Artificially low rates …

We have long maintained that the current credit crisis had its roots in Alan Greenspan’s decision to keep the Federal Funds rate artificially low as a partial solution to the bursting of the “dot com” bubble; where “irrational exuberance” led to wild and speculative investing in companies which had no financial future, burned through prodigious amounts of money and existed solely based on their “story” of potential value.

These artificially low rates led the global pool of capital to seek other safe and sound investments with yields higher than the one percent which was being offered by the Fed.

Based on historical statistical models, the United States mortgage market was the next safest thing. And since investors did not want to be burdened with the hassle of collecting individual mortgage payments, dealing with late payments and processing foreclosures, the mortgage backed security was used as the investment vehicle of choice. These securities simply pooled mortgages with simple characteristics (rate, maturity date, type, etc.) into a security where investors would be able to earn the stated rate without dealing with the mechanics of the mortgages themselves.

Unfortunately, the mortgage market was extremely limited to the number of creditworthy borrowers and was far smaller than the global pool of capital clamoring to invest in these higher yields.

Where it all went wrong …

There can a time when all of the creditworthy borrowers had the mortgages they wanted and the marketplace for new mortgages was drying up. With the global capital pool clamoring for investments, the Wizards of Wall Street and their rocket scientists who served as financial engineers proposed a solution. Let’s simply enlarge the marketplace to include borrowers with lesser credit and hedge away the risk using repurchase agreements (forcing the originators to take back non-performing loans), an credit default swaps to provide a measure of insurance to protect yields against the possibility of foreclosure.

The big Assumption …

The trick in making these subprime and Alt-A loans from borrowers with credit impairments suitable for investors was convincing the ratings agencies that these less-than-perfect mortgages that were collateralizing these securities were, in combination with the hedges, the equivalent to triple-A rated (investment grade) securities. Thus the pension funds, mutual funds, banks and others who were precluded from investing in non-investment grade securities now had a higher yield investment product they could legally purchase.

Again, as the pool of acceptable mortgages continued to dry up, underwriting standards were continually lowered until they reached the point of so-called “NINJA”  liar loans where you needed to only state your income, employment and assets – with no verifications necessary.  At this point in time, the possibility for fraud was magnified by greed.

Sensing that the mortgage availability pool was drying up, the Wall Street Wizards and their rocket scientists created more exotic investments. Pooling pools of mortgages. And, in some cases, devising “synthetic” investments which only mirrored the investment characteristics of mortgage pools. In essence, the ran the mortgage documents through a shredder and continued to sell smaller and smaller strips of the paper.

The assumption that the statistical models of foreclosure were valid were no longer accurate. Historically, the data did not allow for the prevalence of continual re-financing activity to mask near defaults, there were no secondary sources of credit as with the recently-invented HELOC (Home Equity Line of Credit) and no one anticipated a failure of the credit scoring models based on the borrower’s previous credit history. The model failed because each time a borrower re-financed, the previous loan was marked “satisfied in full” and added to the borrower’s credit rating. If the borrower chose to pay off a crushing credit card debt using a mortgage, the records likewise indicated that their credit was clear and they had additional borrowing power.

Everything worked well until the real estate market downturn …

Everything was going well as the sands under the foundation were shifting. The real estate market began a downturn meaning that appraisals no longer supported the larger loans that were needed to re-fi distressed borrowers. Without these loans to keep the borrower afloat in a sea of debt, foreclosures mounted. Thus putting pressure on mortgage pools which could then not continue to pay investors the agreed upon yield. Thus investors began backing out of the marketplace by redeeming their portion of the investment pools and deciding not to re-invest.

The Coup de grâce …

In their infinite wisdom, financial institutions investing in these mortgage, decided to leverage their returns by using borrowed funds to increase their yields. In some cases using 30-to-1 and even 100-to-1 leverage rations.

For the purposes of illustration: assume you are an investor with $1 million dollars of seed capital. You now borrow $4 million dollars from another financial institution and then use the combined $5 million to purchase $20 million dollars in securities; which you then use as collateral to purchase $100 million in other securities. Considering that you have a well-respected name in finance and a healthy-appearing balance sheet – and your purchases are all rated “investment grade,” what could possibly go wrong?

Using this simplified model, let us assume that the market declined 5% which produced a loss of $5 million dollars on your original investment. Technically you are now insolvent since your $1 million in equity capital has been wiped out. And you still owe the $4 million in borrowed money plus the purchase price of the collateralized securities.

But because of the accounting system that was used, you could hide these losses from shareholders, investors, counterparties and the regulators in “off the balance sheet” accounts – nobody could see the building disaster. Accounting was “notational” where you only were required to pay the interest rate differences – not the entire amount.

Under this system, you could continue to roll the dice once again to try and make yourself whole. The very essence of gambling. The smart people knew this was gambling as they had a law crafted to preclude the usage of state gambling laws to restrict securities manipulation.

The downward spiral …

With mortgages defaulting, investors refusing to invest more short term money in mortgage-related security pools, things looked bad and were growing worse by the minute. Until the media discovered that many of the credit default swaps which were used to hedge these mortgage pools and turn them into investment grade securities could not possibly satisfy all of the claims that would be presented. Companies who were making money hand-over-first issuing these CDS guarantees based on their balance sheets and reputations did little to insure that they maintained actuarially sound reserves and could actually weather a downturn in the mortgage securities market.

Which leads us to the Federal Reserve and the Treasury Department – as well as the world’s central banks – pumping in TRILLIONS of dollars to stabilize the entire financial system in this cataclysmic disaster.

