Thursday, October 23, 2008

Where Americans Should have Invested their 401Ks

If you had purchased $1,000.00 of AIG stock one year ago, it would now be worth $49.00.

With Fannie Mae, you would have $16.50 left of the original $1,000.

With Bear Stearns, you would have less than $5.00 left.

If you had purchased $1,000.00 of Freddie Mac stock you would have $49.00 left.

If you had purchased Lehman Bros., you would have nothing left.

But, if you had purchased $1,000.00 worth of beer one year ago, drank all the beer, then turned in

the cans for recycling, you would have $214.

Based on the above, the best current investment advice is to drink heavily and recycle.

This is calleTd the 401-Keg Plan.


Oldschool said...

Financial Collapse for Dummies

Nothing is complicated.

An issue is most often referred to as "complicated" when truth is being obfuscated for some reason. When the response to a reasonable question begins with the phrase "it's complicated"; one can rest assured that he is about to hear either a blatant lie, or the that the respondent really doesn't know what he's talking about. If one has a sound understanding of almost any subject, it can be explained succinctly and clearly enough for anyone to understand

This is not to say that some subjects take more effort to explain and understand than others.

The current state of U.S. financial markets is just such subject. It's more complex than one line descriptives handed out by pundits and politicians - but no where near as complex as some high minded financial analysts would have one believe. Oddly, it just may have something to do with a "pig" and "lipstick."

OK - this will take about 15 minutes of sincere effort on the readers part, but here goes ...

First - The Players:

United States Congress
Mortgage (consumer banks)
Investment banks
Fannie Mae / Freddie Mac
Insurance Companies
Home buyers/depositors

What happened . . .

The U.S. Congress, following a long held public policy of promoting single family home ownership, put increasing pressure on the banking industry to make more loans available to historically underprivileged people. Traditional mortgage lenders resisted putting money at unusually high risk. Congress took action to "incentivise" risky lending.

1. They loosened the standards for the repurchase of mortgage securities by the Federally chartered "secondary mortgage" banks, "Fannie Mae" and "Freddie Mac."

2. They eliminated the statutory separation of "investment banking" and "consumer banking" allowing more competing capital into the mortgage lending market. Soon, traditional consumer banks were offering investment products, and investment bankers were opening passbook saving accounts. (This was probably inevitable, and not bad in itself. But it did increase the ability of this problem to spread quickly)

Money flowed into the housing market. Loans were made on what would be considered "risky" terms by conventional standards. Ok so far ? Most people understand the history of this debacle up to this point. But how do 5% of U.S mortgage defaults become an international monetary apocalypse?


In truth this is the point at which poor policy, market meddling, and immoral lending practices crossed the line into pure unabashed fraud, and criminality. This is the "blame" that no one seems to want to affix.

Mortgages were quickly sold back onto the secondary market.

That is, banks having made risky loans quickly sold them back to Fannie Mae and Freddie Mac.

These two Federally Chartered Corporations then bundled, and repackaged groups of loans into investment grade securities, and sold them on the open market as AAA rated Treasury Listed securities.

---This dear readers, is FRAUD. It is CRIMINAL. It is PROSECUTABLE. It is knowingly misrepresenting high risk investments as Federally backed low risk debt intruments. It's perpetrators should be imprisoned for life. Their actions have put the worlds free market economy at risk in a way that no terrorist attack could.

Of course, complicit in this crime are the same people that now tell us that only they can save us from their own deceitful, corrupt, willfully criminal behavior. Those people, of course reside in The Congress of The United States.

ok, enough drama for now, back to our story . . .

Financial Institutions all over the world bought these high yielding, low risk, investment grade securities. Many of the lenders who sold these risky assets to Fannie Mae, Freddie Mac, bought back the re-packaged securities and held them has high quality assets. They were actually allowed to use these securities to justify their ability to make more loans. Many investment banks bought these securities and further bundled, and repackaged them has high yielding investment securities.

For many years, these high yield, "low risk", securities demonstrated good performance and became popular investment products throughout the world. It is probably impossible to know how many dollars are actually invested in funds that are supported by these base assets - the original "risky" loans.

Because these were being sold by a "Government Entity" there was something of an implicit guarantee of the full faith and credit of the U.S. Treasury, although no explicit guarantee actually existed.

Often, investors buying these investment products from the "FM's" would be wary of the non- guarantee of the Federal Government, and choose to insure their revenue stream with an insurer such as AIG. Additionally, insurers sought to invest some of their premiums in high yielding mortgage backed securities.

All of this activity put huge amounts of available liquidity into the home mortgage market. The huge amount of available mortgage money put excessive upward pressure on the price of homes. This resulting inflation of the value of homes was also a major factor in what made these loans profitable. This is becomes a classic "bubble" situation, where the escalation of home prices was creating profit for the mortgage industry, thereby providing more available capital to lend, which in turn drove prices higher.

In short . . .

High risk loans (dare we call them "a pig") were being bought, aggregated, repackaged, and sold as securities by Federally Chartered companies which "implied" being backed by the U. S. Treasury. (Sounds a bit like "lipstick"). For a some time, these securities showed large gains, and provided liquidity for even more risky loans. Eventually, the rate of loan failures grew high enough to depress the market value of homes, thereby eliminating the source of gain in most of these re-packaged funds. Because the underlying asset values began to steeply decline, and "mark to market" rules were enforced; the once highly rated investment securities began to also erode in value.

