After the onslaught

I get the feeling that the rally yesterday has a lot of people heaving a sigh of relief, believing we passed through a tough two weeks, and now the financial world is going to be one big bull market party for another 25 years, but there just might be a teeny little problem with that scenario.

Like the fact that the majority of adjustable rate mortgages that will ratchet up eventually have not yet done so. Ooops.

With all that inventory out there and more arriving everyday, what are the odds the price of housing is up within a decade? I’m thinking slim to none. Result? More foreclosures and more bankruptcies.

The vast proportion of blame for this entire blowout lies in failing to consider risk appropriately when seeking returns. If the government promises to cover your losses, what risks wouldn’t you take? How would you risk $10,000 of your own money in a casino? How would you risk it if your losses would be covered by someone else, but you keep the winnings? I really hate the idea of multi-million dollar bonuses being paid to twenty something geniuses with our tax dollars as the backstop. Don’t seem right.

There have been two great episodes of “This American Life” that describe the three main pieces of the meltdown. They were titled “The Global Pool of Money” #355 and “Another Scary Show about the Economy” and I highly recommend picking up the pod casts (free!) at iTunes or NPR.org.

There are three areas these two hours of audio cover, and they do it in a really easy to understand way. The three are:

1. Just what happened in the sub-prime meltdown and what caused it?
2. How does credit crunch and what is commercial paper?
3. Why do I care about credit default swaps?

The sub-prime meltdown was an unintended consequence of a good idea taken way, way too far. In the beginning of the decade, developing nations, primarily BRIC, Brazil, Russia, India and China began throwing off huge profits, and needed somewhere to put them to get a safe and fair return. Meanwhile the US was artificially holding down interest rates to give the economy a post-9/11, post Internet bubble boost. The only safe good yields seemed to be US Treasuries (basically loaning the US government money) and American mortgages.

As you’d expect, these folks bought up all the debt we felt like issuing, and under the Bush administration that was one hell of a lot of debt. They also couldn’t get enough of America’s mortgages, which had a long history of decent yields, like 5-7% with relatively few defaults. What could be better? Wall Street contacted banker and mortgage brokers and let them know they would buy all the mortgages the banks and brokers had. This was all well and good until they purchased every last mortgage taken out by people who could afford the, packages them into financial instruments (a process called securitization) and sold them to the willing buyers from the Global Pool of Money.

The problem really started when there were no more Americans qualified to own a home and have a mortgage who didn’t already have one. This is when Wall Street, loving the big fees and commissions they were earning started lowering their standards. Hearing the actual players in this game describe what they were doing is absolutely fascinating. They seemed to know that what they were doing didn’t make sense, but it paid so incredibly well that they just kept doing it.

First, a mortgage broker of banker would call her Wall Street contact and ask if maybe they’d buy a loan with only 10% down instead of 20. Calling all the investment banks, maybe one would take it. The rest would fall in line.

Next, maybe assets could just be stated rather than proven. Slowly, but inexorably the standards slipped and slid until the now infamous liar loans, requiring no money down, no income and no assets. Incredibly, Wall Streets brilliant minds were watching historic mortgage performance (loans made under much tougher rules) and decided everything was fine. Until on day in the fall of 2007 when it wasn’t. A waive of late payments and foreclosures popped up on somebody’s radar and the whole game of musical chairs stopped cold.

Small banks and brokers were left holding these ridiculous, toxic loans they had expected to hold for hours or days, and now no one else wanted them. What caused the meltdown was realizing that these financial products made up of lots and lots of horrible loans were held worldwide by just about every financial institution out there, and because they were so difficult to value, nobody knew who was in how much trouble, and the credit markets slowed to a crawl. It’s not that all the loans were bad, it’s that no one knew which ones were what.

How much would you pay for a case of beer containing 23 bottles of tasty Heineken and one bottle of anthrax tainted Heineken? These cases of poison beer are the first thing the US Treasury is going to buy from the banks. Can’t you just see the earnest girls and boys of Wall Street scrambling through all the paperwork to find the most worthless, absolute trash debt they can find to palm off to the government for as much money as they can get? Makes you proud, don’t it?

On the second hour, we learn about the commercial paper market and how the credit market froze solid. I’ve got a degree in Economics and worked at the senior executive level at companies private and public, but I didn’t know what commercial paper was. It’s not that complicated, but given its size, I’m amazed I’d never heard of it.

When the Treasurer or CFO of a big company gets to work, the first thing he asks is “How much money do we have?” They use ServiceMaster as an example, and the answer can range from “We’re short $50 million” to “We have an extra $50 million.” Based on this a clerk will call a guy on a desk on Wall Street and either say “We need $50 million by 11 am” or “We can loan $50 million by 11 am” and generally it just got done. One day loans, simply overnight by large and substantial companies.

As the subprime crisis got worse, there was a crisis of confidence and the commercial paper market, involving hundreds of billions of dollars flowing in and out and back and forth stopped dead. No loans offered, only loans requested. Nothing. Nada. Zilch. Ouch.

That was in September 2008. And since then it’s pretty much been a one way ride. Imagine if credit cards stopped working and all you could count on was cash. Would you loan any of it you had? I doubt it. You’d sell everything you could for cash and invest in food. That’s what companies are doing, selling stocks and buying gold, US Treasury debt, gold and other safe stuff. When everyone is selling prices drop. Witness the S&P down 40% in 12 months. Buy and hold indeed!

Commercial paper market. Sound so innocent, like a division of Dunder Mifflin.

The third part of the Scary Economy covered is the market for credit default swaps, and this one is a doozy.

Remember how in the first section, everyone got in trouble because they couldn’t figure out who held how much debt and whether it was worth anything or not? Well there was about $10 trillion in the US home mortgage market as of last year. If that $10 trillion somehow went bad, somebody would at least be left holding one hell of a lot of real estate with a value that is at least a large fraction of $10 trillion. Maybe only $2 trillion, maybe as much as $7 trillion, nobody really knows, but there is some kind of value there.

A staggering $500,000 per American household, credit default swaps (CDS) totaling $60 trillion dollars are out there and not looking particularly healthy. So what is a credit default swap? It is an unregulated private agreement between two parties to insure a bond. If you have a million dollar bond from Ford, and you start worrying that Ford will default and fail to pay you for the bond, you can buy a credit default swap. In return for an annual fee, let’s say $20,000 the other party will make good on the bond if Ford fails to. Get it? It’s like insurance. But then the boy and girl geniuses take a whack at it.

What if you could take out insurance on your neighbor’s house? In insurance lingo, this creates a moral hazard, in which your motivations can become less than altruistic. You might not flick matches next door, but you might not be so quick to call the Fire Department if you smelled smoke.

There are an estimated $5 trillion in corporate debt that could be covered by credit default swaps, and yet there are an estimated $60 trillion in actual CDS’s out there. So 11 of 12 of these bets are held by people who don’t even own the underlying bond. All of these deals are private, unregulated and invisible to all other people and organizations. If a billion dollar bond fails, on average it’s going to take down $12 billion. For a $100 billion dollar bond, the losses are a staggering $1.2 trillion.

All of the organizations are in a circle, with a knife on the throat of the one in front and a knife on the throat from the one behind and everyone is feverishly praying that no one sneezes. When the Fed throws a hideously expensive $700,000,000,000 bailout at a ticking time bomb at $60,000,000,000,000 it suddenly starts to feel like we’re tossing bricks into the Grand Canyon for all the effect it could have.

See it here:
Proposed bailout $700,000,000,000
Credit default swap liability $60,000,000,000,000

That, boys and girls, is why they call it a panic.