Enter Henry Paulson, Treasury Secretary …

Let us now see what Treasury Secretary Henry Paulson has to say about the seeds of the crisis. Paulson, you remember, was the one who picked the $700 BILLION bailout number out of thin air because it sounded right, spent about half the money before deciding the plan was not working and then returned for the remaining funds saying he wanted to try something else. All amid a background in which the Treasury Department refuses to reveal how the funds were actually used by the recipient financial institutions and others eligible for the TARP (Troubled Asset Relief Program) funding.

According to the London Financial Times …

“Paulson says crisis sown by imbalance”

“Global economic imbalances helped to foster the credit crisis by pushing down global interest rates and driving investors towards riskier assets, outgoing US Treasury Secretary Hank Paulson told the Financial Times.”

“In a valedictory interview, Mr Paulson cast the crisis as partly the result of a collective failure to come to terms with the way the rise of emerging markets was reshaping the global financial system. These imbalances – arising from differences in the inclinations of different nations to save and invest – are reflected in large current account deficits and surpluses around the world.”

“The US Treasury Secretary said that in the years leading up to the crisis, super-abundant savings from fast-growing emerging nations such as China and oil exporters – at a time of low inflation and booming trade and capital flows – put downward pressure on yields and risk spreads everywhere.”

So far we have the rapidly expanding global pool of capital and the search for acceptable yields.

Diffusion of blame and responsibility?

“This, he said, laid the seeds of a global credit bubble that extended far beyond the US sub-prime mortgage market and has now burst with devastating consequences worldwide.”

It’s getting murky.

“Excesses . . . built up for a long time, [with] investors looking for yield, mis-pricing risk,” he said. “It could take different forms. For some of the European banks it was eastern Europe. Spain and the UK were much more like the US with housing being the biggest bubble. With Japan it may be banks continuing to invest in equities.”

Murkier …

“This argument – already advanced by a number of economists and largely endorsed by Federal Reserve chairman Ben Bernanke – suggests that the roots of the crisis do not simply lie in failures within the financial system.”

Impenetrable blackness!

The smartest economists, working for some of the most prestigious financial firms, couldn’t have foreseen, and thus prevented the problem. It is only because of the 20-20 clarity of hindsight than some of these economists guessed right about the capital markets and are now being hailed as financial“gurus” while the others are being denounced as “goats.”

Let us pause for a moment and consider the economist employed by the National Association of Realtors. Here was an economist who published a book “The Rules for Growing Rich: Making Money in the New Information Economy” which appeared in June, 2000 just when the dot com bubble was bursting.

Adding insult to injury, he came out with another book “Are You Missing the Real Estate Boom” in February, 2005 and one year later in February, 2006 re-titled the book “Why the Real Estate Boom Will Not Bust—And How You Can Profit from It” just months before the real estate bubble burst.

And this was a well-respected economist who served as the chief Economist for the National Association of Realtors and their spokesman on economic forecasts, interest rates, home sales, mortgage rates, as well as other policy issues and trends affecting the United States real estate industry. <Source>

So why should we believe the economists who are now pointing their fingers in another direction – away from the Fed, government regulators and the financial community?

Had the Wall Street Wizards not concocted their derivatives-based schemes to satisfy the burgeoning demands for adequate yields by the enlarging capital pool – or had the regulators disallowed “off balance sheet” accounting and cracked-down on predatory lending practices by originators who would say or do anything to generate the mortgages Wall Street demanded, this might have not happened.

But the real criminals in this tale of woe were the greedy bastards who disregarded their fiduciary responsibilities to their investors and used outsized leverage to place their financial institutions at risk – many doing so for little more than their bonuses which ranged from tens of millions to hundreds of millions of dollars.

Paulson finally gets it right …

“It also implies that avoiding crises in future will require global macroeconomic co-operation as well as better financial regulation and risk-management.”

And to answer our own question: Paulson does not directly cite Greenspan, the Federal Reserve or Wall Street whence he comes … as he points the finger at the “global system.” In essence, diffusing responsibility and giving the tax-paying citizens of the United States the finger.

What can YOU do?

It is a new age when you cannot trust the government to provide a level playing field as they pander to the financial community’s special interests. Likewise, you cannot trust some of the world’s major firms – who may have significant, and as yet undisclosed, financial problems. Follow the old Better Business Bureau guideline: “Investigate Before YOU Invest.”

For those of you who are in financial difficulty, weigh your options carefully and seek professional advice from someone who will act in your best interest under a fiduciary responsibility agreement. You cannot simply trust your lender, servicer, those who are selling re-finance schemes or pre-packaged bankruptcies. Do not fall prey to “voluntary” mitigation programs which are designed to milk your remaining funds before throwing you to the wolves. Watch carefully, that you do not accept any mitigation that extends your liabilities beyond your home to your other assets or even your future earnings as now being proposed by Obama’s appointees.

Do not invest in things you do not understand like derivative contracts. Do not invest with companies simply because of their branding – look what has happened to some of the most respectable names in the financial world. Stay within the limits of  government-backed programs such as FDIC which is a direct call on government funds. Do not believe the supplemental insurance being offered by brokerages and others – consider AIG, one of the largest insurance companies in the world – stay within fundamental coverage limits.

Always consider risk vs. reward. And don’t forget to factor in inflation.

Be well and be safe.

-- steve

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Reference Links:

FT.com / US - Paulson says crisis sown by imbalance