Make no mistake; the economy is on the brink of a minor depression. So too, is the world. The United States has trillions of dollars in bad debt. Much of it is owned by financial institutions that have yet to completely fess up.
The first $350 billion in the bailout TARP package sent a small ripple through the financial community, salving fears of imminent collapse, but it has done nothing to swell the company coffers to the point where they will part with cash in the favor of loans to individuals and businesses.
Let me give you an idea of how bad this is has become. I have a client that is a very successful company. The company has no debt. They have millions of dollars in cash. They earn millions per year, and have tens of millions in annual revenues. This company went to purchase new company vehicles. The dealer was running a “special,” where financed vehicles received an additional $1,000 off the purchase price. This sounded like a good deal, so my client applied for financing. They were turned down. This is one of the most solid, privately held companies you will ever find, and they could not get credit from a car company that is dying to sell cars. How is the rest of American business going to survive and thrive? (By the way, this company simply paid cash for their cars.)
As low as interest rates are, banks still do not have the money to lend, or the margin for error that will allow them to take any risk at all. As the great philosopher, Mr. T used to say, “Pity the fool.” In this case, we are all fools.
All this leads me to believe that we are going to see one big time national bank. I would prefer the scenario where a separate bank is formed. This bank purchases the “bad debt” from major institutions and works out arrangements with the homeowners. If done right, there may not be too much of a loss. Eventually, this bank can wind itself down and stay out of the way.
The alternative is for the U.S. to begin purchasing existing banks. This would begin to fully nationalize banks, causing a whole host of new issues. Congress helped create this mess by mandating that Fannie and Freddie give low credit loans (some claim that this reached 50% of all loans). While I cannot fault the intent of the legislation, I can fault its economic soundness. This was bound to fail.
This would have become a problem, but nothing on the scale we have seen. What Congress failed to see (as did most other financial experts) was that investors (and investment banks) would rely on statements from Fannie and Freddie that these loans were sound. Capitalism would seize upon the interest rate plan and leverage these things to the hilt to create enormous profits and enormous (unforeseen) risk.
We ain’t in Kansas anymore. The world has changed—forever.
As much as I hate to see it, there are many good people, myself included, who are feeling the strong pinch of this economic slowdown. It is like a vice clamping down on opportunity. If business is the engine that pulls our prosperity, capital is the fuel that makes it run. We can have the best people, the best products and the best technology, but if we lack the capital to run our businesses, the whole train shuts down.
I expect that talk will quickly heat about creating a national bank. It will be another big hit to our national debt. I estimate $4 trillion. If done properly, this cost could shrink to less than $1 trillion by the time the debt is wound down.
When this comes to pass, and it will, look for the stock market to make a 20%-30% rally, as uncertainty fades. Then get ready for a long road back to our former prosperity. The increased national debt, plus our government’s inability to reduce its spending, has cause me to lower my growth expectations significantly.
All this said, we are still the land of opportunity. We have the intellectual capital and ingenuity to better our world from where it is today. Yes, we will have higher taxes. But there is great hope for anyone with the will and perseverance to succeed.
This reminds me of an old quote. It goes like this:
Press on. Nothing in this world can take the place of persistence. Talent will not. The world is filled with unsuccessful individuals with talent. Education will not. The world is full of educated derelicts. Genius will not. Unrewarded genius is almost a proverb. Persistence and determination alone are omnipotent.
Press on!
www.lumbert.com
www.jaylumbert.com
www.shaksperbooks.com
Wednesday, January 28, 2009
Tuesday, January 13, 2009
Kudos to Jim Rice HOF
Yesterday it was announced that Jim Rice was voted into the baseball Hall of Fame. It was a long time coming (15 years) but an election well-deserved.
Jim Rice dominated baseball for a period of ten years, putting up near-steroid numbers in an era when beer, caffeine and greenies were the only performance enhancing drugs. His numbers paled when compared to the inflated totals of McGuire, Sosa and Bonds—athletes built up to gargantuan proportions by illegal drugs.
I am glad that Rice finally received his due. He was my favorite player for a decade and I still like and respect him as a man. I recently heard that he had Lasik surgery and can see well without glasses. Too bad Lasik wasn’t an option when he was playing. He was never comfortable with glasses and I still believe it was his eyesight that shortened his career, not his bat or his heart.
HOF is no longer a four letter word for the old left fielder. Now it is a badge he can wear with pride and honor.
www.lumbert.com
www.jaylumbert.com
www.shaksperbooks.com
Jim Rice dominated baseball for a period of ten years, putting up near-steroid numbers in an era when beer, caffeine and greenies were the only performance enhancing drugs. His numbers paled when compared to the inflated totals of McGuire, Sosa and Bonds—athletes built up to gargantuan proportions by illegal drugs.
I am glad that Rice finally received his due. He was my favorite player for a decade and I still like and respect him as a man. I recently heard that he had Lasik surgery and can see well without glasses. Too bad Lasik wasn’t an option when he was playing. He was never comfortable with glasses and I still believe it was his eyesight that shortened his career, not his bat or his heart.
HOF is no longer a four letter word for the old left fielder. Now it is a badge he can wear with pride and honor.
www.lumbert.com
www.jaylumbert.com
www.shaksperbooks.com
Thursday, January 8, 2009
Detroit's Secret Plan
If you are baffled at how GM and Ford can rack up a combined annual loss of more than $50 billion and still call themselves viable without making drastic changes, don’t be. They have a secret plan.
Whatever rhetoric you hear from Detroit and Washington, don’t believe it.
The UAW has no intention to give up its contract. Why should they? This was bargained in “good faith.” (Some might argue that the threat of a strike is not good faith, but the fact is: both sides agreed to this deal.)
Management seems more intent upon joining the Washington bread line than fixing the fundamental flaws in its operations.
Here’s why. Detroit and Washington have a secret plan and it has two parts.
Nationalized health care. This will transfer the burden of Detroit’s massive health care costs for current and former workers to the American taxpayer.
Force their competition (Toyota, Nissan, Honda, BMW, Daimler, etc.) to join the UAW. This will level the cost field, as Detroit’s competition will have the same labor costs. It will also drive car prices up another $2,000.
This is why Detroit seems content upon taking handouts from Washington.
The Clinton’s made a strong push to nationalize health care during Bill’s first term. This attempt failed dramatically. Obama made it a central part of his platform, although he couched it in different words. The new administration will not hit us with it like the Clintons did, it will be presented as simply part of “the great solution” to our national ills. I see this as virtually inevitable. Whether it is the best thing for our nation will be debated for decades. Only time will tell.
With the rapid evolution of Socialistic thinking in America (the belief that government can solve everything—witness AIG, Lehman, Citi, Countrywide, Fannie & Freddie, etc.) it is a now just a small step to the next level. The Fed and Congress have poured trillions into failing companies and they (Congress) will soon explain that it is “far more efficient” to have single-payer health care. It is good for the country. Reminds me of the joke about the Canadian health care system: There is a ten month waiting list for a maternity bed.
