Thanks.

What is your take on the role of the ratings people in all of this?

If Fed and Treasury are going to take all of this paper off peoples books for a certain amount (I’ve heard $0.30 on the dollar) who exactly will be repackaging these and reselling them to the public?

I heard Bill Gross on CNBC yesterday say that he expected to get a call regarding this. He seems to be regarded as as a top notch Bond guy, but who actually gets to make that call? And finally, if it is someone like Gross charged with reselling these, what kind of fee would he get for his trouble? Do any profits revert back to Treasury? Is there a way to track any profit made by past bailouts by the Government?

That’s a lot of questions I know, and apologize in advance.

The root cause is the irresponsible human excrement that are not paying back the loans they took out to buy houses and real estate.

We need to change the laws to make it so that anyone who does not pay back their loans are stripped of every asset they own, and if that doesn’t cover the loan, then half of every dollar they make is taken to repay the loan until it is paid off. And if they stop working, they don’t get any welfare and they starve to death. And if they steal we execute them.

People need to realize that taking out a loan is an act of utmost seriousness, for which they will be held responsibile, and it will never be forgiven under any circumstances.

The root cause is individual irresponsibility.

Great summary.
Maybe it’s my ignorance, but I don’t see how you can package MBS’s filled with subprime mortgages into bonds with AAA or AA ratings.. Financial alchemy it seems – turning toxic waste into gold. It worked.. for a while…

Apparently, the system requires a certain amount of regulation to protect us from ourselves.

Sorry, Ayn Rand.

I rely on news articles and have no other insight to write about this like you. Yesterday I wrote about The players in this debacle

If you believe I may have attributed too much to someone or overlooked another player entirely then please let me know. I most certainly appreciate your writings.

---

Activists Taking Action: Unified Patriots

If you keep at it, it may even make sense to dolts like me.

One question, though. Buying the leveraged MBS commits you to receiving a fixed long-term interest rate and to continuing to pay the current short term rate no matter what it becomes, right? Doesn’t the recent Fed history of jockeying the prime everywhere from 5% to 1% and back play hob with the risk calculation of such a commitment?

If you borrowed money to buy MBSs, what is the collateral? If the collateral is the package of MBSs and that package goes under water, then why not default?

To put it another way using your example (if my feeble mind is following this properly)… I put up $1 and borrow $30 to buy something for $31 that I hope will turn into say $36, so that I pay back the $30 and pocket $5 minus the interest on the $30. But if the $31 MBS drops to $25 and the person who loaned me the $30 wants more dough, then if the MBS is the collateral I would be tempted to say forget it and let the lender take it, only putting me out my original $1. The lender then eats the loss.

Along with the many who have already commented similarly – thank you BH for your in depth insight into these complex econ concepts – truly an education for many of us.

So my take on this – and slap me down BH or others if there are weeknesses in my take – is that we are suffering from bad government policy creating an opportunity for unfettered greed.

Let me explain that. The opportunity was created by the liberalization of mortgage guidelines – with the noble idea of getting more people into home ownership – lead by the “FMs”. The economic “heat” generated by the increased mortgage market, was seized upon by the sharpies running investment houses, and run to its extreme riding the wave of MBS mania as described by BH above. This heat fed into the normal cycle of real estate market expansion and contraction, making it expand beyond the usual. When the inevitable contraction occurred, RE prices were so far beyond real value that it was a big fall, and the house of cards collapsed, via the MBS phenomenom.

So far I am basically regurgitating what I learned largely from reading BHs articles.

I offer the following based on my experience – that leads me to a different take on who to blame and who to penalize.

