Comedians Create a Sketch about the Current Situation but You Need To Educate Yourself

In this YOUTube video is a funny populist take on our current economic meltdown by two British comedians. While this is humorous, it does demonstrate a fundamental lack of understanding of what caused our markets not to work.

There are four key components to this melt down:

(1) Crony-Capitalism
(2) The Federal Reserve Itself
(3) Mark to Market Accounting Rules
(4) The Sarbanes-Oxley Law

While these four components are not exhaustive of all the causes these are the major actors of our current situation. I intend this article to be the beginning of a discussion on alternative ways to solve our current crisis as well as explain some of its root causes. I have included the video because it does demonstrate what most American’s believe to be the cause; fat cat greed, incompetence and bad lending decisions. I know that some readers will dismiss some of the arguments in this article and all I can ask is to continue educating yourself on rational economic principles. Never stop thinking for yourself and don’t believe the headlines that are meant to sell newspapers and news broadcasts.

Let us consider where we are today and the nationalization of our financial institutions. I will argue that neither a bailout or rescue plan that will put the American tax payer on the hook for mortgage loans is a good idea. I argue instead the current mess is the direct effect of our Federal Reserve System along with good intentioned laws e.g. Sarbanes-Oxley and Mark to Market accounting rules.

Crony Capitalism

The first key is something called crony-capitalism. Crony-capitalism is when market participants give lip service in defending free market capitalism while at the same time making deals with government officials to regulate and limit their competition. There is no doubt business owners are not necessarily defenders of free competition but their bottom line. If you follow the money into Washington it is easy to see why certain decisions get made and certain regulations are passed. This is not partisan this happens with Politician’s on both sides of the aisle. These cronies pretend to be for capitalism and free markets but will ask for the government to subsidize their decisions when they fail as well as regulation to limit competition. In August of 2007 when the private (not government backed– non Fannie Mae / Freddie Mac ) mortgage loans that were packaged and securitized began to no longer be purchased by wall street; there was an immediate sentiment: if it’s not backed by the Federal Government, then how can one know what these securities are worth? As the comedians in the video dramatized it seemed to have been a game of musical chairs with the last person holding a pool of mortgage money was left wondering if maybe too much money was paid for these security packages. What the video fails to explain is that in these mortgage packages all the mortgages are not equal. All the mortgages were not made to unemployed first time home buyers unable to make their payments. Not all mortgages even ones that adjust necessarily only adjust higher. The fact is that over ninety years the line between the government sector and the private sector in mortgage money lending has become very blurred.

The Federal Reserve

The Federal Reserve is the first culprit that is the foundation of this mess. It is neither politically feasible nor popular to criticize this federal institution when the general population has very little understanding of its role and the destructive nature of its decisions. With the nationalization of our money in 1913, this was the first nationalization project of the federal government. In 2013 the FED will celebrate its 100th birthday. What needs to be discussed and understood is it will also have eroded more of the average Americans wealth than any other government taxing system ever created. This institution can create dollars out of thin air that in turn devalues all the current dollars in the system, otherwise known as inflation – higher overall prices. Increasing the money supply typically drives interest rates lower. That is why there is a direct correlation between the FED decreasing the money supply to lower inflation and interest rates being pushed higher – remember the 80’s and Paul Volker. So what has the FED been doing? Increasing the money supply via federal debt and printing money that has created our inflationary pressures. Where do you think the additional money will come from in this “rescue package”? In my opinion, what the Fed and congress are doing is the largest power grab in the history of the federal government while it allows some private firms to buy assets at fire sale prices. Instead of changing the rules so the free market can correct its mistakes and return to sanity it will just make the government bigger. Do you really think that 95% of the performing mortgage securities have no value? There has to be a reason for this seizure and it is not the market participants “the fat cat Wall Street types”. It is the rules that are in place today that have caused this mess and it lies at our federal government’s feet because they make the rules.

Market Sentiment and Mark to Market

While you watch this video these two comedians do a wonderful job in the beginning of why “market sentiment” comes into play. One major reason is a mark to market. Read this article if you are interested in a fuller discussion of this concept from William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985 that lived through the 1980’s S&L crisis. http://online.wsj.com/article/SB122178603685354943.html?mod=article-outset-box

Yes there is euphoria if you are marking to market in an increasing market or panic if you are marking to market in a declining market. This is what just happened. Why? What if you got an appraisal on your home and the value was determined to be $500,000 last year. Assume you paid $250,000 just five years earlier you feel much richer. What If you get an appraisal today and the home is worth $200,000, then you feel like you took a huge loss. Let say the reason your home was valued at $200,000 is because your neighbor was foreclosed on and the bank sold it at auction. Is your home worth $200,000 really?

What mark to market impels you to do is, complete an appraisal on your home daily, regardless of how long you plan to keep this home. If you did not sell at $500,000 there was no gain and if you don’t sell at $200,000 there is no loss. Just because your neighbor is financially distressed and was foreclosed on and his home sold for $200,000 doesn’t mean you will take the same loss. But under the mark to market rules along with the liability of the Sarbanes-Oxley law; institutions that hold mortgage securities have to mark the price (valuation on the books) of like securities to those of institutions that are distressed and selling at foreclosure sale prices. Further since the market was never allowed to filter out the truly failing mortgage from those that are performing – partly because of how they are packaged and sold – the market has not been able to price the good mortgages and discount the bad. In the simplest terms this can be understood: There were lending products created over the last ten years that had a high likelihood of not performing – bad loans. There were also loan products however non-traditional that have a high likelihood of performing – good loans. The bottom line problem was the market was never allowed to empirically discover the good from the bad.