Under current law, voting by employees deciding whether or not to unionize is a private matter. Votes are counted, with no one knowing how anyone votes. There is a bill that is making its way through Congress that will force “open voting” when company employees choose whether or not to join unions. This will place enormous pressure on those voting not to join unions. Many of us have seen how this can happen. I have seen (and felt) this myself. Should this bill become law, it will take little time for auto industry wages and benefits in right-to-work states to skyrocket.
Problem solved. Detroit is competitive again. Auto workers keep their substantial six figure jobs. They keep their benefits and their marvelous pensions. While you and I pay more in taxes and more for our cars.
www.lumbert.com
www.jaylumbert.com
www.shaksperbooks.com
Whatever rhetoric you hear from Detroit and Washington, don’t believe it.
The UAW has no intention to give up its contract. Why should they? This was bargained in “good faith.” (Some might argue that the threat of a strike is not good faith, but the fact is: both sides agreed to this deal.)
Management seems more intent upon joining the Washington bread line than fixing the fundamental flaws in its operations.
Here’s why. Detroit and Washington have a secret plan and it has two parts.
Nationalized health care. This will transfer the burden of Detroit’s massive health care costs for current and former workers to the American taxpayer.
Force their competition (Toyota, Nissan, Honda, BMW, Daimler, etc.) to join the UAW. This will level the cost field, as Detroit’s competition will have the same labor costs. It will also drive car prices up another $2,000.
This is why Detroit seems content upon taking handouts from Washington.
The Clinton’s made a strong push to nationalize health care during Bill’s first term. This attempt failed dramatically. Obama made it a central part of his platform, although he couched it in different words. The new administration will not hit us with it like the Clintons did, it will be presented as simply part of “the great solution” to our national ills. I see this as virtually inevitable. Whether it is the best thing for our nation will be debated for decades. Only time will tell.
With the rapid evolution of Socialistic thinking in America (the belief that government can solve everything—witness AIG, Lehman, Citi, Countrywide, Fannie & Freddie, etc.) it is a now just a small step to the next level. The Fed and Congress have poured trillions into failing companies and they (Congress) will soon explain that it is “far more efficient” to have single-payer health care. It is good for the country. Reminds me of the joke about the Canadian health care system: There is a ten month waiting list for a maternity bed.
Under current law, voting by employees deciding whether or not to unionize is a private matter. Votes are counted, with no one knowing how anyone votes. There is a bill that is making its way through Congress that will force “open voting” when company employees choose whether or not to join unions. This will place enormous pressure on those voting not to join unions. Many of us have seen how this can happen. I have seen (and felt) this myself. Should this bill become law, it will take little time for auto industry wages and benefits in right-to-work states to skyrocket.
Problem solved. Detroit is competitive again. Auto workers keep their substantial six figure jobs. They keep their benefits and their marvelous pensions. While you and I pay more in taxes and more for our cars.
www.lumbert.com
www.jaylumbert.com
www.shaksperbooks.com
Wednesday, January 7, 2009
Theft In Detroit
In September, 2007 I warned of the impending collapse of the financial markets. I felt a little silly for the next month or so, as the stock market continued to climb. But I was certainly vindicated in the next 15 months. The Dow plunged from well above 14,000 to below 8,000.
Late last year I warned that the next collapse would occur in the Hedge Fund markets. Then we hear about the $50 billion lost by Bernie Madoff. This is more complicated than a simple financial failure, but the results are the same. Hedge fund managers had free reign to alter values (particularly with mortgage securities) to what they wanted them to be. Madoff is one of many.
This time I am going to address the situation in Detroit. According to General Motors documents, in 2006 the total cost per worker is approximately $73.26 per hour, or $146,520 per year. The Associated Press reported that this figure dropped to $69 per hour in 2008. This compares to an hourly cost of $48.00 per hour for Toyota, in this country. For you non-geeks this represents a disparity of $21 per hour, or about $42,000 per year per worker. Yikes! How would you like a $40,000 raise?
U.S. car makers pay an estimated $2,600 per car in excess wages and benefits to current and former UAW employees. This compares to about $300 per car for the Japanese car makers. This means that, before an American car leaves the lot, it must fetch $2,300 more than its competitors to achieve the same profit. Good luck. Unless this disparity vanishes, there is absolutely no hope for the U.S. auto industry.
I estimate that it will take $100 billion or more just to get these companies through the current business downturn. Even then, they will return to marginal profitability, if any, unless serious changes are made.
I don’t blame the unions for negotiating the best deals they could. But things change. Business changes. The world changes. And if companies cannot adapt, they will fail, or at least they should. Many companies have been forced to trim their work force. Some have lowered wages. Many have cut back capital expenditures and closed plants.
The UAW has given back some (little) of its gains, but many of the union contracts still call for exorbitant benefits (and salaries) to be paid to non-workers. Full health care is provided for early retirees. A worker still gets $30,000 per year put into his retirement accounts. Hello. This is the 21st century. These things don’t happen anymore. Do you get $30,000 put away each year into your retirement account?
In December the U.S. government stepped in with a temporary bail-out for U.S. auto makers, worth about $14 billion. This should help them stay in business for a few more months, until our new president can have his say. I fear that we will hear more spin and the problem will linger for years, with the U.S. taxpayer footing the bill.
If we are going to continue to subsidize union workers and inefficient businesses, we should at least understand what this really means to Americans.
Because of this wage disparity, every person who buys a new car will spend $2,000 more than they should, whether they buy American or not. Because of the UAW wage inflation, every competing car manufacturer is able to charge more for their cars and still remain competitive. Basic economics, folks.
Every person who buys a (relatively new) used car will pay more too. Used cars are priced in relation to new cars. If new cars cost more than they should, so will used cars.
Why should ten or fifteen million people per year pay more for their cars, just so UAW workers can keep their huge pension accounts? And why should the U.S. government subsidize this theft?
That’s not all. If Washington provides a long-term, $100 billion bailout, as I fear they will, this represents a $2,000 cost to each of fifty million tax payers. If you pay taxes (Social Security included) then your wallet will be affected. Do you want to send $2,000 to Washington and pay $2,000 extra for your next car, just so some early retiree can have free health care and a line worker will get his $30,000 pension deposit? I thought not.
Late last year I warned that the next collapse would occur in the Hedge Fund markets. Then we hear about the $50 billion lost by Bernie Madoff. This is more complicated than a simple financial failure, but the results are the same. Hedge fund managers had free reign to alter values (particularly with mortgage securities) to what they wanted them to be. Madoff is one of many.
This time I am going to address the situation in Detroit. According to General Motors documents, in 2006 the total cost per worker is approximately $73.26 per hour, or $146,520 per year. The Associated Press reported that this figure dropped to $69 per hour in 2008. This compares to an hourly cost of $48.00 per hour for Toyota, in this country. For you non-geeks this represents a disparity of $21 per hour, or about $42,000 per year per worker. Yikes! How would you like a $40,000 raise?
U.S. car makers pay an estimated $2,600 per car in excess wages and benefits to current and former UAW employees. This compares to about $300 per car for the Japanese car makers. This means that, before an American car leaves the lot, it must fetch $2,300 more than its competitors to achieve the same profit. Good luck. Unless this disparity vanishes, there is absolutely no hope for the U.S. auto industry.
