuing patchwork quilt of overlapping, conflicting and nonsensical regulators and regulations.

The solution...

Unlike Steve Forbes who apparently wants to "bandage the patient" in order to buy time for an orderly work out, I have a different set of prescriptions.

One, adopt a goal of increased transparency in financial accounting. No more "legal" fictions to squirrel away bad results or the manipulation of reserves to "smooth" earnings. Keep the mark-to-market provisions. If something has a future value, recognize it in a footnote along with the valuation assumptions -- but do not allow computer-generated fiction to become facts on someone's balance sheet.  There is a significant difference between "fair market value" and "no market value" when no buyers can be found. To recognize and record value where there is none, is to post false and misleading financial information -- which is still a crime under the current laws.

Two, immediately regulate the ratings agencies and hedge funds.

Three, suspend or limit the ability to "sell short" in times of financial panic. There is no doubt that we are seeing not only the results of speculators bidding up commodities of which they will never take possession, but also the misuse of large capital reserves to manipulate the stock market by selling millions of dollars of securities to force the decline of a stock -- and book a profit when the short positions are covered. And since there may have been nothing fundamentally wrong with the underlying company, re-purchasing the stock for its ascendancy to its un-manipulated original value. Along with the regulation of short selling, raise the margins for speculative commodities and stock purchases which will force more capital into the system and discourage "gambling" as opposed to "investment."

Four, let insolvent firms fail to the point that they are liquidated and their assets shared by their shareholders. Thus a Countrywide or Bear Stearns, whose book value significantly outweighs the purchase price offed in pre-arranged "bailout deals," could return real value over time as the assets are sold for the benefit of creditors and investors.

Five, punish the guilty. Force those who were complicit in creating the problem to return a significant, if not all, of their salary and bonuses. Along with sanctions against the ratings agencies, law firms and accounting firms that signed off on these financial works of fiction.

What can YOU do?

Do not accept any politician's plan to bandage the patient so the wound cannot be inspected and then treated.

Remember, the current crisis is more a "crisis of confidence:" than it is a true financial crisis. Do not sell into panicked markets.

What we need is more transparency in financial transactions, not less. Anyone who even suggests that less transparency is necessary for fiscal stability is wrong. All assets, inluding real estate, should be subjected to mark-to-market requirements.

Realize that the current economic crisis is not as bad as thy media and political parties would have you believe. Subprime mortgages are a small part of overall mortgages. Overpriced real estate will again be sold enthusiastically to willing purchasers once the prices are rationalized at a more reasonable level.

Ask about the other collateralized assets which far outweigh those held in subprime mortgages: credit card debt, auto loans, leasing contracts, merger/buyout debt -- and what they are not telling you about their chances for default.

If you must assign blame, it falls directly on the Fed (cheap money), the Administration (payment option ARMs to promote home ownership), the various and sundry regulators who hope that you will not notice that they are complicit in the fraud now being perpetrated on the American public, and the law and accounting firms which created legal fictions to enable these dastardly deeds.

Watch for the adverse results of pumping billions into our markets: either in inflation or an upcoming bubble in commodities. We are now repeating the exact same "easy money" program that led to the last bubble.

Do not vote for any candidate or current politician who is willing to subvert the safety, security, sovereignty and economic strength of the United States or limit an individual's right of self-defense for their personal philosophy, power, prestige or profits.

-- steve

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