Tuesday, September 30, 2008

The Problem with the Bailout

If, as I explained earlier, we have 12.5 million homes with negative equity, and many of them are owned or guaranteed by Fannie Mae and Freddie Mac, the Federal Government are now the landlords of up to 25 million people, assuming they are married couples. This spells disaster for the political system that allows incumbents to spend taxpayers money to buy votes. We should never put politicians in a position to make it easy for them to aid individual citizens monetarily.

Democrats are going to propose forgiving debts and it becomes easier for them to do it if they own the properties. How is the Federal Government going to be in a position of foreclosing on a voter? I don't see how this is going to work.

Now, it is understood that this bailout is meant to increase liquidity in banks. The bailout is intended to purchase mortgage backed securities from these banks in order to get them out of circulation. But I thought by purchasing Fannie Mae and Freddie Mac, we will be guaranteeing these mortgages, so the mortgage backed securities should be in decent position.  Why do we have to buy them at all?

Saturday, September 27, 2008

Coming soon-The Final Analysis

Over the last month, I have put together the timeline of events that led to the current financial crisis. I feel confident, I have an understanding of the mess we are in.  More importantly, I think the evidence is clear who is responsible. Finally, I have reached the conclusion people should go to jail. I will put together a final analysis and will try to disperse it to as many media outlets as possible.  Here is the outline of the problem.

I. Overview of the current financial crisis
A. Real Estate Values-Rapid Appreciation and Depreciation
B. Liquidity Crisis in the Financial Markets
C. Government Intervention
II. The Creation of the Housing Bubble 
A. Community Reinvestment Act
B. Government Sponsored Entities
1. Fannie Mae and Freddie Mac
a. mission
b. growth
c. failure
C. The Players
1. Banks
2. Borrowers
3. Government Regulators
4. Wall Street
5. Federal Reserve
6. United States Congress
7. Office of the President
D. The Financial Instruments
1. Mortgages
2. Collateralized Debt Obligations
3. Mortgage Backed Securities
4. Credit Default Swaps
5. Commercial Paper
E. Assigning Blame
1. Fannie Mae and Freddie Mac
2. Democrat Party 
3. Wall Street Greed
4. Contagion of World Banking System
F. Criminal Activities
G. Government Bailout
H. Effect on Economy
I. Where to Go From Here

Credit Default Swaps-Read this!

September 28, 2008, New York Times


Behind Insurer’s Crisis, a Blind Eye to a Web of Risk



“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.

As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.

The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.

Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.

Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.

Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.

A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.

Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.

Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

The London Office

The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.

The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.

But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.

Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.

He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.

At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.

When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.

Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.

Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.

The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.

Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.

Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.

These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.

At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”

Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.

Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.

Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.

Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.

Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”

Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.

A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.

An Executive’s Optimism

Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.

Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.

A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.

For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.

“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.

Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.

In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.

Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.

So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.

Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.

Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.

In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.

This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.

The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.

“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”

At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.

As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.

Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.

For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.

“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”

Friday, September 26, 2008

Credit Default Swaps-$62 trillion problem

The second shoe to drop. I am working desperately to understand this issue, but my gut tells me this is going to cost more than $1 trillion to fix the problem.

I know the seizing of the credit market has strong roots in the housing bubble, but I think something fishy is going on with these credit default swaps. These unregulated insurance policies were securitized and traded without a normal trading platform. There isn't a commodities board like the Chicago Board of Trade, for example. Two values exist for these which are also confusing. Some suggest the value as $63 trillion in assets. Others indicate only their total value as $2.5 trillion. Regardless, the trading of these stopped, and this had something to do with the market seizure.

Criminal investigations are being conducted by the Securities Exchange Commission and the New York Attorney General Andrew Cuomo.

The Credit-Default Swaps Market Starts to Shrink

Community Reinvestment Act

And all of my research leads me this the video.  It is a must see.  It sums up a damaging case against Democrats and Fannie Mae and Freddie Mac.

A passionate explanation of how the Community Reinvestment Act started the housing bubble is offered by Lawrence Kudlow on CNBC

I have tried to keep an open mind through my discovery of the entire issue. This video lays blame at the hands of Democrats and the Community Reinvestment Act which has it's mission to force banks to make loans to people who wouldn't ordinarily qualify. I don't know all of the details of this program, but these videos reinforce everything I have read and watched to date. With the information I have so far, I don't believe it was the only problem, but it seems very reasonable this was the major, initial contributing factor.

The sub prime mortgages were at the heart of the housing bubble because they created a larger pool of buyers (higher demand) than was actually in the market. With increased demand came higher prices. Higher prices brought speculation, from speculators, Wall Street and other mortgage lending institutions. Low interest rates set by the Fed fueled the growth of the mortgage buble.

None of this, however, would have started without bringing in $1.7 trillion dollars of sub prime mortgages through a program to "encourage" people to buy homes without being qualified. This encouragement was brought to bear directly from the Community Reinvestment Act. Take particular note to the "regulatory changes of 1995" section. It outlines the whole tragic mess as Wall Street "securitized" sub prime loans that fell under the CRA's guidelines.

I am trying to get to the bottom of the role of credit default swaps and how that plays into this problem. You can read my summary of the dire economic problems here.

Regardless, this is the best summary of the problem I have watched so far.

Thursday, September 25, 2008

The Solution

All these problems, what are the answers?

1. Delay the decision as long as possible in order to buy time and to make the most educated decision possible.

I have always lived my life with one principle in mind. Never spend a trillion dollars under duress. Whenever I spend a trillion dollars, I want to consider all options, understand all issues and make a very educated decision to reduce my risk, and prevent having to spend another trillion dollars on a bad decision.  