I estimate that it will take $100 billion or more just to get these companies through the current business downturn. Even then, they will return to marginal profitability, if any, unless serious changes are made.
I don’t blame the unions for negotiating the best deals they could. But things change. Business changes. The world changes. And if companies cannot adapt, they will fail, or at least they should. Many companies have been forced to trim their work force. Some have lowered wages. Many have cut back capital expenditures and closed plants.
The UAW has given back some (little) of its gains, but many of the union contracts still call for exorbitant benefits (and salaries) to be paid to non-workers. Full health care is provided for early retirees. A worker still gets $30,000 per year put into his retirement accounts. Hello. This is the 21st century. These things don’t happen anymore. Do you get $30,000 put away each year into your retirement account?
In December the U.S. government stepped in with a temporary bail-out for U.S. auto makers, worth about $14 billion. This should help them stay in business for a few more months, until our new president can have his say. I fear that we will hear more spin and the problem will linger for years, with the U.S. taxpayer footing the bill.
If we are going to continue to subsidize union workers and inefficient businesses, we should at least understand what this really means to Americans.
Because of this wage disparity, every person who buys a new car will spend $2,000 more than they should, whether they buy American or not. Because of the UAW wage inflation, every competing car manufacturer is able to charge more for their cars and still remain competitive. Basic economics, folks.
Every person who buys a (relatively new) used car will pay more too. Used cars are priced in relation to new cars. If new cars cost more than they should, so will used cars.
Why should ten or fifteen million people per year pay more for their cars, just so UAW workers can keep their huge pension accounts? And why should the U.S. government subsidize this theft?
That’s not all. If Washington provides a long-term, $100 billion bailout, as I fear they will, this represents a $2,000 cost to each of fifty million tax payers. If you pay taxes (Social Security included) then your wallet will be affected. Do you want to send $2,000 to Washington and pay $2,000 extra for your next car, just so some early retiree can have free health care and a line worker will get his $30,000 pension deposit? I thought not.
Thursday, October 9, 2008
Hedge Funds: The Quiet Epidemic
Hedge Funds: The Quiet Epidemic
We haven’t been hearing too much about hedge funds lately. But I suspect that there will be some news about them fairly soon, as they become the next group to wash out from today’s financial crisis.
The typical hedge fund raises money from “accredited investors” through private placements that allow them to operation outside the scrutiny of the Securities Exchange Commission.
We will soon be finding that many hedge investors consisted of corporations, pension plans and college endowments.
Hedge funds started becoming popular in the 1990s. Among the very wealthy, investing in hedge funds became a kind of status symbol. Waiters at cocktail parties and charity banquets regularly overheard such statements as, “Yes, buy my hedge fund returned 89% last year.”
Some of the nation’s top money managers gravitated to this environment because, being unregulated, hedge managers can actually take a share of investor profits. Managers are also (virtually) unrestrained in the leverage they can use.
Hedge managers borrowed large sums of money and placed big bets on things like currencies, stocks and commodities. Hedge funds have been blamed for driving the price of oil futures to astronomical levels. They have been blamed for driving stocks down by taking huge short positions (selling shares you do not own, with the expectation of buying them after prices fall), particularly in financial services companies. They have been charged with collusion and market manipulation. But, because they are unregulated, there is little documentation about how they have invested or what they own—until the roof caves in.
Popular Hedging Strategy
For years, one of the biggest hedging strategies was borrowing money in the U.S. or Japan, because interest rates were low. This cash is then converted into Icelandic krona and used to purchase Icelandic government bonds. http://www.nysun.com/business/low-us-interest-rates-mean-dollar-is-used/73644/
It has not been unusual for there to be a spread of 10% or more between the borrowing cost and the Icelandic bond yield. The spread detailed in March, 2008 (hyperlink above), showed a 2.25% U.S. interest rate and a 15% Icelandic yield, a difference of 12.75%. Let’s say I have $1 billion in investor money. I then go out and borrow $10 billion at 2.25% interest. I pay $225 million in interest to a U.S. bank. I earn 15% on my bonds, which is $1.5 billion. This gives me a net profit of $1.275 billion. This is a 127% return on my invested capital. Let’s say the hedge manager takes its share of the profits. This still leaves 100% to the investors in one year.
This would seem like a slam dunk. And it has been, for a good while. During the past year, there has been a huge swing in the exchange rate between the krona and the dollar. On September 8, 2008, it took 86.1 krona to purchase $1. On October 6, 2008 it took 127.8 krona to buy $1. This is a 48% drop in value in one month. My $10 billion in Icelandic bonds is now worth just $5.2 billion. This is a $4.8 billion loss on the original hedge fund investment amount of $1 billion. In other words, on paper, the investors in this fund have lost 480%.
http://www.exchange-rates.org/history/ISK/USD/G/30
http://www.spiegel.de/international/business/0,1518,582487,00.html
Now, don’t quibble with me that there would be interest on the bonds (about 1.25%) during the month. Yes, I understand that there is a chance that the bonds will return to their original value. There is also a chance that things will get worse.
Here’s the big problem. Investors in hedge funds typically have to wait at least 90 days before withdrawing cash from the fund. They issue a call on their cash, and the manager has 90 days to unwind his investments and send the money. We know that many big investors are running short of cash. They are doing everything they can to get out of a sinking ship before losing everything. In our example, lets assume that half of our investors ask for their money back. This leaves about $200 million in bonds and a $5 billion note to some U.S. bank. Do we really think this loan will be repaid?
This same sort of thing has been going on with investments in CDOs (mortgage backed securities). This time our hedge manager borrows $10 billion in Japan at 1%. The manager turns around and buys CDOs yielding 6%. We have a neat little profit of 50% on our invested cash. After splits with the manager, investors earn a solid 40%. Not bad, until these CDOs prove to be worthless.
And entire unregulated industry has been feeding on these types of investments for years. And there are going to be many wealthy people selling their McMansions in Beverly Hills and Westport because of this collapse. We haven’t read too much about this yet. But we will.
www.lumbert.com
www.shaksperbooks.com
We haven’t been hearing too much about hedge funds lately. But I suspect that there will be some news about them fairly soon, as they become the next group to wash out from today’s financial crisis.
The typical hedge fund raises money from “accredited investors” through private placements that allow them to operation outside the scrutiny of the Securities Exchange Commission.
We will soon be finding that many hedge investors consisted of corporations, pension plans and college endowments.
Hedge funds started becoming popular in the 1990s. Among the very wealthy, investing in hedge funds became a kind of status symbol. Waiters at cocktail parties and charity banquets regularly overheard such statements as, “Yes, buy my hedge fund returned 89% last year.”
Some of the nation’s top money managers gravitated to this environment because, being unregulated, hedge managers can actually take a share of investor profits. Managers are also (virtually) unrestrained in the leverage they can use.
