Free markets? Part 2

My friends, we are indeed in a severe recession. But should we call into question all of our beliefs in capitalism? No. The issue we face is one of financial market collapse. The collapse was not caused by the complex but rather by the simple. Many pundits will talk about the “CDO with ABS,” and yes, there was excessive financial engineering. But the real root cause of our troubles rests with institutions which lent money poorly. In my last blog post, I discussed my own observations as a young MBA graduating with a degree in finance from Wharton. We believed we should use advanced mathematics and some of the new learning’s from physics to “measure and eliminate risk.”” As the Financial Times recently noted, we thought we could “complete the markets.”

What would be an example of the “slicing and dicing” of traditional investment vehicles? I have discussed the dismemberment of bonds. The other interesting case study is mortgages. Perhaps it is now self-evident, but for my parents, born in 1938, the only mortgage they knew included 20% cash down payment and a 30 years fixed rate. Of course today, we have zero down payment, and no payments until 2010! Radio advertisements that sound like furniture store sales tout 1% interest rates for three years with as little as 5% down payment. The absurdity is that it continues and yet this is what caused much of the problem!

But why would banks lend to people who don’t have a job, a down payment nor a respectable credit history? Well that’s where the slicing and dicing comes home to roost. Banks used to generate a mortgage loan (literally, you would go to the bank and apply for a mortgage and speak to a bank employee). Then the bank would keep that mortgage as an asset (they own the right to receive both interest and principal from you). They made these loans based upon the checking and savings deposits, and the Certificate of Deposit held. But today there has been a radical separation of the process AND of the mortgage instruments themselves. Banks and “mortgage banks” generate loans – they accept your application and sell you a product (see above). But they DO NOT hold them. Indeed, because they do not hold them, they are more risk oriented in their lending practices. But who would be foolish enough to buy mortgages with a high probability of default? The answer is institutional investors and sovereign nations. Why? Because they were bundled together in large denominations, say $100 million dollars, backed by “quasi-government” agencies and given an AAA rating by Moody’s. With 1,000 to 5,000 individual mortgages with a “Collateralized Debt Obligation” the risk had to be reduced…right? Well, not everyone was so sure. That’s where Fannie Mae and Freddie Mac come in. They GURANTEED these debt instruments. But why did they do it when the risk of default was higher than in the past? Because of the Community Reinvestment Act, signed into law by Bill Clinton and extended under George W. Bush. This allowed FNMA and FDMA to accept mortgages into their bundling programs when the borrower had less than 20% down and when the rates were not fixed, and indeed highly speculative. This was done in the name of “allowing every American the chance to own a home.” So much for progressive intervention into the market.

But I would be remiss if I blamed the government. My main point here is that the “Masters of the Universe” thought they could use math to eliminate risk and make the markets “completely free.” And they were wrong. They gave the financial markets a false confidence. Those who did not understand the models were too embarrassed to say anything, and when people finally did question them, they were marginalized because the money was flowing and who needs a curmudgeon around anyway.

Let me go into some more detail. Banks originate loans. Fannie Mae buys them and bundles them into large assets then sold in the capital markets, primarily by long-term investors like insurance companies, pensions and sovereign funds. At this point, banks are free to lend more money. They do not have the loans on their books. The turnover of mortgages accelerated.
More loans were being made against the same capital base as before. Hence the risk had to be increasing. Now what about the “collateralized debt obligations” purchased in the capital markets? Didn’t someone wonder about the risk of these large hybrids of fixed and variable rate mortgages, and other corporate debt? Yes. That’s where derivatives come in, and insurance products against default risk. Companies started to sell insurance policies to protect buyers of these “Collateralized Debt Obligations of Asset Backed Securities.” But contrary to the idea that financial engineering was “completing the perfect market,” these securities and insurance policies were not traded. Moreover, because there was no market, there was no regulation. Ironically, a large majority of these securities ended up back with the BANKS! But they were not on their balance sheets. Instead, they were placed in off-balance sheet entities called “Structured Investment Vehicles” or SIVs. Since these instruments were not traded, they were not evaluated or “marked to market.” They were not regulated. They were evaluated by complex mathematical models which held the fundamental assumption that “spreading the risk wide enough makes it go away.” In reality, two things happened: First, people who could not afford a home stopped paying; and second, the banks (both commercial and investment) found that they indeed held securities in which interest payments declined and loans suddenly became real estate from foreclosures. As the reality set in, the “house of cards” collapsed, and is still collapsing.

Is this Armageddon? No. If you want to know the truth, we could just start over. Don’t believe me? Please pick up a copy of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay which details the ponzi schemes of 1637 (tulip mania), the South Sea Company of 1711–1720, and the Mississippi Company of 1719–1720. Speculation led to a separation of financial markets from real economic activity. Sound familiar? We will survive, but trust me, it is likely we will do this again somewhere in the next 100 or so years…


Anonymous said…
I'm from nj and you'll be getting my vote. Intelligence over flamboyant showboating

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