I am a geologist. I have worked off and on over my career with gold mine promoters, doing exploration and anlysis of properties. There is an infamous stock exchange in Vancouver BC that is where venture capital is raised by these promoters. Early in my career, when I was very green, I worked for a promoter that became one of the most successful in his game ever. He is now one of the richest men in the world. What I learned from him was that the game amounts to this – create a flow of capital from a large pool, funnel it through a vehicle – in this case a gold mine promotion – and by various machinations, take out your millions. It is basically a pyramid scheme with a big hole in the side of the pyramid near the top that leads to the promoters, wallets. These unscrupulous promoters (and not all uncrupulous) often do this knowing full well that their mines are worthless and that the investors are going to get hosed, but could care less. They lie about the mines and collect the cash. It is all about getting theirs, no matter what it costs others. When I figured out what was going on, I jumped ship and never looked back, giving up a stock option that would have set me up in my early career. So it goes.

Anyway, in this crisis I am seeing exactly the same game being played out. I know a builder-developer who saw the real estate correction coming and sold out his inventory and equipment early and is doing just fine thank you when everybody else in his area is going bankrupt. One of my friends who grew up in the insurance and investment business (left it many years ago to pursue other things) had been warning me about this crisis, describing it exactly how it played out for years before it happened.

Now if these guys could see it, you know that the sharpies running AIG, Lehman, the FMs, etc. could too – they just didn’t care. They were getting their cut of the capital flow before it collapsed, knowing full well that the house of cards would fall.

I am a true conservative. I believe that nationalizing the markets and taxing the rich will only penalize the middle and working class in the long run by stifling the economy. So I do not support the actions of the Bushies and the Fed. However, I am not surprised by their solution. I have always believed that Bush is really a continuation of the great American liberal tradition that flows through Wilson, FDR and JFK, and that both of our main political parties have drifted so far to the left that Bush appears to be conservative to many, but he is not – however that is another discussion.

My point is that the misguided government policies created the soil in which greedy market mavens could grow the conditions that lead to our current crisis.

Burdening the rest of us with a $Trillion debt will further crush the dollar (read inflation), and only the innocent will be punished. I am not sure how to point the punishment gun so as to get the bad guys and leave the good standing – maybe only protect the IRAs, 401Ks, etc. of the rank and file, then arrest and prosecute the sharpies. Whatever, it is clear to me that this crisis is the result of greed driven theft, with malice of forethought, just like those unscrupulous gold mine promoters.

Hmm, maybe this simplified explanation will prove enlightening?

You have two cows. You sell three of them to your publicly listed company, using letters of credit opened by your brother-in-law at the bank, then execute a debt/equity swap with an associated general offer so that you get all four cows back, with a tax exemption for five cows. The milk rights of the six cows are transferred via an intermediary to a Cayman Island company secretly owned by the majority shareholder who sells the rights to all seven cows back to your listed company. The annual report says the company owns eight cows, with an option on one more. Sell one cow to buy a new president of the United States, leaving you with nine cows. No balance sheet provided with the release. The public buys your bull.

It all makes sense: I can see it not working in reverse when the system is asked to run, effectively, backward. Strips the gears: it can’t run in reverse the way it’s built now.

But also, there’s another root cause:

So why the hell are they allowed to run 30-1 leverage ratios, even to buy assets considered safe?

That’s something we will need to change.

The fundamental idea of creating an ownership society based on expanding home ownership is a very good idea and a laudable one: people should be encouraged to invest in themselves and invest in their futures and own property, with all that comes with it. It stabilizes society: it creates responsibility, it encourages people to think carefully about their decisions.

That gets short-circuited when lenders become irresponsible and buyers become irresponsible, because all they’re looking to do is buy it, flip it, and move on to the next one. I don’t know how you regulate that behavior: it’s really a matter of inculcating a sense of responsibility that transcends the law into millions of people.

I paid cash for the condominium I bought in Chicago: I walked into the closing with a cashier’s check for the full balance, drawn on my bank account, with my own money. I didn’t take a mortgage. Obviously I’m an extreme example, but I wanted no part of the craziness that I saw going on in the mortgage/housing market at the time.

People need to learn that you should not try to buy things you really cannot afford, particularly if you’re not willing to work to keep them because your only goal in buying them is to flip them over to some other, bigger sucker. It’s one of those flaws of human nature that we fall for this so well, but instead of streamlining it, we’ll have to restructure the system to put tripwires in the paths of people who are doing it.

