Tuesday, September 23, 2008

At last the outrage? Goodie, lets get it on!

Don's recent message of outrage over the proposed $700 billion bailout of financial institutions hatched up by Paulson, Bernanke, and our administration was fairly typical of most that I have read from many diverse opinion makers. In fact, we are in the midst of a major bull market on "Outrage". No surprise here. If fed enough bullshit I assume you are going to start behaving like one...an angry one.
While it is currently being debated in congress, there has been much written in complaint about the plan and those seem to resonate amongst the letters to the editors as well.

Paulson's scheme is deceptively simple, buy up all of the crap derivatives that are constipating the system so that the credit pinch will be loosened up again. As always, the devil is in the details. The argument against the plan is that it bails out the very institutions that got us into this mess. (Along with many naive or willfully larcenous borrowers). These banks and investment houses are the creators, buyers, and sellers of what is known in financial parlance as derivatives. In addition, if this plan is set in montion, it isn't entirely clear how a repeat of the greed and avarice wouldn't simply repeat. There wil always be greed and avarice of course, but what have we learned that we might put in place to prevent these specific mistakes from being repeated?

Derivatives are financial instruments whose value changes in response to the changes in underlying variables. In the case of our mess, mortgages were pooled in large tranches which were used to issue Mortgage Backed Securities (MBS). The derivative nature of these securities is that their value is derived from the value of the underlying mortgages. There are various types of MBSs. The most common are Interest Only/Principal Only (IO/PO), Collateralized Mortgage Obligations (CMOs), and Commerical Mortgage Backed Securities (CMBSs). But there isn't a need to delve into these details here. An important point is that changes in interest rates can effect these derivatives in two distinct and contradictory ways. A reduction in interest rate will devalue the security (such as a CMO). An increase in rates will cause an extension of risk in the CMO. The value also drops because the cash flows must be discounted at a higher rate for a longer time to reflect that risk. These distinctions are even more pronounced between IOs and POs. In the case of POs, they are guaranteed the principal payments and offered a value at a discount (the spread). If the loan is paid in advance, the holders of POs receive their guaranteed payout just the same. Therefore they made their gains much quicker. IOs on the other hand, are clobbered by prepayments that occur when interest rates drop and refinance of the underlying mortgage, thus the prepayment, takes place. As a holder of the IO, you bear the risk of that happening, and are compensated for it in the discount structure. A side note to this is that IOs and POs are specifically intended to narrow the nature of an investor's bet. By breaking down a package of mortgages into two bets, the investor is able to choose which side of the interest rate forecast he believes in. This is the arguable value of constructing such derivatives. They allow the investment community a way to manage risk. Obviously it didn't work that way. That is mostly because all the way up the food chain, home buyers, mortgage brokers, consolidating banks, Wall Street Bankers, none of these are truly incentivized to care very much about the true valuation of the underlying mortgage, especially if the assumption is that property values are always rising.

The above is basically how sub-prime mortgages were packaged and sold to investors around the world. For eight years up to the Summer of 2007, we gorged on easy credit, (either as borrower, agent, loan packager, investor, or creditor) and excesses were rife. Mortgages written to non credit worthy individuals, with some written at 100% (and more) of the house value, were common. The rationale was the the lending institution was protected by the rapidly rising house values. The loan, it was thought, would never "turn over", meaning reach a value point where it no longer made sense to pay the mortgage. But as we all know now, it did. Now extend this to corporate borrowing. Over the past decade, the exponential growth of credit derivatives has created unprecedented amounts of financial leverage on corporate credit. Similar to the growth of subprime mortgages, the rapid rise of credit products required ideal economic conditions and disconnected the assessors of risk from those bearing the risk. (Imagine that..a cardinal rule in investing was broken by some of the top and most savvy investors in the world. The Lehman Bros. company and their ilk of Wall Street investment banks, The AIG insurance company, the Fannie Mae and Freddy Mac loan guarantee corps. all broke this cardinal rule.) Not only that, the deals were so complex, that no one can say for sure what the underlying values of these derivatives were, then, or now. (Which is why we should ve very dubious of the $ 700 billion figure.) So when liquidity dried up, and there was no market for these unknown derivatives, causing even more credit strictures all over the world, and extending into other areas of credit including student loans, and the meltdown is on. It is so severe that banks do not even want to loan to each other, unsure what the borrower's actual value should be. Enter the Fed and their money printing machine. Enter higher commodity prices (which are valued in dollars). Enter slowing of business, fewer jobs, etc etc.
So do these banks deserve to be bailed out, with the latest plan from the Bush government to buy up $700B of this crap with taxpayer money we don't have yet?
To me, this sounds like adding gasoline to the fire. But we are once again being led by fear. The fear vision coming from the Bush administration is basically the risk of an all out depression. Loss of jobs, dramatically reduced spending power, (all of these things are happening anyway). In other words, if we don't pay it forward, we will suffer the consequences of further precipitating a crisis beyond anyones control. I am getting sick and tired of this negative incentives (scred if you do, screwed if you don't). I am sick and tired of the Bin Laden images, and the excuses as to why we can't get him. I am sick and tired ...full stop.
So now the question becomes one of whether we believe this threat and believe in the solution. I have to be honest and say I do not know for sure, but obviously I smell old fish. It isn't within my capacity to perceive the threat anymore then I can perceive the solution. It sounds to me like being between the proverbial rock and hard place, which is exactly the kind of leverage Bush likes to have to get his way. I want to say "fuck you" to the whole deal and ask them to vacate the White House early. Good Riddance to bad rubbish. The thing that I know for sure is that it pisses me off that Bush will still get his pension, along with the rest of his gang. I think he owes us. I think he owes some jail time too.
It is also likely that the senior people at the banks, who perceived of this travesty, and ignored common sense at the very thing they are supposed to do best, will still walk away with pockets full of obscene pay and bonus packages, even as their workers are laid off in droves and Manhattan starts to look empty.

For a far better read on this topic I urge you to visit today's Paul Farrell column on Marketwatch. He has been on a steady diet of gall for some time now, and it hasn't affected his astute observational or writing skills. In the meantime, keep your powder dry. It is far to risky, in my opinion, to be in the market today, with perhaps the exception of tucking away some gold. And remember, the best way to express your outrage is to drive Bush, and anyone who even remotely sounds, looks, or smells like him, out of office in November.

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