The Mess We're In

The following is from my genius brother-in-law explaining parts of the corporate relationship to the current economic crisis. It's long, but well worth it. My own (much shorter and less authoritatively based) musings follow:
------------------------------------------------
Lenders:
First, a brief history: In the mid '90's Congress forced lending institutions to lower their lending standards because lower credit scores were more common among certain ethnicities than others and this was viewed by Congress as discriminatory. Lending institutions fought against this move by Congress because it raised the risk levels lenders would have to bear while not providing for a concomitant increase in profit potential.

What Lenders Did: Banks found that, in fact, foreclosure rates and late payments were not rising as they had feared. They were writing more loans, making lots more money and the risk they initially feared did not seem to be materializing (even through the tech crash). So, seeing that lowering the bar one rung made more money without materializing risk, lenders (not forced by Congress) decided to lower the bar another rung. Again, they made more money and the risks did not materialize. At this point some lenders drew the line (typically traditional banks, i.e., not banks whose primary existence was low credit mortgages). Others kept moving that rung lower and lower.

Why it worked for so long: Lenders typically do not hold a mortgage; they sell them to investment banks who bundle them up (collateralized mortgage obligations, or CMOs) and in turn sell some of them to investors who hold them like bonds and receive the mortgage interest (along with principle) as a return. CMOs are traditionally very safe investments and are frequently insured, meaning that if default occurs, an insurance company keeps the payments going to the investor (AIG is one of the largest CMO insurers in the world). Insurance companies naturally want to make sure that what they are insuring is of high-quality. They determine this via their own due diligence but rely very heavily upon ratings agencies (Standard & Poors, Fitch, etc...) to study the CMO and give it a risk ranking. The rating agencies continued to rate CMOs and other mortgage derivatives very highly even as the lending standards were getting lower and lower. If the ratings agencies give it a high enough rating, it will be insured and investors will buy, period. As long as the housing market remained strong this self-perpetuating string of events continued.

When the Shit Hit the Fan: When it became clear that the CMOs actually held some percentage of toxic mortgages (even if were 5% or lower), it became clear that the rating agencies had failed, which meant that insurers had insured debt they never would have insured had the ratings been accurate, which meant that investors bought supposedly "very safe" income investments which they never would have bought had they not been insured. Once this occurred, insurers stopped insuring and investors stopped buying, which meant that lenders were left with 1,000's of mortgages that they could not bundle and sell. These lenders were NOT set up as mortgage servicing companies so they did not have the necessary reserves or infrastructure to simply hold the loans and ride out the mess. Thus they die, or are on their death bed today.

Note and Clarification: Note that no lenders have been bailed out. Also, remember that some traditional banks DID stop the lowering of standards at a point prior to the wacky stuff that followed. These banks, whose existence was not predicated so heavily on mortgage loans are riding out the storm.

Freddie's Fannie
A Brief History: Fannie Mae and Freddie Mac used to be Government Agencies whose job was to "help" provide stability to the mortgage markets (a massive part of the economy). They were stop-loss agencies; if lenders followed proper risk guidelines set by Fannie and Freddie, then F&F would back the mortgage. F&F were pseudo-privatized and became pseudo-governmental agencies. As such, they could pursue profit like a private company but their Charter, written and approved by Congress, gave the government the authority to force F&F's hand in bad markets to help stabilize a messy mortgage environment. Due to the pseudo-government agency status of F&F, bonds sold by F&F to investors bear a credit rating just below Federal Bonds. In fact, through this entire mess, F&F bonds have been terrific investments just as Treasuries have.

The Worst of Both Worlds: As private businesses, F&F fell into the same trap as so many lenders. Then, after massively over-leveraging themselves, like the investment houses did (more on them later), the Shit Hit the Fan as noted above. Then, their hands started to be forced under their Charter to try to come to the aid of the lenders. However, having so leveraged themselves and having their own leverage unravel, F&F simply did not have the reserves or wherewithal to help, period.

Bail-Out: The Feds brought F&F back into itself. The feds did NOT bail-out stockholders who saw their investment disappear. The feds DID stand behind the F&F bonds because of the pseudo-governmental status which has always, universally been interpreted as a federal backing of the bonds. To not back them would have been viewed as the Feds breaking faith because they allowed the bonds to be sold with an implicit, universally understood guarantee. F&F's "bail-out" is truly different in kind because of this implicit, universally understood guarantee.

Investment Houses (Bear Stearns, Lehman, Merrill, Morgan, etc...)
Preliminary Clarification: These are NOT Banks - they are NOTHING like banks - they have different rules and oversight than banks - if banks are apples, investment houses are oranges (or lemons...).

What was Happening: As mentioned earlier, Lenders sold mortgages to Investment Houses who in turn bundled them (and created hybrid derivatives) and sold them to investors. Like the lenders, they did not see the original fears materializing and began to get more and more aggressive with what they would buy and how they would sell. They made gobs of "easy" money acting as the middle man while the housing market remained strong. Again, their fear was falsely held in check in part due to the high credit ratings the mortgage backed securities were receiving from the rating agencies.

What Happened: Like the lenders, when the wheels came off the supposedly unstoppable mortgage machine, the Investment Houses were left with TRILLIONS of dollars of exposure to mortgage derivatives (Lehman alone had upwards of $9,000,000,000,000 in exposure). Investment Houses are not allowed to hold these investments to maturity - they MUST sell them. If they are unable to find a buyer they are forced, due to Sarbanes-Oxley (read Congress) to "mark to market", which means they must declare them to be worth $0.00, a total loss; even though a large percentage of the mortgages are perfectly good mortgages (Traditional banks CAN hold these derivatives to maturity and CAN give them a value). When the Investment Houses declare these massive losses, their reserves need to be brought up significantly, but the interest rates to bring up the reserves become astronomical (in some cases higher than 50%) because the future ability to pay back the loans is severely suspect. Thus, insolvency ensues.