Hedge managers borrowed large sums of money and placed big bets on things like currencies, stocks and commodities. Hedge funds have been blamed for driving the price of oil futures to astronomical levels. They have been blamed for driving stocks down by taking huge short positions (selling shares you do not own, with the expectation of buying them after prices fall), particularly in financial services companies. They have been charged with collusion and market manipulation. But, because they are unregulated, there is little documentation about how they have invested or what they own—until the roof caves in.
Popular Hedging Strategy
For years, one of the biggest hedging strategies was borrowing money in the U.S. or Japan, because interest rates were low. This cash is then converted into Icelandic krona and used to purchase Icelandic government bonds. http://www.nysun.com/business/low-us-interest-rates-mean-dollar-is-used/73644/
It has not been unusual for there to be a spread of 10% or more between the borrowing cost and the Icelandic bond yield. The spread detailed in March, 2008 (hyperlink above), showed a 2.25% U.S. interest rate and a 15% Icelandic yield, a difference of 12.75%. Let’s say I have $1 billion in investor money. I then go out and borrow $10 billion at 2.25% interest. I pay $225 million in interest to a U.S. bank. I earn 15% on my bonds, which is $1.5 billion. This gives me a net profit of $1.275 billion. This is a 127% return on my invested capital. Let’s say the hedge manager takes its share of the profits. This still leaves 100% to the investors in one year.
This would seem like a slam dunk. And it has been, for a good while. During the past year, there has been a huge swing in the exchange rate between the krona and the dollar. On September 8, 2008, it took 86.1 krona to purchase $1. On October 6, 2008 it took 127.8 krona to buy $1. This is a 48% drop in value in one month. My $10 billion in Icelandic bonds is now worth just $5.2 billion. This is a $4.8 billion loss on the original hedge fund investment amount of $1 billion. In other words, on paper, the investors in this fund have lost 480%.
http://www.exchange-rates.org/history/ISK/USD/G/30
http://www.spiegel.de/international/business/0,1518,582487,00.html
Now, don’t quibble with me that there would be interest on the bonds (about 1.25%) during the month. Yes, I understand that there is a chance that the bonds will return to their original value. There is also a chance that things will get worse.
Here’s the big problem. Investors in hedge funds typically have to wait at least 90 days before withdrawing cash from the fund. They issue a call on their cash, and the manager has 90 days to unwind his investments and send the money. We know that many big investors are running short of cash. They are doing everything they can to get out of a sinking ship before losing everything. In our example, lets assume that half of our investors ask for their money back. This leaves about $200 million in bonds and a $5 billion note to some U.S. bank. Do we really think this loan will be repaid?
This same sort of thing has been going on with investments in CDOs (mortgage backed securities). This time our hedge manager borrows $10 billion in Japan at 1%. The manager turns around and buys CDOs yielding 6%. We have a neat little profit of 50% on our invested cash. After splits with the manager, investors earn a solid 40%. Not bad, until these CDOs prove to be worthless.
And entire unregulated industry has been feeding on these types of investments for years. And there are going to be many wealthy people selling their McMansions in Beverly Hills and Westport because of this collapse. We haven’t read too much about this yet. But we will.
www.lumbert.com
www.shaksperbooks.com
Tuesday, October 7, 2008
The Anatomy of a Financial Crisis
6o Minutes and Half the Truth
When I watched the 60 Minutes piece on television the other night, I was impressed at how they were able to boil down a very complicated, global financial meltdown and break it into two easy-to-understand pieces. According to 60 minutes, it was a case of greed and planned ignorance among the Wall Street crowd.
Our investment banks up risky mortgages, packaged them without regulation and sold them (using huge offering memorandums detailing mathematical models designed by physics experts and cosmologists) to an unwary public as investment-grade debt. Then they “insured” the payment of these securities (CDOs) through something called “Credit Swaps.” Of course, it wasn’t called insurance. That would have meant regulation, and the setting aside of reserves to meet this liability. Ultimately, (according to the show) it was the credit swaps that caused many large financial institutions (Lehman, Bear Stearns, AIG, etc.) to teeter on (or over) the edge of bankruptcy.
I give CBS credit for explaining the nub of the issue in a way that hockey moms and Joe six-pack can understand. Unfortunately, CBS only addressed half of the cause. They were correct in describing Wall Street execs as greedy, amoral souls (my words) intent on reaping huge profits, regardless of risk, at any cost. But CBS completely ignored the role that Congress should (could) have played in preventing this global crisis.
According to CBS, Congress allowed $50,000,000,000,000-$60,000,000,000,000 ($50-$60 trillion for those of you who get a brain freeze with so many zeros.) to go unregulated. This is as much as the total U.S. net worth, of $55 trillion. http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=cb82625a-a1a5-4760-a1a5-0a3b82f53c79
Much of the money used to purchase these securities has been borrowed, perhaps 90% or more. To put this in perspective, debt currently held by the U.S. public is about $5 trillion. Total U.S. government debt is about $10 trillion. The U.S. Treasury puts this at $4.2 trillion. But they have not added the $700 billion bailout or the $ 5 trillion of debt assumed in the takeover of Fannie Mae and Freddie Mac.
http://www.treasurydirect.gov/NP/BPDLogin?application=np http://www.federalreserve.gov/releases/g19/Current/
So, somewhere out there in the ether, financial institutions have borrowed three times as much as every American and the U.S. government combined. And these are the people that are lending money to us?
How did this happen? I have explained the mechanisms in prior blogs, so I won’t go into that here in detail. Simply put: Financial institutions (for themselves and for their clients) purchased these things (CDOs, mortgage-backed securities, toxic debt) with the expectation that there were assets backing them.
The rating agencies relied upon a twenty-year bull market in real estate (brought on by duel working families, the lowering interest rates enhanced by a generous Fed policy), complex algorithms developed by geeks trained at Harvard, Stanford, Cal Tech and MIT who had chased the big bucks on Wall Street. They also relied upon the word (and the historical practices) of Fannie Mae and Freddie Mac.
In the 60 Minutes piece, one of the “experts” stated (I am paraphrasing) that math cannot predict human behavior. That is not a correct statement. Math can predict human behavior, but not with certainty. With investments, math can predict behavior (of which a large part is irrational emotion), but only to a point within ranges and probabilities. For example, math can predict that a certain investment’s return will fall between a range of returns with a given probability. Below I give a simple illustration.
Example: A basket of stocks might be expected to return 10% per year over time. There will be a “standard deviation” or volatility to this return. Let’s say that the standard deviation is 10. Our math tells us that two thirds of the time, in a one year span of time, our return will fall within our expected return (10%), plus or minus one standard deviation (10%). This means that our investment return will fall between zero (10% minus 10%) and 20% (10% plus 10%). Ninety-five percent of the time, our return will land within our expected return plus or minus two standard deviations. This gives us a range of -10% to 30% return, 95% of the time. If we go to three standard deviations, our expected return is predicted to fall within our expected return plus or minus three standard deviations. (-20% and 40%) http://en.wikipedia.org/wiki/Standard_deviation
In summary, our math tells us that we can determine the probability of a range of returns given our expected return, plus or minus our standard deviations.
