Greed

We are in a very complex and dire situation. By we, I mean Americans, and I also mean just about ever other developed country. We are growing closer to having a truly global economy, which is great when everything is going well, but it also raises the pain level when we hit rough seas.

How did we get into this mess? That’s a long story. In two words: we’re greedy. I’m not trying to be condescending, I’m a greedy person too. And not everyone is greedy, there are a lot of people living in developed economies that don’t care about material possessions and money, but by and large, we’re greedy people.

Mortgages
In the late ‘80’s “genius” investment bankers started packaging mortgages and reselling them. These investments, called mortgage-backed securities, were fixed income investments very similar to bonds. They were very profitable for the investment banks, but their real benefit was enabling banks to make more loans. For example, after the bank lent someone a mortgage, they would give them the cash and keep a piece of paper that was a promise to pay. In the old days, the bank would have to wait for the mortgage to be paid back before making another loan. Now, as soon as the borrower walked out, the bank would call the investment bank sell them the mortgage for 90 some cents on the dollar. The bank got their money back right away so it could make another mortgage loan and repeat the whole process over again.

The process described above had several effects. It increased leverage (the level of debt) in our society, banks we’re able to lend more, increasing the level of debt in our economy. It also made lending mortgages much more profitable. The increased profitability of mortgage lending led to many more mortgage brokers popping up, and growing much larger. The mortgage brokers were not banks, who relied on customer relationships, they just lent the mortgage, sold it to the investment bank (who sold it to investors) and moved to the next person in line waiting for a mortgage. These brokers (Countrywide e.g.), in many cases, skirted the due diligence they should have done on the person asking the mortgage, such as asking if they had a job, how much money they make, do they have other homes, etc. This is what led to the boom in subprime mortgages, mortgages lent to people in a not-solid financial position.

Why didn’t these brokers care that much about a lenders’ financial position? Well this is in the 2004 - 2006 time frame when it seemed that real estate value went up every single year. Therefore, if someone did not pay, they could foreclose and resell the house for more than the value of the mortgage. In order to entice more people to take out a mortgage, they offered mortgages that started with a very low interest rate for the first 2-5 years, the interest rate would then reset much, much higher, but that was in small print, after all, it was a few years off. Now not only could someone that wasn’t fit to have a mortgage get one, they could afford a really nice house too!

Now, it is unfair to blame the whole mess on the brokers. Many banks did their fair share of this practice too. Overall, however, banks (especially smaller and local ones) did a much better job of sticking to lending standards than mortgage brokers did. All you have to do right now to get a good approximation of how well someone stuck to lending standards and making good loans is to look at a stock chart. Compare U.S. Bank (USB) to Thornburg Mortgage (TMA) since January 2007.

Who helped make sure the whole securitization process ran smoothly? Well that is the job of Fannie Mae and Freddie Mac. Fannie and Freddie were government-sponsored entities that were created to help more people be able to buy a home. Then even Fannie and Freddie got greedy and started keeping some of these mortgages on their balance sheet to boost returns. It’s funny how the ones that didn’t fly off the shelves turned out to be some of the worst loans.

As you can see, our housing market saw quite the bubble form over the prior few years. As more and more people could get loans, they could pay more for housing, making the value of real estate inflate. These increased real estate values were really driven almost entirely by leverage. Leverage was not only at work with people and their homes, it was also at work with corporations.

Investment Banks
In addition to starting the mortgage securitization process and seeing a boon in that business, investment banks were also seeing pressure on their main business model. Investment banks are strategic advisors to companies. They get paid fees for things like: helping a company buy another company, issue stock, buy back their stock, etc. Many of the big banks also have a balance sheet (money to lend to companies). These banks would also make loans to companies to help them achieve their goals. The banks historically made a little by lending, but it was nothing compared to a M&A (buying another company) or IPO (issuing new stock to take a company public) fee.

The investment banking model is entirely dependent on relationships. All the investment banks have basically the same capabilities, with some variation, but that makes the bank getting hired almost entirely dependent on whether the company’s management likes it. Companies and banks acknowledge the give and take relationship. Companies need to borrow money, but banks don’t make a lot on lending money. However, the banks willing to lend money to the company when they need it coincidentally have the best chance to get the big fee engagements when the time is right for the company.

Over the last few years, up through July 2007, debt was readily available. Interest rates were relatively low, banks had lots of cash and companies knew it. If a company needed a loan, it would go to their main bank and say how much they wanted. If the bank said “no”, the company would go down the street to the next bank, the next bank would lend to them no questions asked and in the process put themselves front and center as the main bank ready to reap the big fees when they came along. Therefore, the main bank couldn’t say no. It would lose it’s customer before the “o” in no came out. Banks, like Citi, like JP Morgan, made lots of loans to companies knowing that they were going to lose money on the loan, but that was ok because they would make back way more then they were losing with the next big fee engagement.

