How Did We Get Into This Mess?!

We are a the brink of a meltdown of the US economy unless the American public can be persuaded that tax payer dollars need to be infused into the system. The infusion will keep some level of liquidity in the market and will provide a measure of confidence for the remaining credit lenders to free up capital and allow businesses and consumers to borrow money. There are potentially other ways to fund our way out of the mess but it will take too long and increase the likelihood that panic will set in and then the economic slide will really begin. The fix is more about quickly regaining the confidence of the public and investment institutions, US and Global, so there is not panic.

I recently heard the bail out described this way. We are going to have a financial hurricane one way or the other. It is a matter of whether this financial hurricane will be a category 3 or a category 5. If the US government does not infuse capital into the market we will have a category 5 financial hurricane. The pain to individual families and businesses will be widespread and devastating. What the government is asking is this: could they borrow our money (up to half of our annual federal tax) to soften the blow. If we soften the blow, we might keep this financial hurricane to a category 3. If we can't get your permission, then all bets are off. The economic slide will be long and hard and many of you will be really worse off and may never recover.

How did we get into this mess anyway? It is not as complex as you might think. The events leading to this crisis are very similar to the events that led to the great depression. Prior to the great depression, investors speculated using the margin or gain on their stocks to buy more stock. This created an artificial increase in the price of stocks which created more margin buying until the air was let out of the frenzy. There was no real basis for the stock margins in the first place. It was artificially created through the frenzy of speculation. Stockholders were left with more debt than could be covered by the true asset value of the stock.

Essentially the same thing has happened today but the asset was real estate instead of stocks. Speculators and unqualified home buyers inflated the value of homes because they could borrow cheap money and buy up the supply of housing. This created an upward housing price spiral that generated paper equity that allowed further borrowing. When the air was let out of the speculative frenzy, the price of homes dropped and many borrowers owed more on their home than the sustainable market price. This caused borrows to default on their mortgage loans. This is econ 101. You would think people are smarter than that but buying a home is often emotional and not rational. Most speculators say, I will get out before the music stops. Some do and most don't. Most sub prime home buyers say, I will sell or refinance before I can't a afford the payments.

Who created the cheap money? Mortgage brokers and investment bankers supported by bond rating agencies. Here are some essential points to the transaction trail that I picked up from information at work:

• Over the last 15 years, the government relaxed lending standards so more people at the lower socio-economic spectrum could buy home. Traditional lending practices were perceived as disciminatory. The less well off could never afford a home. So the thinking went...
• Mortgage brokers were able to offer mortgages to buyers who had not saved enough money for a down payment whether for a primary residence or an investment property.
• Many of these borrowers would normally not be able to afford the mortgage unless the interest rate was below the prime lending rate so sub-prime mortgages were used to help buyers to initially afford to buy a home.
• Home owners who wanted to move up to a larger home could now buy more home than they had ever dreamed.
• Brokers justified this lending practice because they assumed that the price of homes would always go up so a down payment was no longer necessary. The rapid appreciation of the properties due to high demand would erase that risk. Given the seemingly unending appreciation of property values, the need for proof of employment or income could be relaxed. As long as home prices continued rapidly appreciate, there was no risk.
• Speculators took out sub prime mortgages to buy a second home or condo and then flip it to make a quick profit. More and more people got into the flipping game until the speculators had effectively bought up a substantial number of new homes or existing homes. Demand for homes drove up price even more.
• Mortgage brokers reasoned that they were not really loaning the money anyway. The lending banks were supplying the actual funding. Mortgage brokers didn't really care if the mortgages were ever paid off. They were working on commission.
• The lending banks in turn accumulated a lot of crappy, risky mortgage loans. The banks didn't want to hang on to these loans but instead sold them to the smart guys in New York - the investment banks.
• The investment banks were interested because they thought they could find a way to repackage the loans and make money. They created a new breed of investment securities and use the crappy sub prime loans as collateral. The thinking was that by packaging the really risky loans with less risky loans, the real risk would be masked and no one would be worse off. The justification was not all the loans would go bad anyway and housing prices were going to continue to rise which would mitigate the risk of defaulting loans.
• The investment banks packaged the securities to create different levels of investment risk. Good securities (safer mix of mortgage loans) , not-so-good securities (mix of safer and not so safe mortgage loans) and ugly securities (greater mix of loans likely to go into default).
• Investors purchasing the good securities would not receive as high a return as those holding the not-so-good and the highest return, of course, would be for the ugly securities.
• The investment banks bought bond insurance for the good securities. The rating agencies gave AAA - A ratings for the good securities, BBB - B ratings for the not-so-good securities and didn't bother to rate the bonds for the ugly securities.
• So the investment bankers managed to create highly rated bonds to insure high risk securities by creatively packaging the mortgage loans.
• The securities were sold to sophisticated institutional investors like municipalities, school boards, insurance companies - investors that were looking for safe, high quality investments. They were not sold to regular investors like you and me but if our investments were in institutional funds then we shared that risk probably without knowing.
• The investment banks were smart enough to know that no one would buy the really ugly securities so they shifted these securities off-shore into special purpose vehicles OK'd by the accounting rule makers to get them off their balance sheets. They simply used these securities as collateral for the other securities. Junk backing up junk. They intended to pay themselves high interest returns on these securities.
• The investment bank lobbyist had done their job in convincing the accounting rule makers that it was in the best interest of the market to not disclose these off-shore entities. Transparency would be a bad thing for the market.
• OK, now the dirt hits the fan...the institutional investor notices that interest payments on these high quality, AAA rated securities are no longer being received. The investor calls the investment bank to find out what is happening. Here is a ficticious but informative dialogue between the investor and the investment banker I derived from a pdf presentation flowing around the e-mail waves. I would have attached but the language is pretty foul so I restated the dialogue with nicer language:

Investor: Why am I not receiving my payments?

Investment bank: The home buyers who took out the mortgages that back your investment securities are no longer able to make mortgage payments or to pay off the loan.

Investor: I thought that if I bought AAA rated securities that I would be paid off first if the investments didn't work out?

Investment bank: The AAA investment securities ended up being riskier than we thought. Very little cash is coming in.

Investor: I thought housing prices always go up and that mortgage borrowers could always refinance?

Investment bank: It was a bad assumption on our part. We screwed up.

Investor: What about the rating agencies? They rated my investment as AAA.

Investment bank: They screwed up.

Investor: But the investment was secured with bonds.

Investment bank: We didn't set aside nearly enough money to match the default rate on mortgages backing your investment.

Investor: What am I suppose to tell my institution?

Investment bank: You screwed up!

I hope this helped you understand what is driving the crisis. You and I are at risk because mortgage brokers, investment bankers, rating agencies and regulatory oversight agencies screwed up. The economic system upon which we depend can no longer lend money because of bad mortgage debt and fear. Lending institutions that do have capital are going to hoard it. They don't trust the markets and they don't want to lose more money. The only institution large enough to help now is the US government. Unless the treasury infuses capital into the market the capital markets will freeze up.

We can't say, let those suckers on Wall Street bear the brunt of their decisions, unless we are willing to suffer the economic shock wave that will occur. The failures are too massive for main street consumers to avoid the impact. Investment banks speculated with their capital and now it is reserved to cover bad mortgage loans and failed the insurance bonds. One of the key reasons the great depression was not avoided and that it lasted so long was government failed to rescue the banks and the banking system soon enough. I believe that our nation faces a similar choice today.

I also believe that if tax payer dollars are infused into the market, that there must be strict guidelines, oversight, etc. Nothing loose. There need to be controls in place, staged periods of capital infusion and strict periods of review to measure and assess impact before additional infusion is made.