Percentage Probability Range of Return
1 Year Low High
67% 0% +20%
95% -10% +30%
99% -30% +40%
The expected return range expands as our certainty increases. In other words, most of the time, the return will fall somewhat close to what we suspect. However, some of the time, unusual things will happen (war, terrorism, financial collapse) that will cause an unexpected return. The greater the certainty, the greater the range of returns.
The longer the time frame grows, the smaller our range becomes. Over time, investments tend to repeat the returns of the past. For example, when our time frame moves to ten years, our standard deviation may narrow to 5%. In this case, our ranges would be as follows:
Percentage Probability Range of Return
10 Year Low High
67% 5% +15%
95% 0% +20%
99% -5% +25%
The Wall Street firms all had mathematical models that predicted the performance of mortgage securities, depending upon quality, initial equity, time duration, property location, etc. These models took such statistics as a borrower’s credit ratings, their occupation, their documentation, length of employment and used them to come up with the probabilities of ongoing payments the probabilities of complete repayment in any given time frame, the probabilities of interest rate resets and what they might be. There were hundreds of variables that went into these calculations.
Obviously, some of the important factors were not included in the calculations, or they were minimized.
Here’s what happened:
When determining their capital base, financial institutions are required to “mark to the market” with securities they hold. They are not allowed to say that investments in their portfolio are worth their purchase price, which may have been far in the past. They are required to assess the current value of the securities on their balance sheets.
For years, there was no actual “market” for these securities. They were not traded on exchanges, they were simply held. Investment banking firms simply assigned values to these securities, since there was no market. Many firms chose to value these securities higher than initial cost. This allowed them to book higher profits (which triggered lucrative stock options) and increase their capital base so they could buy more.
When Countrywide failed, the world (or at least regulators) suddenly realized that these CDOs were worth far less than expected. This forced financial institutions to revalue portfolio securities, dramatically reducing their capital.
Capital is needed by banks before they can issue loans. They must maintain certain capital to loan ratios. So, when capital decreases, loans to business and individuals must also decrease. This causes business to slow, jobs to be lost, etc.
While balance sheets were being redrafted to reflect the current (and rapidly falling) value of mortgage backed securities, another nasty thing was happening to the investment banks. They were being asked to make good on their credit swaps (unregulated insurance).
Companies like Bear Stearns, AIG, Lehman Brothers and Citi had profited greatly by selling “guarantees” on mortgage backed securities they thought would never lose value. They were forced to pay the interest (and principal) on mortgages when homeowners began defaulting. This hampered cash flow. It also dramatically increased liabilities as it decreased capital. This is the equivalent of bank hari kari.
Do not underestimate the function of these credit swaps. This “insurance” was purchased by investors, because they often borrowed the money to buy these investments in the first place. These securities were purchased with enormous leverage, so even a small drop in value would be devastating to a bank’s (investor’s or pension’s) capital base.
Enter the Perfect Financial Storm
As it became apparent that these CDOs were worth nowhere near the values on bank balance sheets, banks (I use this term broadly) were forced to readjust their capital base. Many of the investment banks (Lehman, Bear Stearns, Citi) also faced mounting liabilities from their credit swaps. Within a few short months, enormously profitable, asset rich companies became completely insolvent. If allowed to continue, this insolvency would have blown through our society like a hurricane. In fact, this has already started, nearly pulling the world beyond a global recession into a depression.
Banks cannot lend money when they have no capital. This is a simple fact, but an awesome, bitter truth.
Wall Street firms must take much of the blame for this problem. Their mathematical algorithms predicted this. Nothing is certain. But the probability of this happening was slight, and considered an “acceptable risk” of business. Big mistake.
One of the main problems for this statistical breakdown was that Fannie Mae and Freddie Mac dramatically relaxed their underwriting standards, without really telling anyone. These two organizations purchase about half of all mortgage loans in the country. Their purchase is generally considered to be a kind of “seal of approval” with regard to quality.
These two organizations allowed mortgage companies to send increasingly inferior loans, purchased them and sold them off for profit. Appraisal standards deteriorated. Documentation standards grew lax. Borrowers became a commodity, not a banking decision.
This strategy allowed men like Fannie CEO, Franklin Raines, to make hundreds of millions of dollars while they cooked the books and destabilized our economy. Wall Street banks, hedge funds and pension plans were willing buyers. But Fannie and Freddie flat out lied about what they were selling.
What Was The Government’s Contribution?
Our government must shoulder a good portion of the blame for this. This crisis was caused by too little regulation and too much regulation. It was caused by corporate greed, but also by political ambition and greed. This helped cause and then magnify the problem.
1992:
It began in 1992 when Clinton vowed to end “corporate greed.” He demanded, and got, legislation that limited the tax deduction on corporate salaries to $1 million. Congress didn’t realize that corporate executives are like highly paid athletes (except that many of them actually produce something). They are free agents, able to go to the team that will pay them the most.
These executives are worth far more to companies than $1 million. However, it is not good business practice to pay taxes on compensation, since it leaves less for shareholders. Corporations used the complex tax laws to find a way around the 1992 law limiting corporate deductions. They replaced large corporate salaries with smaller salaries combined with incentives. Many of these incentives were based upon stock performance. This caused executives (including those at Fannie Mae and Freddie Mac) to drive stock performance, even if it meant breaking the law and committing fraud.
This is a classic case of unintended consequences. The president and Congress thought they were addressing corporate “greed.” Instead, they created a way to make it worse.
This law change was one of the main culprits in the “tech bubble” of the 1990s. Company executives forced their stock prices upward in order to trigger stock options. This caused businesses to lose much of their long-term focus, in favor of questionable accounting practices and short-term thinking.
The ensuing stock market collapse (of 2000) helped create a ready market for mortgage backed securities. Pension plans grew underfunded, and they needed securities with low risk and high returns. Wall Street filled the enormous demand with mortgage backed securities. A crisis was incubated.
Hedge funds caught on to this game. They used a common exclusion (Regulation D) to the Securities Act of 1933 to create large pools of investments outside the regulation of the SEC. They raised billions of dollars, borrowed trillions and invested in mortgage backed securities. If they could borrow at 3% and earn 6%, they profited greatly from the spread. Big time.
Investment banks used the liberal Fed window to borrow funds to purchase (hedge) mortgage backed securities. This was almost a license to print money and profits skyrocketed.
Fannie and Freddie were seen as golden boys, manufacturing the geese that laid these golden eggs.
No Regulation
Republican leaders pushed for fewer regulations of the securities markets. Their mantra was that regulation inhibits productivity. But both parties stood by and allowed a shadow market to grow far too large with little regulation.
Mortgage Fairness
For years, Fannie Mae was not buying loans issued to low income, low credit borrowers. Democratic leaders called this discriminatory and pushed for mortgage “fairness.” This caused Fannie to buy mortgages they would not normally even consider. With little government oversight, they were able to almost do this at will.
Poor loans received the Fannie “stamp of approval” and sold along with the rest, as quasi-investment grade.
The Fed
The tech bubble (partly caused by tax legislation) caused our stock markets to become highly overvalued. P/E ratios were twice their traditional multiples. At the end of the boom, business had to digest a spending binge, so it was up to the American consumer to pull our economy along and prevent a big recession. Enter the Fed.