Again, this business model, like lending mortgages to anybody works great as long as the economy is going strong. But, when the economy slows down, those big fee engagements don’t come along. This way of conducting business and the mortgage mess drove leverage to unprecedented levels in the history of mankind. Leverage, the level of debt, increases the risk of a firm going bankrupt. Purely looking at leverage, the risk of a going concern going bankrupt had never been higher than it was in summer 2007.

Credit default swaps
Credit default swaps (CDS) are a specialty financial product the essentially provides insurance on an asset defaulting. For example, if you bought a corporate bond you could buy credit default swaps and lock-in a return, albeit a smaller one. Credit default swaps have been used on all types of fixed-income assets, including many mortgage backed securities.

As our economy has levered up for the past several years, more and more companies, including insurance companies like AIG began issuing credit default swaps. It was, after all, a very profitable business. So we have increasing leverage, meaning and increasing risk of bankruptcy, or default, and some of the biggest financial firms are taking positions worth hundreds and hundreds of billions insuring against default.

Credit default swaps have become a favorite gauge of how likely it is that a certain bank will go under in these trying times. As the spread (the premium) on a given bank’s credit default swaps rises, so does the market’s perceived risk that the firm will go under.

Out of bounds
One of the major issues leading to this crisis is firms stepping out of their normal area of business in order to boost profits. AIG, unlike most insurance companies, began doing credit default swaps. Many bond insurers, like MBIA (ticker: MBI) who used to insure municipal bonds, started insuring mortgage-backed securities. The list goes on and on. Why did these firms enter new markets? Simple, there was a lot of money to be made. There is nothing wrong with that, this is capitalism after all. But in true capitalism it’s a live or die world, and if the firms that stepped over their bounds went bankrupt or almost went bankrupt, the next time new opportunities presented themselves, there would be a hell of a lot more due diligence done before those markets were entered.

But we now live in a world where firms can grow to be “too big to fail”. I agree, AIG was too big to fail. There were too many counterparties all over the world who had contracts with AIG, our financial world would be in chaos had the firm gone out of business. How have we not had a problem with this in the past? Is anti-trust growing more and more lax? Probably a little, but that is not the problem, AIG had lots of competition. How do companies like Citi and AIG operate in so many geographies, markets and products yet remain organized, focused and profitable and why wasn’t anyone ever able to do it before? Some would say they don’t, but if you give them the benefit of the doubt, the only answer is technology. We’ve never had a problem this big before because we’ve never had the technology to allow firms to grow as big as they are now. Our own advances in technology gave corporations enough rope to hang themselves, and many of them succeeded. Firms had the capacity to expand product offerings across more markets fast and more efficiently than ever before and handsomely increase profits. Stocks, bonds, all forms of money are not transferred in hard form anymore, they are ones and zeros going from computer to computer.

Firms took full advantage of technology and market conditions (low interest rates and a strong housing market) fill their greedy desires and maximize profits. There is nothing wrong with using technology to get bigger, taking advantage of market conditions or being greedy. This is capitalism.

The hammer
The sledgehammer that broke the proverbial camel’s back was the housing market. When the housing market turned downward in summer 2007, the value of mortgage backed securities went down because the value of mortgages went down. Some people’s mortgages were now worth more than the underlying home. Why pay it off? The economy was starting to weaken. At the same time, lots of those adjustable rate mortgages discussed above were re-setting to higher interest rates, making the interest payment unaffordable to many homeowners, driving more of them closer to defaulting.

As more of the mortgage backed securities weakened, first the mortgage brokers were hit hard, then the insurers. Now, with the credit default swaps through the roof, all the issuers of the credit default swaps are being forced to post cash collateral, driving them to insolvency (they don’t have any more cash)

What needs to happen?
We went through a multi-decade levering process that needs to be at least partially unwound. What does that mean? Profits will go down because businesses can’t finance expansion as regularly. This will drive stock prices down. Academically, as leverage increases, returns on equity increase and with it the firms’ stock price. That unwinding will take equities lower as well.

Am I saying the Dow goes to 8,000? No. But will the recovery be as quick as the drop? Not in my opinion. However, there are, and will continue to be tons for great buying in the stock market.

What will start the turn back towards a more normal state will be when the housing market begins to turn. That will ease some of the stress in the system. However, by that time we may be in a recession. Stay tuned.