FINALLY – HERE’S WHAT HAPPENED TO OUR ECONOMY

As a Payback Time investor you should always be aware of what is happening in the market so that you can try to foresee when the market is being set up for a potential crisis. A while back I wrote that the blame for the credit crisis and the subsequent affect it had on the stock market should land on the shoulders of the people who didn’t repay their loans and the lenders who lent them the money. Everything else followed from those two sets of players. Many of you objected that I was letting Wall Street off easy. You were right. I was right. We were both right. Read on because here’s what happened. And if you want to know more, read a great book called The Big Short, by Michael Lewis.

 

1. The Federal Reserve lowered the cost of borrowing to prevent a recession. These cheap loans made real estate payments go down and real estate prices to go up because for the same money per month borrowers could afford bigger, more expensive houses. Real estate prices shot up and made real estate speculation seem like investing as people borrowed and bought houses to sell them and make profits.
2. At the same time, the Feds encouraged banks and mortgage companies to lend to marginal borrowers by threatening to sue banks for discrimination and by pushing Fannie Mae to buy more marginal loans.
3. Investment banks discovered they could bundle these loans and sell the cash flows from them as different mortgage securities with different risk and return levels. With the help of the rating agencies and the supposed subordination of the bonds some of these cash flows were even rated AAA. These bonds were a big hit with investors because they had a high rate of return and the (supposed) low level risk of a government bond. The big demand for these mortgage bonds encouraged lenders to do even more lending to even less qualified borrowers because they weren’t holding the mortgage — they were selling it to investment banks or the federal government and then using the cash to make more loans.
4. The worst of the pool of mortgages - the subprime mortgages - were harder to sell. The investment banks solved that problem by pooling all of the worst mortgages together into a mortgage bond and got it rated AAA as well. As Lewis puts it, “This was financial alchemy, turning lead into gold.” It was accomplished by the use of a mathematical formula that had worked for many years. The formula ‘proved’ that if you combine a lot of unrelated high risk loans into one big bond, the risk of the bond as a whole was quite low. The rating agencies and investment banks didn’t realize that subprime loans in California were, in fact, related to subprime loans in Florida by the fact that both were owed by speculators and the moment real estate started to level off, the borrowers would stop paying their mortgages. Formula in hand, the investment bankers convinced the rating agencies these bonds were AAA and then convinced AIG to insure them. The demand for these types of mortgage bonds worsened the problem as now there was a great deal of money earmarked to lend to just about anyone. (If you want to know more, Lewis really lays out the details on how the investment banks turned low quality loans into high quality mortgage backed securities.)
5. Still, there was no real problem yet because if these bonds failed, the investors would lose and then there would be less money to lend, which would shut down the machine. Not a good situation, but not a crisis.
6. Here comes the problem: Some very smart insiders saw the writing on the wall and knew that these risky bonds would default as soon as the real estate bubble burst. These investors wanted a way to profit if these bonds failed completely. But… at the time there was no good way to do that.
7. Several clever investment banks created an insurance policy against the default of the bonds and got AIG to write it for a small premium. AIG didn’t understand the risk these bonds represented, because they are in the business of insuring investments that rarely go bad. By buying insurance against the bonds defaulting, these investors would make a fortune when the bonds defaulted. Because they knew they were going to default.
8. Then these investment banks realized the insurance policy was just like the original bond. If the bond was good, then the insurance wouldn’t pay off. So they created a derivative of the bond insurance policy (which was already a kind of derivative of the mortgage bond, which was already a derivative of the original mortgages). This derivative acted just like the bond except with massive leverage. If the bond goes down, you lose beyond huge. This derivative was taking the other side of the smart guy’s short. In other words, they were betting that the bonds would stay solvent.
9. Just as they securitized the original mortgages, investment banks sold securities on these derivatives of derivatives of derivatives and got a portion of them rated AAA, too. The bond sales guys sold these things everywhere because they were AAA low risk and had a high return. They ate their own cooking and bought billions of dollars of these things for their own firms.
10. Then real estate did the inevitable and stopped going up. Subprime mortgage borrowers did what they had to do and started defaulting almost immediately, surprising almost everyone except the guys who saw it coming and had insured against it (went short). And the bonds started failing.
11. Investment banks lost billions and suddenly had no money to pay off their daily investing trades, which threatened to boil into a worldwide credit freeze. The situation became worse because the bonds that had been guaranteed by AIG weren’t so guaranteed after all because AIG didn’t have the money to pay up on the insurance policies.
12. Nearly every single major financial company threatened to go bankrupt, either because it made investments in securities that went bad, or because they could not get paid on their investments held by institutions becoming insolvent.
13. Our federal government decided to save all these firms and we now owe trillions.

The moral of the story? Depends on who you talk to, but as an investor I think we can conclude that the mere fact that everyone is doing something is a huge sign to not do it. Watch for signs. Is there a stampeding crowd? Think before you follow it. There’s a good chance it doesn’t know where it is going. When strippers in Las Vegas are paying mortgages on 5 houses (see the book), you might want to short real estate.

Just remember what we’ve learned over and over from history: Where there is massive greed, run the opposite way.

Now go play!

- Phil Town