Alan Greenspan quietly engineered a housing boom to create equity and consumer spending. He did this by consistently lowering interest rates (among other things). As home equity rose, consumers refinanced their homes. They used refinancing proceeds to purchase goods and services and drive the economy.
Political Games
As early as 2002, Congressmen began calling for an investigation into the practices of Fannie Mae and Freddie Mac. Fannie and Freddie were quasi-government organizations. They were independent, publicly traded companies, but their debt was guaranteed by the Federal Government. As a result of this crisis, they are now, technically, owned by Uncle Sam. So is their debt.
Fannie was being run by Clinton appointee and adviser, Franklin Raines. When it became apparent that Fannie was abusing the system, Republicans began calling for an investigation. (Raines has since been assessed a fine of more than $23 million) The Democrats saw this as a political problem, not an economic one, so they blocked meaningful oversight.
Democrats control Congress, so they chair the banking committees of the Senate and the House. Christopher Dodd and Barney Frank simply refused to investigate any wrongdoings by Fannie and Freddie. So, the problem grew greater, until everything collapsed.
The Fed Bailout
Enter the Fed rescue plan, or “bailout.” This will help stabilize markets and keep some liquidity in our banking system. But it will not replace the trillions in capital that have been lost by the world’s financial system, and by investors. It will not make this problem go away; it just softens the blow. We will face lower stock market returns for a good decade because of this. Inflation will be greater because of the massive infusion of money by the Fed. Our children and grandchildren will pay the ultimate price, because they will have to pay on this debt for decades.
The Final Result – A Perfect Financial Storm
As you can see, this problem was caused by a confluence of seemingly unrelated factors, all converging to create the perfect financial storm. We had the law change that helped create the tech bubble. The stock market collapse caused Greenspan to help create the housing boom. Pension plans cried for higher yielding, low risk securities. Wall Street built computer models that convinced the rating agencies to consider mortgage backed securities as investment grade debt. Low interest rates allowed unregulated hedge funds to join the investment banks and pension plans. Together, they bought as much as could be created. Congress forced a lowering of underwriting standards. Fannie Mae (and Freddie Mac) executives cooked the books and lowered quality to drive their stock prices higher to trigger stock options. Democratic leaders refused to investigate. Republican leaders pushed for deregulation and allowed a huge piece of the financial world to go unregulated. Insurance companies and investment banks borrowed huge sums of money to purchase these securities. Then they “insured” them to add to their profits. Wall Street ignored the bottom end of the mathematical return range, seeing it as acceptable risk. When mortgage holders began defaulting, investment banks were forced to “mark to the market.” This caused a dramatic fall in capital, and instant insolvency. The credit markets seized and the world economy ground to a halt. Investment banks and insurance companies were asked to make good on their guarantees and couldn’t deliver. World stock market values plummet and the capital base grew even weaker. The U.S. Government more than doubled our national debt (when we add the assumption of Fannie Mae and Freddie Mac debt).
This reminds me of hurricane Katrina and New Orleans. It has been three years, and New Orleans is still not the same. Areas of the city remain blighted. The local economy still suffers. And the danger still remains.
The same thing goes for our nation and the world. The United States will feel the effects of this for years. We will have lower corporate earnings than we might have enjoyed. Inflation will be greater than it would have been. We will create new regulations. Those regulations will have their own unintended consequences. And someday, hopefully not too soon, we will probably do it all over again.
www.lumbert.com
www.shaksperbooks.com
When I watched the 60 Minutes piece on television the other night, I was impressed at how they were able to boil down a very complicated, global financial meltdown and break it into two easy-to-understand pieces. According to 60 minutes, it was a case of greed and planned ignorance among the Wall Street crowd.
Our investment banks up risky mortgages, packaged them without regulation and sold them (using huge offering memorandums detailing mathematical models designed by physics experts and cosmologists) to an unwary public as investment-grade debt. Then they “insured” the payment of these securities (CDOs) through something called “Credit Swaps.” Of course, it wasn’t called insurance. That would have meant regulation, and the setting aside of reserves to meet this liability. Ultimately, (according to the show) it was the credit swaps that caused many large financial institutions (Lehman, Bear Stearns, AIG, etc.) to teeter on (or over) the edge of bankruptcy.
I give CBS credit for explaining the nub of the issue in a way that hockey moms and Joe six-pack can understand. Unfortunately, CBS only addressed half of the cause. They were correct in describing Wall Street execs as greedy, amoral souls (my words) intent on reaping huge profits, regardless of risk, at any cost. But CBS completely ignored the role that Congress should (could) have played in preventing this global crisis.
According to CBS, Congress allowed $50,000,000,000,000-$60,000,000,000,000 ($50-$60 trillion for those of you who get a brain freeze with so many zeros.) to go unregulated. This is as much as the total U.S. net worth, of $55 trillion. http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=cb82625a-a1a5-4760-a1a5-0a3b82f53c79
Much of the money used to purchase these securities has been borrowed, perhaps 90% or more. To put this in perspective, debt currently held by the U.S. public is about $5 trillion. Total U.S. government debt is about $10 trillion. The U.S. Treasury puts this at $4.2 trillion. But they have not added the $700 billion bailout or the $ 5 trillion of debt assumed in the takeover of Fannie Mae and Freddie Mac.
http://www.treasurydirect.gov/NP/BPDLogin?application=np http://www.federalreserve.gov/releases/g19/Current/
So, somewhere out there in the ether, financial institutions have borrowed three times as much as every American and the U.S. government combined. And these are the people that are lending money to us?
How did this happen? I have explained the mechanisms in prior blogs, so I won’t go into that here in detail. Simply put: Financial institutions (for themselves and for their clients) purchased these things (CDOs, mortgage-backed securities, toxic debt) with the expectation that there were assets backing them.
The rating agencies relied upon a twenty-year bull market in real estate (brought on by duel working families, the lowering interest rates enhanced by a generous Fed policy), complex algorithms developed by geeks trained at Harvard, Stanford, Cal Tech and MIT who had chased the big bucks on Wall Street. They also relied upon the word (and the historical practices) of Fannie Mae and Freddie Mac.
In the 60 Minutes piece, one of the “experts” stated (I am paraphrasing) that math cannot predict human behavior. That is not a correct statement. Math can predict human behavior, but not with certainty. With investments, math can predict behavior (of which a large part is irrational emotion), but only to a point within ranges and probabilities. For example, math can predict that a certain investment’s return will fall between a range of returns with a given probability. Below I give a simple illustration.
Example: A basket of stocks might be expected to return 10% per year over time. There will be a “standard deviation” or volatility to this return. Let’s say that the standard deviation is 10. Our math tells us that two thirds of the time, in a one year span of time, our return will fall within our expected return (10%), plus or minus one standard deviation (10%). This means that our investment return will fall between zero (10% minus 10%) and 20% (10% plus 10%). Ninety-five percent of the time, our return will land within our expected return plus or minus two standard deviations. This gives us a range of -10% to 30% return, 95% of the time. If we go to three standard deviations, our expected return is predicted to fall within our expected return plus or minus three standard deviations. (-20% and 40%) http://en.wikipedia.org/wiki/Standard_deviation
In summary, our math tells us that we can determine the probability of a range of returns given our expected return, plus or minus our standard deviations.