The Sarbanes-Oxley Law

The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities and Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. It also imposes criminal penalties on the officers of a corporation signing off its balance sheet. The SOX law along with the Mark to Market requirements has caused a great deal of the devaluation of the financial institutions.

Conclusion

I think between Mark to Market along with crony-capitalism these loans have not been properly valued. Crony-capitalism prevented the market participants doing the hard work of figuring out what loans were poorly made; it was easier to go to their favorite Uncle Sam for protection. This is what I think began, in the summer of 2007, the mantra: “I am not buying it unless it is guaranteed by the government.” Now the investors are pleading to have the Government to buy these loans now so that they can buy them back at a profit later. Let’s think before we react again and again only to make matters worse for our future. Do you really want to eventually only have large government controlled banks backed by your tax dollars? Do you really want to replace all the private lending institutions with members of congress? Don’t you think it is better to have individuals making daily decisions in their best interest as opposed to a committee making decisions in their best interest – that interest being keeping their job on the committee? If we give this much power to such a small group of people, whom will they ultimately serve? The last question is how can this small group know better? What possibly can guide them in making correct decision? These are my questions I look forward to your answers and further comments.

Further Discussion of the How the Market Works

What is the secondary market that buys non-government backed mortgage debt? The Collateralized Mortgage Obligations (CMO) with their corresponding Credit Default Swaps (CDS) are pools of mortgage loans made to various credit types from A paper to D paper. Each pool is weighted with these credit classes to defend against the risk of any one credit class defaulting. The uncertainty of their overall value is based on how these mortgage loans were packaged. What appears to have happened was when the market began to shift and began to appear that loans were defaulting; the buyers of these pools could not distinguish what classes had the possibility of defaulting. The entire pool was unable to be valued because there was no way to separate A paper from D paper. How did they ultimately become worthless is the real question?

Deposit Banks vs. Mortgage Banks

One first needs to understand the difference between lending money to sell into the secondary market the use of credit lines or hold in portfolio the use of depositor’s money. This is what fundamentally separates the pure mortgage banker from a pure deposit bank. A mortgage banker has short term lines of credit from large institutions that are used to make individual mortgage loans that are either sold one at a time or in a pool. The buyers of the loans eventually are sold to institutional investors (Wall Street) in very large pools -- for this discussion I do not include Fannie Mae or Freddie Mac. Mortgage bankers vary in size from small operations to large national operations. The large and mid-size mortgage bankers were the first of the mortgage lenders to become bankrupt beginning in August of 2007. The larger mortgage bankers had actually created new loan products that were packaged and sold into these pools. These loans were comprised mostly of subprime, Alt A loans and jumbo loans. For the most part these loans were adjustable rate mortgages because of the inverted yield curve at the time. One could classify all loans not backed by the government (conventional – Fannie / Freddie and Ginnie – FHA / VA) into this group. Mortgage bankers had been making these loans since the mid 1990’s. The market had become increasingly competitive over the past ten years with the explosion of these products. Therefore more and more loan programs were created to compete with older loan programs. All the major lenders jumped into this market, including large institutional banks creating divisions for mortgage banking purposes trying to carve out new niches to be profitable. For this discussion I am ignoring Fannie and Freddie and their foray into the Alt A and Sub-prime market because it is an entire article in itself. The deposit banker has the ability to make loans from its deposit base within guidelines defined by banking regulations typically holding 10% of the deposit and lending the remaining 90%. These deposit banks therefore can make portfolio loans up to a defined percentage of deposits at which point it will theoretically run out of money to lend without further deposits. Therefore most deposit banks also sell mortgage loans on the secondary market. Today the only A paper competitive jumbo loans on the market are made by deposit banking institutions for their portfolio. In a future article I am going to expand on why I think Washington Mutual failed but the main reason was it moved away from a portfolio lending philosophy to one that mirrored the giant lender Countrywide.

Secondary Market Stopped Working

Why were the mortgage bankers the first lenders to fail? The main reason for mortgage bankers going bankrupt, take for example American Home Mortgage a national mortgage banker the first major to go under, they had new mortgage pools to sell into the market and found their market closed. The inability to sell their mortgage loans, quickly led to their credit lines being closed because they could not meet margin calls. Why? The institutional banks that gave the originating lender a credit line wanted payments on these lines and when the lenders ran out of money because they could not sell these pools; were forced to sell all their loans at deeply discounted values – a fire sale. These fire sales tie back to the pools that already existed in the market. The owners of these pools were quickly questioned on the value of all the underlying mortgages via accounting standards. The first problem was the accounting rules that institutions had to mark these securities to market which I discuss further in the article. These existing pools now had to be marked to the fire sale market. This is what seized up the market in the first place. In essence all mortgages could not be valued properly and had to be valued at the deeply discounted value of the insolvent mortgage bankers. This created an increasingly negative spiral downward for the mortgage pools. At first I thought what was happening in late 2007, was the large institutions were eliminating their competition by increasing margin calls regardless of the class of mortgage assets being sold. I sat and could not believe that all non-government mortgages all of a sudden had no value. An example is Thornberg Mortgage. Thornberg was a recognized well operated mortgage banker that made loans to highly qualified borrowers with non-traditional jumbo loans. Thornberg is still in business today but has no competitive mortgage loan product to sell. But the questions from firms like Thornberg asked; how can Wall Street paint all mortgage loans with one brush? Thornberg’s argument was there is a real difference between our paper and sub-prime paper and the two are not equivalent. The questions and arguments went unanswered. But maybe Thornberg should have questioned the accounting methods imposed on Wall Street as well as whom the market believed the Government, the Fed, would ultimately back? Over the past few months we all have seen exactly which firms have been backed.