There were two more elements to this history. What you have written is 100% correct and your ability to take a most complex subject and reduce it to layman’s terms is to be applauded.

There was also greed. The first investors that saw the viability of this who got in made their millions and then got out inspired many behind them to try the same thing.

The companies and individuals who climbed on board did not have the safe “paper” to invest in and began to build a house of cards on riskier and riskier investments. They wanted their share of the pie.

Also there is one thing bothering me and has been for a few years now. I believe that the single greatest blow was 9/11. I believe that what happened on 9/11 and subsequently masked a very weak economy coming out of the 1990s.

I was in California at that time and engaged in the high tech industry. One day in 1998 I sat down at a symposium and I was querying each of the members there. I discovered that everyone was meeting their payrolls with borrowed money. Whether venture capital or out and out loans they were surviving on borrowed money.

In early 2000 the “margin call” on this came due. In six months Silicone Valley had lost one million jobs.

After 9/11 to keep the economy going we went deeper and deeper in debt. If 9/11 had not happened President Bush had the country pointed in the right direction to wean business off the borrowed teet. It never happened though.

I think the question now from my chair is should we go over one trillion dollars in additional debt to bail out companies that should have known better.

Plus Nancy Pelosi has said she will not allow any bailout plan without 25 billion dollars to the auto industry and a new and larger economic stimulus plan which will add additional billions to the plan. Beyond that she wants help to individual home owners.

What they are looking at is probably a 1.4 trillion dollar bailout and probably higher.

Rush has quoted Hank Greenberg (former CEO of AIG) that regulation can not prevent bad management. To wit, I ask: “What does prevent bad management?”

Morality and ethics. Absent these restraints on human behavior we are left with a twisted form of egoism mixed with utilitarianism that WILL NOT limit egregious lying, cheating and stealing. Even murder can be rationalized and justified without an absolutist and universal moral CODE. Therefore some form of regulation is needed. Laws serve as a baseline, the foundation of human interaction. As our founders stated we are “A nation of laws and not of men” – meaning our knee must bow to a higher power. When this is cracked or nonexistent all manner of sin and malfeasance will occur by default.

What many conservatives fail to recognize is that many of our institutions are working in concern, albeit a partnership of convenience rather than agreement, to increase the power of the powerful and suppress the upward mobility of the middle-class. This is the real reform and the root of the problem. All the superficial fixes are just window dressing on a collapsing home.

Thank you for this explanation — one of the clearest I’ve seen about MBS and the current crisis.

As someone who worked on Wall Street for over 20 years and saw the advent of the MBS market, I would also add that MBS were considered the Second Coming, at least at my investment banking firm (which shall remain nameless, but may or may not be in talks with Morgan Stanley as I write).

All those poor unemployed and underemployed bond market peeps, not to mention the folks who formerly specialized in “tax shelters” (i.e., oil and gas drilling programs and leases of the 1970s and early 1980s)! Suddenly, they had jobs on the new MBS department! And not boring bond market jobs either; they got to be Santa Claus every day!

When something sounds too good to be true, it generally is. Pity it took this long for that principle to be applied here.

This is a model that is mathematically impossible. At 200-1, they can only withstand a default rate of 1/2 of 1 percent (.5%), yet the historical default rate for mortgages is between 2% to 3%.

Why did they do this?

Because their executives we’re paid based on the number of assets on the balance sheet.

One other note – most of these were on the balance sheets as tier three assets, which means shareholders were told the value of the assets based on “Mark to Model”, not true market value. Accounting rules need to be changed for greater shareholder transparency.

One other note (part two!) – If $700 billion will be used to buy up these assets at 30 cents on the dollar, then we are talking writedowns of $1.633 trillion dollars off the original value of the assets. Add this to the $500 billion already written down, and we are at $2 trillion in losses! And this does not factor in the the hedge funds that can not participate in the bailout!