Percentage Probability Range of Return
1 Year Low High
67% 0% +20%
95% -10% +30%
99% -30% +40%
The expected return range expands as our certainty increases. In other words, most of the time, the return will fall somewhat close to what we suspect. However, some of the time, unusual things will happen (war, terrorism, financial collapse) that will cause an unexpected return. The greater the certainty, the greater the range of returns.
The longer the time frame grows, the smaller our range becomes. Over time, investments tend to repeat the returns of the past. For example, when our time frame moves to ten years, our standard deviation may narrow to 5%. In this case, our ranges would be as follows:
Percentage Probability Range of Return
10 Year Low High
67% 5% +15%
95% 0% +20%
99% -5% +25%
The Wall Street firms all had mathematical models that predicted the performance of mortgage securities, depending upon quality, initial equity, time duration, property location, etc. These models took such statistics as a borrower’s credit ratings, their occupation, their documentation, length of employment and used them to come up with the probabilities of ongoing payments the probabilities of complete repayment in any given time frame, the probabilities of interest rate resets and what they might be. There were hundreds of variables that went into these calculations.
Obviously, some of the important factors were not included in the calculations, or they were minimized.
Here’s what happened:
When determining their capital base, financial institutions are required to “mark to the market” with securities they hold. They are not allowed to say that investments in their portfolio are worth their purchase price, which may have been far in the past. They are required to assess the current value of the securities on their balance sheets.
For years, there was no actual “market” for these securities. They were not traded on exchanges, they were simply held. Investment banking firms simply assigned values to these securities, since there was no market. Many firms chose to value these securities higher than initial cost. This allowed them to book higher profits (which triggered lucrative stock options) and increase their capital base so they could buy more.
When Countrywide failed, the world (or at least regulators) suddenly realized that these CDOs were worth far less than expected. This forced financial institutions to revalue portfolio securities, dramatically reducing their capital.
Capital is needed by banks before they can issue loans. They must maintain certain capital to loan ratios. So, when capital decreases, loans to business and individuals must also decrease. This causes business to slow, jobs to be lost, etc.
While balance sheets were being redrafted to reflect the current (and rapidly falling) value of mortgage backed securities, another nasty thing was happening to the investment banks. They were being asked to make good on their credit swaps (unregulated insurance).
Companies like Bear Stearns, AIG, Lehman Brothers and Citi had profited greatly by selling “guarantees” on mortgage backed securities they thought would never lose value. They were forced to pay the interest (and principal) on mortgages when homeowners began defaulting. This hampered cash flow. It also dramatically increased liabilities as it decreased capital. This is the equivalent of bank hari kari.
Do not underestimate the function of these credit swaps. This “insurance” was purchased by investors, because they often borrowed the money to buy these investments in the first place. These securities were purchased with enormous leverage, so even a small drop in value would be devastating to a bank’s (investor’s or pension’s) capital base.
Enter the Perfect Financial Storm
As it became apparent that these CDOs were worth nowhere near the values on bank balance sheets, banks (I use this term broadly) were forced to readjust their capital base. Many of the investment banks (Lehman, Bear Stearns, Citi) also faced mounting liabilities from their credit swaps. Within a few short months, enormously profitable, asset rich companies became completely insolvent. If allowed to continue, this insolvency would have blown through our society like a hurricane. In fact, this has already started, nearly pulling the world beyond a global recession into a depression.
Banks cannot lend money when they have no capital. This is a simple fact, but an awesome, bitter truth.
Wall Street firms must take much of the blame for this problem. Their mathematical algorithms predicted this. Nothing is certain. But the probability of this happening was slight, and considered an “acceptable risk” of business. Big mistake.
One of the main problems for this statistical breakdown was that Fannie Mae and Freddie Mac dramatically relaxed their underwriting standards, without really telling anyone. These two organizations purchase about half of all mortgage loans in the country. Their purchase is generally considered to be a kind of “seal of approval” with regard to quality.
These two organizations allowed mortgage companies to send increasingly inferior loans, purchased them and sold them off for profit. Appraisal standards deteriorated. Documentation standards grew lax. Borrowers became a commodity, not a banking decision.
This strategy allowed men like Fannie CEO, Franklin Raines, to make hundreds of millions of dollars while they cooked the books and destabilized our economy. Wall Street banks, hedge funds and pension plans were willing buyers. But Fannie and Freddie flat out lied about what they were selling.
What Was The Government’s Contribution?
Our government must shoulder a good portion of the blame for this. This crisis was caused by too little regulation and too much regulation. It was caused by corporate greed, but also by political ambition and greed. This helped cause and then magnify the problem.
1992:
It began in 1992 when Clinton vowed to end “corporate greed.” He demanded, and got, legislation that limited the tax deduction on corporate salaries to $1 million. Congress didn’t realize that corporate executives are like highly paid athletes (except that many of them actually produce something). They are free agents, able to go to the team that will pay them the most.
These executives are worth far more to companies than $1 million. However, it is not good business practice to pay taxes on compensation, since it leaves less for shareholders. Corporations used the complex tax laws to find a way around the 1992 law limiting corporate deductions. They replaced large corporate salaries with smaller salaries combined with incentives. Many of these incentives were based upon stock performance. This caused executives (including those at Fannie Mae and Freddie Mac) to drive stock performance, even if it meant breaking the law and committing fraud.
This is a classic case of unintended consequences. The president and Congress thought they were addressing corporate “greed.” Instead, they created a way to make it worse.
This law change was one of the main culprits in the “tech bubble” of the 1990s. Company executives forced their stock prices upward in order to trigger stock options. This caused businesses to lose much of their long-term focus, in favor of questionable accounting practices and short-term thinking.
The ensuing stock market collapse (of 2000) helped create a ready market for mortgage backed securities. Pension plans grew underfunded, and they needed securities with low risk and high returns. Wall Street filled the enormous demand with mortgage backed securities. A crisis was incubated.
Hedge funds caught on to this game. They used a common exclusion (Regulation D) to the Securities Act of 1933 to create large pools of investments outside the regulation of the SEC. They raised billions of dollars, borrowed trillions and invested in mortgage backed securities. If they could borrow at 3% and earn 6%, they profited greatly from the spread. Big time.
Investment banks used the liberal Fed window to borrow funds to purchase (hedge) mortgage backed securities. This was almost a license to print money and profits skyrocketed.
Fannie and Freddie were seen as golden boys, manufacturing the geese that laid these golden eggs.
No Regulation
Republican leaders pushed for fewer regulations of the securities markets. Their mantra was that regulation inhibits productivity. But both parties stood by and allowed a shadow market to grow far too large with little regulation.
Mortgage Fairness
For years, Fannie Mae was not buying loans issued to low income, low credit borrowers. Democratic leaders called this discriminatory and pushed for mortgage “fairness.” This caused Fannie to buy mortgages they would not normally even consider. With little government oversight, they were able to almost do this at will.