As debt instruments began to default, creditors called in insurance policies that insured them. (Goodbye AIG)

As individual investment portfolios declined in value to reflect "mark to market" standards; investors fled the funds, called in their cash and looked for safer alternatives.
(Goodbye Investment Banks)

Banks were required to mark the asset values to almost nothing, dramatically upsetting their asset to loan to asset ratio and severely limiting their ability to legally make new loans.
(Goodbye available cash to normal borrowing customers)

As bank loan to asset ratios continue to decline, they risk not having available liquidity to even meet demand deposit obligations. That is, checks drawn on such banks could be refused, the bank declared insolvent, and depositors money become unavailable, creating a possible FDIC take over.

At the very end of this debacle sits the FDIC. The Full Faith and Credit of the United States of America that guarantees every dollar in every FDIC bank up to 100,000.00. Of course, like AIG - the FDIC has no where near the amount of available cash to actually cover a massive "run on the bank". If such a "run" were to occur, the obligation of the FDIC would force the massive "printing of money" by the Treasury and a massive devaluation of the dollar. In other words, apocalypse now.

That's where, we are rumored to be. One step from a national "run on the bank" which can only be prevented by the American taxpayers stepping in and assuming the mortgage holders position on the debt which underlies a vast web of world wide investment.

Will the "rescue" work?

Probably. If by "working" one means avoiding a total collapse of the monetary system. However, if one believes this will return inflated values to financial markets - not likely.

Was it necessary ?

Probably not. But politics has a way of making crisis out of problems when the political climate is most favorable. In any event - that is the stuff of another post. For now, in summary:

-Congress pushed for high risk loans to be made.
-Lenders sold the loans back to Fannie Mae, Freddie Mac
-Fannie and Fredie aggregated and repackaged the the loans, then marketed them as high grade investment securities.
-Banks and Investment banks bought the Fannie Mae securities, and often repackaged them further into various investment products.
-When loan defaults increased, housing prices dropped, decreasing the value of the loan securities, which by now permeated a vast world wide investment market.
- Congress & the Treasury Secretaty conjure up a "plan" that villanizes Wall Street, lionizes regulation, and socializes a vast segment of the US economy.

And this - they call a rescue.

Ted said...

Jim: love it.

James Bowie said...

You joke, but beer is a very smart buy before an economic downturn. When times are good, people drink, and when times are bad, people drink.

In the summer of '05, one of the best buys in town was Lakeport Breweries. 24 beers for $24 dollars; the stock did great.

KC said...

I must be missing something:

$1000 / ~$20 a twelvepack = 50 twelve packs

50 twelve packs x 12 beers = 600 cans

600 cans x $0.05 a can = $30

James Curran said...

Buddy. If your paying $20 for a 12 in the US, you gotta have your head read.

KC said...

I thought of that but the math makes no less sense in reverse:

$214 / 0.05 = 4280 cans of beer
4280 / 12 = 356 twelve packs of beer
$1000 / 356 = $2.81 a twelve pack

James Curran said...

You'll have to put your complaint in writing and address it to the blog joke committee. The committee will then get a government grant to study the relativeness of the aforementioned joke. Focus groups will be called in. Surveys will be commissioned and, after 2.5 years of polling everyday Americans at a cost of millions of dollars, Canada will still have a minority government.

sharonapple88 said...

Oldschool, if the subprime mortgage fiasco was the effort to give minorities the chance at ownership, it's failed miserable. Really, the whole thing was an exercise in greed.

By their very nature, subprime loans mean that the person getting them would have to pay higher interest rates because the person is more likely to default and therefore the financial institution was in its "rights" to charge more in interest. Often it appears as though there was a low interest teaser rate at the start of the mortgage and then the rate increased afterwards (to the subprime rate), and it's during this period that most people are defaulting on their loans.

Now, it would make sense to give someone a subprime mortgage if their background showed that they deserved one, but even if you equalized the credit rating, income, etc, low-income African-Americans were 2.4X more likely to get a subprime loan than a low-income white person. Upper-income African Americans were 3X more likely to get a subprime loan than a white person of equivalent income. Low-income Latin Americans were 1.4X more likely to get a subprime loan than a white person, and 2.2X when the Latin-American had a high-income.

Prime mortgages during this time had a rate of 6.2-6.8%.

Subprime mortgages could have a 2/28 rate -- where there was a fixed rate for the first two years, and then a variable rate for the rest of the term, usually with a margin (a few percent more). Most of the people taking these loans were able to pay off the first two years, but they were often crushed by the period after that. It's possible that if the extra tacked on were removed.

Having said this, the market could have survived the mortgage collapse.

(More in next comment).

sharonapple88 said...

What's really killing them are the credit default swaps.

The credit default market is about $45 trillion dollars -- twice the value of the entire New York Stock Exchange.

The mortgage market is $7.1 trillion.

(The top 25 banks actually had $13 trillion in these credit default swaps.)

Credit default swaps are insurance policies, but if they were actually called insurance policies, they'd be regulated.

Basically, speculators were trading these credits and the credits were larger than the things they were suppose to cover. There were actually CDS to cover other CDS.

As Matt Taibbi said about the situation, "[W]hat we're talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan. Which do you think has a bigger effect on the economy?"