This is a model that does not work. At 200-1, they can only withstand default rates of 1/2 of 1%. The historical default rate is closer to 2% – 3%. Why did they do this? Their executives were compensated by the total amount of assets on the balance sheets – regardless of the quality.

Also, if $700 billion is to be used to buy up these assets at 30 cents on the dollar, it means that there will be writedowns to these assets of $1.633 trillion dollars. Add this to the $500 billion in writedowns already effected, and that brings the total losses to over $2 trillion dollars. And this does not include future losses for hedge funds not allowed to participate in this bailout.

Excuse me for envisioning Washington’s response to the extraordinary market crisis described in this post being just another regulating, earmarking, and back scratching bazaar. What is the likelihood that cooler heads will prevail and this problem will be taken seriously?

Excuse me for envisioning Washington’s response to the extraordinary market crisis described in this post being just another regulating, earmarking, and back scratching bazaar. What is the likelihood that cooler heads will prevail and this problem will be taken seriously?

The MBS is the problem. My understanding of MBS is that there is no quickly accessable centralized tracking system of individual mortgages embedded in MBS. Therefore, periodic fair valuing of the MBS is impossible on short notice (if at all). So, when in doubt (and leveraged 50/1), panic and declare MBS of zero value.
Reducing leverage doesn’t fix the problem, just makes it smaller. MBS seems like a good product, but what we have now is only half baked.
And half baked represents most ideas of these financial geniuses. Remember IPO’s for startups priced at $50+ a share?

Thanks for this post – I understand it. Here are some things I do not understand:

1) The real estate behind the MBS is not worth zero. If I could, I would buy some MBS at the current level and get into the real estate business in a pretty big way. Question: Is it possible to dissect the MBS to get at the individual mortgages, or is that not possible? Can the holder of a MBS become a banker and foreclose as banks do?

2) I am still worried about credit card debt being packaged into similar securities. I wonder which companies are exposed to that type of risk. Question: Are these type of securities the next shoe to drop, or are those securities priced and leveraged according to the higher risk they represent?

The last part of your post about the Shadow Banking System makes perfect sense. During this whole thing, I bought five investment properties and I am trying to remember whether I even needed to show anyone my ID. Too many mortgage dollars were chasing too few real estate goods, and I soon got priced out of the market. Question: Have we seen the beginning of the end of the re-pricing of real estate, or is that the last scene of this slow-motion train wreck? Or will too few dollars be available for too many properties?

Thanks, thanks and thanks again.

Great post

What is your take on the Community Reinvestment Act. Larry Kudlow, Jim Quinn and others have been saying that the sub prime crisis was caused by the CRA forcing banks to make loans in high risk areas.

I don’t buy this argument. I agree with you that securitization was the main problem. Even if banks were under pressure to make loans across red lines, most of the sub prime lending was done by independent mortgage companies not covered by CRA.

I think CRA, like all market manipulation, has negative unintended consequences, but saying CRA caused the sub-prime mess is inaccurate.

I think they should drop this talking point.

What does Wall Street look like when you take the leverage out?

Less profitable on the good days. A lot less profitable.

Somewhat less likely to have meltdowns, but also a lot less likely to generate multimillion dollar annual incomes for investment bankers and hedge fund managers. Also a lot less likely to generate fat returns for the investment banks themselves.

Wall Street is predicated on the premise of making outrageous amounts of money in a short period of time. If regulation drops the potential for profits, it will play heck with the whole system.

It could even get to the stage where our best and brightest have to go to work for manufacturing companies and the like.

Drudge had a link to this scary article saying that were on the verge of a meltdown. That got me to thinking…

Didn’t our buddy George Soros make a mint by artificially driving down the price of the pound so he could scoop up tons of pounds at bargain rates? Could something similar happen here orders of magnitude higher if say enough foreign interests – Chinese or Middle Eastern most likely, though perhaps Russian too – get enough control over enough of our economy or markets that they can manipulate it to their advantage? That would be a scary thought.