Bail-Outs: It is fairly universally recognized that Bear-Stearns was bailed out (NOT stock holders) because it was the first to fail and the Feds hoped that stepping in once and early would stem the tide and because BS had another huge firm on the hook. The structure of the Bail-Out was NOT to give tax-payer money upfront, but to promise to use taxpayer money in the future IF JP Morgan (who bought BS) was unable to "fix" BS. It is also important to note that JP Morgan had over $3,000,000,000,000 in exposure through BS so, had BS simply declared bankruptcy, JPM may have been sunk as well (the hook).

Lehman Bros was not bailed out because it was not 1st and because it had no one on the hook "enough" to bring someone else down with them.

Merrill Lynch's CEO, who was brought in after the Shit Hit the Fan, did everything he could to clean up the Balance Sheet, even though he was demonized for "hurting" the company by doing so. In retrospect, he saw the writing on the wall and saved the shareholders. He cleaned the balance sheet so well that Bank of America offered to buy Merrill Lynch at a premium. Merrill Lynch's astute moves bailed out the stock holders from a complete loss as was seen in BS and Lehman.

Morgan Stanley and Goldman Sachs may or may not sell themselves. Stay tuned...

AIG - The World Economy's Insurance
What it is: AIG is the world's largest insurance company; the world's, not just America's.

What it Does & the Current Problem: AIG is much more than a Life Insurance company or an All State. AIG insures debt, meaning that it will continue to make payments to an investor if the underlying party fails. AIG insures Trillions of mortgage debt, without which the debt would be unsellable to investors. AIG insures TRILLIONS of municipal debt, without which municipality bonds could not have been issued. If AIG goes down, Trillions of life insurance benefits disappear, trillions of dollars of interest disappears, trillions of dollars of municipal debt becomes toxic, trillions of dollars of foreign investment disappears. In fact, it is almost impossible to quantify the effect of AIG failing on the world economy. The world's financial markets would completely shut down (for a while). Whether any one company should be allowed to become so important is beside the point; it simply is.

The Bail-Out: Taxpayers are "lending" AIG $85,000,000,000 at 11.5% interest to give AIG time to sell-off assets and recover from the complete freeze of credit. The thinking behind the bail-out is that as things settle and the credit markets begin moving again and all those "unsellable" CMOs that had to be valued at $0.00 work their way back into the market at honest values (most CMOs are made of a high percentage of good mortgages), that the unbelievably intense pressure on AIG will subside, allowing it to shore up its reserves at "normal" rates and remake itself into a leaner company.

The Sky Is NOT Falling
There is nothing new under the sun and our collective memory is way too short. Yes, seeing 150 year old Investment Houses go down is disconcerting. Yes, seeing tax dollars used to pay for management stupidity is annoying. Yes, it will get worse before it gets better. Yes, we are going to see high inflation. No, the sky is NOT falling.

I would not be surprised to see the indexes pull back another 15 - 20% before things turn around. However, if they do, bear in mind that this kind of 50% pullback from a new high happened LESS THAN 10 YEARS AGO. The thinking that led to the run-up prior to our current calamity, the tech calamity, and every other previous calamity was the same; the paradigm has changed, something is forever different. The thinking during our present calamity, the tech calamity, and every prior calamity is the same; the paradigm has changed, something is forever different. To put it in the words of a brilliant historian whose name escapes me, "Man learns from history that he does not learn from history"; this is true in all realms, be it political or financial. We are living in the dark days of a bear market. Clarity is difficult in the darkness, but history can provide a guide. Market history has this to say (these are averages);
10% Downturns happen about once every year and last on average 113 days
15% Downturns happen about once every two years and last on average 215 days
20%+ Downturns happen about every 3 1/2 years and last on average 329 days
--------------------------------------------------------
My (The Duck's) opinion:

The advent of the credit card, the ability to spend and increase personal debt from home via the internet or T.V., and the commercialization of greed starting with shows such as Robin Leech’s “Lifestyles of the Rich and Famous” has brought on the combination of increased sense of entitlement and greed to the poor and middle classes, as well as the means and access to increase personal debt to reach greedy goals. This was not possibly a problem before 20 years ago. I do not cease to be shocked at the number of people in my small town who have 1 or 2 year old boats, Harleys, Cadillac Escalades (they spinnin' ni**er, they spinnin') and all kinds of new goods. Way back when, the poor rarely saw the wealthy. The poor therefore didn't have visual access to the wealthy's goods, and cash systems based on the value of gold didn't afford the poor the ease to buy without means. If the poor wanted more, they cut back expenditures and saved, or worked harder and increased income.

Greed amongst the wealthy is not new and never will be surprising. I think the level of greed amongst the poor and middle class is something new under the sun. (the poor used to suffer from envy, but now Visa has brought a whole new vice into their, our, reach.) It is the individuals in America who are the root cause, living beyond their proprietary means. They have entered into mortgages which they could only afford in the best of times. When average times did eventually come, their over-extension has put everyone else in jeopardy. And now my tax dollars will bail them out instead of help me buy my own home, for which I have patiently waited, knowing this fallout would happen.