Wednesday, September 24, 2008

What Went Wrong....A 5 Step Plan to a Meltdown

There are many, many problems with the bailout process crawling through Washington. Not the least of which is that no one - Congress, the White House, Sec of Treasury and Joe Q Public - seems to know what they are trying to fix.

I should start by saying that none of this is a surprise to those in the know. Many talented financial minds could see the dominoes lined up and all it would take is someone to push the first one over to start the calamity.

Without further adieu here's the 30 second run down on what went wrong.

1) The bubble in home prices was fueled by the availability of cheap credit which lead people to underestimate the risk of the US housing market.

***** Anyone with 2 firing synapses could see that the pace of housing price increases was unsustainable. However, there were bonus checks to be earned so no one stopped to ask if that condo in South Beach was really worth $400,000.

Who is to blame? Everyone that overpaid for a house that they can barely afford. If you paid more than 3 times your salary for a house, you overpaid and you're part of the problem.

2) Home prices peaked in 2006 and combined with poor lending standards (no doc loans, neg amortization loans, ridiculous amounts of home equity lines written) to push delinquencies and defaults on mortgages up.

*****Again, it was plain to see home prices had to fall and when they did it was going to create great pain for the marginal buyer.

Who is to blame? Mainly consumers buying beyond their means, but the realtors, bankers, appraisers and the housing propaganda industry that convinced everyone to put all of their eggs in one basket also played a role.

3) Okay here is where it gets sketchy. Wall street created investments that consisted of packages of loans that were to be repaid. A package of good credits would pay X%, a package of sketchy credits would pay x+1%, etc.

***** In theory there was nothing wrong with this process at first. Eventually, I think Wall Street understood that their prime credits were becoming less and less reliable, but they kept selling the debt instruments because bonus time was just around the corner.

Who is to blame? Wall Street, the rating agencies (S&P, Moody's), the SEC, and investors (for not doing their own due diligence).

4) Here is where it gets wacky. The big financial firms took the increased liabilities and issued “credit default swaps” contracts (CDS) that insured the packaged mortgages.

**** Again the theory was sound, but the products underlying them were problematic. The CDS's were set with triggers that forced the banks to pony up additional capital if their ratings were ever cut.

Who is to blame? This is principally on Wall Street - they should have seen that there was substantial risk to the system if they were ever downgraded. Their own hubris probably led Wall Street to ignore this risk.


5) When the losses in mortgage products started to hit Wall Street credit was curtailed. Now all of the dominoes were falling rapidly, highly leveraged lenders couldn't refinance their obligations, which led to more downgrades, which led to credit seizures, etc, etc.

**** This is where we are today. In the good old days of American Capitalism this scenario would have called for the banks to increase the rate of interest that they pay out to their customers. This would have increased the flow of funds to the distressed banks and they would have had lower earnings (maybe even losses), but they would have survived. In today's, Soviet-style version of American Capitalism the banks go to their friends in Washington (say a well placed former CEO as the Secretary of Treasury) and beg for a bailout.

Who is to blame? By now I hope that it's clear that there is no one person, firm or concept that led to this result. We all loved living beyond our means and now we're being asked to pay for the sins of the past 10 years.

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As I said yesterday, this plan is going to lead to skyrocketing inflation and dramatically higher interest rates for the US Government because no one will want to lend to us. Bloomberg finally picked up on the concept today....

"Treasury Secretary Henry Paulson's $700 billion proposal to stabilize the banking system may push the national debt to the highest level since 1954, threatening an erosion of foreign appetite for U.S. bonds.


The plan, which asks Congress for funds to buy devalued securities from financial institutions, would drive the debt above 70 percent of gross domestic product and the annual budget gap to an all-time high, possibly exceeding $1 trillion next year, economists estimated.

At risk for the world's largest economy: a jump in interest rates prompted by the glut of additional Treasuries needed to finance the plan, and a diminished desire among international investors to add to their holdings. The dollar yesterday slid the most against the euro since the European currency's 1999 introduction."

The good news is that the Office season premier is tonight!

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