Poor loans received the Fannie “stamp of approval” and sold along with the rest, as quasi-investment grade.
The Fed
The tech bubble (partly caused by tax legislation) caused our stock markets to become highly overvalued. P/E ratios were twice their traditional multiples. At the end of the boom, business had to digest a spending binge, so it was up to the American consumer to pull our economy along and prevent a big recession. Enter the Fed.
Alan Greenspan quietly engineered a housing boom to create equity and consumer spending. He did this by consistently lowering interest rates (among other things). As home equity rose, consumers refinanced their homes. They used refinancing proceeds to purchase goods and services and drive the economy.
Political Games
As early as 2002, Congressmen began calling for an investigation into the practices of Fannie Mae and Freddie Mac. Fannie and Freddie were quasi-government organizations. They were independent, publicly traded companies, but their debt was guaranteed by the Federal Government. As a result of this crisis, they are now, technically, owned by Uncle Sam. So is their debt.
Fannie was being run by Clinton appointee and adviser, Franklin Raines. When it became apparent that Fannie was abusing the system, Republicans began calling for an investigation. (Raines has since been assessed a fine of more than $23 million) The Democrats saw this as a political problem, not an economic one, so they blocked meaningful oversight.
Democrats control Congress, so they chair the banking committees of the Senate and the House. Christopher Dodd and Barney Frank simply refused to investigate any wrongdoings by Fannie and Freddie. So, the problem grew greater, until everything collapsed.
The Fed Bailout
Enter the Fed rescue plan, or “bailout.” This will help stabilize markets and keep some liquidity in our banking system. But it will not replace the trillions in capital that have been lost by the world’s financial system, and by investors. It will not make this problem go away; it just softens the blow. We will face lower stock market returns for a good decade because of this. Inflation will be greater because of the massive infusion of money by the Fed. Our children and grandchildren will pay the ultimate price, because they will have to pay on this debt for decades.
The Final Result – A Perfect Financial Storm
As you can see, this problem was caused by a confluence of seemingly unrelated factors, all converging to create the perfect financial storm. We had the law change that helped create the tech bubble. The stock market collapse caused Greenspan to help create the housing boom. Pension plans cried for higher yielding, low risk securities. Wall Street built computer models that convinced the rating agencies to consider mortgage backed securities as investment grade debt. Low interest rates allowed unregulated hedge funds to join the investment banks and pension plans. Together, they bought as much as could be created. Congress forced a lowering of underwriting standards. Fannie Mae (and Freddie Mac) executives cooked the books and lowered quality to drive their stock prices higher to trigger stock options. Democratic leaders refused to investigate. Republican leaders pushed for deregulation and allowed a huge piece of the financial world to go unregulated. Insurance companies and investment banks borrowed huge sums of money to purchase these securities. Then they “insured” them to add to their profits. Wall Street ignored the bottom end of the mathematical return range, seeing it as acceptable risk. When mortgage holders began defaulting, investment banks were forced to “mark to the market.” This caused a dramatic fall in capital, and instant insolvency. The credit markets seized and the world economy ground to a halt. Investment banks and insurance companies were asked to make good on their guarantees and couldn’t deliver. World stock market values plummet and the capital base grew even weaker. The U.S. Government more than doubled our national debt (when we add the assumption of Fannie Mae and Freddie Mac debt).
This reminds me of hurricane Katrina and New Orleans. It has been three years, and New Orleans is still not the same. Areas of the city remain blighted. The local economy still suffers. And the danger still remains.
The same thing goes for our nation and the world. The United States will feel the effects of this for years. We will have lower corporate earnings than we might have enjoyed. Inflation will be greater than it would have been. We will create new regulations. Those regulations will have their own unintended consequences. And someday, hopefully not too soon, we will probably do it all over again.
www.lumbert.com
www.shaksperbooks.com
Wednesday, October 1, 2008
Financial Healing Underway
As bad as things may seem in the world of finance, I believe that the healing is now underway.
Congress now has no choice but to pass the emergency legislation that will allow an injection of liquidity and the cleaning of balance sheets. While there is no easy solution, a solution is at hand.
The world economy is fundamentally sound. Yes, we are probably in the midst of a mild recession. This recession will probably get worse before it gets better. This is not an unusual thing for the stock market to endure; it is normal. However, the stock market typically looks into the future a good six months. The market will often rise before a recession is over, as it sees that the end is drawing near.
I have a strong belief in the fundamental greatness of our nation’s people and in our economy. Yes, things have happened recently that will make it more challenging to prosper in the future. So, maybe our financial candle won’t burn quite as bright as it might have. We have greater debt issues to deal with. We will have greater “safeguards” (i.e. Regulations) for the economy. But our economy will burn brightly, and our nation will prosper.
Now is not a time to look back and cry about the spilled milk or the opportunities we have lost. It is time to clean up the mess and leave it behind. Congress will pass a big spill cleanup bill this week. We must now look forward and embrace our great way of life.
There are many “bargains” out there for those investors with a long-term time horizon. There are many money managers with very long “buy lists,” praying for an influx of capital to invest. Twenty years from now, we may look back to these days as an extraordinary buying opportunity in U.S. equities. This may be seen as a time when the U.S. economy roared out of the financial ashes and surprised us all with its resilience and strength. That’s what I am betting on. America has suffered an injury. But like with any great athlete (and our economy is like a financial superstar) an injury just strengthens the inner fire to succeed. That is where I think we are today. Our nation is in physical therapy for a severe, but treatable injury. We can handle it, so let the games begin again.
Congress now has no choice but to pass the emergency legislation that will allow an injection of liquidity and the cleaning of balance sheets. While there is no easy solution, a solution is at hand.
The world economy is fundamentally sound. Yes, we are probably in the midst of a mild recession. This recession will probably get worse before it gets better. This is not an unusual thing for the stock market to endure; it is normal. However, the stock market typically looks into the future a good six months. The market will often rise before a recession is over, as it sees that the end is drawing near.
I have a strong belief in the fundamental greatness of our nation’s people and in our economy. Yes, things have happened recently that will make it more challenging to prosper in the future. So, maybe our financial candle won’t burn quite as bright as it might have. We have greater debt issues to deal with. We will have greater “safeguards” (i.e. Regulations) for the economy. But our economy will burn brightly, and our nation will prosper.
Now is not a time to look back and cry about the spilled milk or the opportunities we have lost. It is time to clean up the mess and leave it behind. Congress will pass a big spill cleanup bill this week. We must now look forward and embrace our great way of life.
There are many “bargains” out there for those investors with a long-term time horizon. There are many money managers with very long “buy lists,” praying for an influx of capital to invest. Twenty years from now, we may look back to these days as an extraordinary buying opportunity in U.S. equities. This may be seen as a time when the U.S. economy roared out of the financial ashes and surprised us all with its resilience and strength. That’s what I am betting on. America has suffered an injury. But like with any great athlete (and our economy is like a financial superstar) an injury just strengthens the inner fire to succeed. That is where I think we are today. Our nation is in physical therapy for a severe, but treatable injury. We can handle it, so let the games begin again.
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