2. Never reward bad behavior.

People are a creature of habit. We all understand this principle because we took psychology in college. Ivan Pavlov proved through the use of his famous dogs that repetitive behavior creates a conditioned response. In human applications, if a person is rewarded for work well done, she is likely to duplicate well done work. Inversely, if a person is rewarded for work done poorly, he will look to duplicate shoddy work.

3. Keep it simple.

Politicians do not understand the world of high finance. If they did, we wouldn't be in this mess. Doing the same thing and expecting a different result would point to stupidity, so it is hard to expect our government to do this right. So the solution must be simple enough for Maxine Waters to even understand.

4. Accountability.

The first billion dollars should go to building a prison for all the people that got us into this mess. If Martha Stewart went to jail for 6 months for insider trading over $40,000 when she was worth $1 billion, a proportional relationship of jail time should be reserved for those who swindled the taxpayer out of $1 trillion.

Loan Modification Provision

Aaarghh. RepresentativeMaxine Waters, on Fox News, just said that the part of the bailout that was just agreed to is a "loan modification provision." My worst fears have come true.

Waters is concerned that people with a $3000 per month mortgage, who now can only afford to pay $2000, need to be able to get a mortgage reduction through this bailout.

Where is the personal responsibility? Now we are rewarding people who are unable to pay their mortgage. What are we saying to people scrimping and saving to pay their mortgages on time? 

If this is becomes law, heads need to roll. Over the last 5 years, as homes were increasing in prices, there were many who watched their neighbors overextend themselves, purchasing the latest big screen television, hot tub, pool table, Nintendo Wii, the latest SUV, and a host of other extravagant purchases, living way beyond their means by buying and refinancing homes that they could not afford.

Rewarding this behavior punishes those living within their means. This is immoral and should not be open for compromise.

Let me remind you of how compromise works. If a person wants to take all of your money, and you don't want to give up your money, a compromise means you gives up half of your money. My point is, there are good ideas and bad ideas. One should never compromise for the sake of compromise. A bad idea is always a bad idea. 

And rewarding people who overextended themselves is a bad idea.

Wednesday, September 24, 2008

Derivatives and Marked to Market Regulations

At the heart of the financial crisis crippling the global financial system is an accounting regulation gone awry.

It is called 'marked to market,' which requires banks to value their assets using fair market value instead of the purchase price or future value in their financial statements. The intent of regulators was to prevent banks from inflating their balance sheets as assets were overvalued in a declining market. 

A very basic understanding of how banks operate is vital to understand this issue.  Bank liabilities are deposits, money borrowed from the Federal Reserve, and shareholder equity. The major portion of a banks assets are the loans made to their customers such as car, auto, business and credit card loans. The other portion of their asset base is their cash or cash equivalent portfolio. Since holding cash generates little interest income, banks hold much of their liquid assets in securities such as Treasury bills and bonds issued by Fannie Mae and Freddie Mac called mortgage backed securities. Many larger banks even began writing their own securities called credit default swaps.

When the real estate market started to crumble, home values dropped in value by as much as 35%. Mortgage backed securities and credit default swaps, liquid assets which were bought and sold in the open market, became hard to value.  Banks didn't know how much these securities were worth. Rating agencies didn't understand how these derivative securities should be rated. What was rated as AAA, had underlying mortgages that were in foreclosure.  Even though these securities were paying a good rate of return today, they were losing value over time.

Suddenly, banks weren't able to sell these securities because buyers no longer understood how they should be valued and the market dried up. Suddenly, these derivatives didn't have any value.

Within the last 5 months, financial institutions reported billions of dollars of paper losses as they wrote down these securities to fair market value and were required to raise more money to meet their asset/liability ratio requirements. It was difficult to raise money when banks were taking significant losses. 

Banks access money in two ways. They can go to the Federal Reserve if they meet their capital requirements. In other words, banks need to have a 1:10 capital to asset ratio.  As banks wrote down the value of their assets, they didn't have enough capital to meet their requirements.

Banks alternatively raise money by issuing bonds called commercial paper. These short term securities have been considered very safe investments and allowed banks and large corporations to meet capital needs. As banks began to show massive losses, they were unable to issue commercial paper in order to meet their financial obligations.

When banks are unable to raise money, they can't lend money.  

And the financial system teeters on the brink of collapse.

Tuesday, September 23, 2008

Criminal Activity in Financial Crisis

What did they know and when did they know it?

With the financial system in total meltdown, it is good that politicians don't focus on who is to blame. But in time, it is important to know who is responsible for this mess and how soon can we build a prison to house them.

Once the prison is built, we need to transfer this gentleman and some of his friends to be the first guests.  (Chris Rock has a funny skit on the same subject)

But I digress.

Fannie Mae and Freddie Mac helped create this mess through the invention of complex derivatives. The criminal investigation should focus on inflating profits by allocating revenue to income versus reserves and the executives who profited from false tax returns.  Secondly, the creation of credit default swaps and mortgage backed securities were sold as a risk free asset and we need to know if these securities were sold by promising the Federal Treasury would assume the risk. 

When something this big hits, fix the problem first and go after criminal activity hard. Whoever was responsible for these derivatives needs to spend some time in the big house.

How to combat Sarah Palin's Experience

Matt Damon, the premiere expert on the experience it takes to be President, claims Sarah Palin doesn't have the experience to face down Russian President Putin.

The obvious question is, "and Senator Barrack Obama does?" 

But the farce of the experience question is found by asking, "who in Washington predicted the financial crisis, and how did their experience help in their predictions?"

Some politicians may have thought Fannie Mae and Freddie Mac had problems.  But not one politician thought it was a problem big enough to put this issue on the front pages of the newspapers until the crisis already hit.

If you look at Barrack Obama's acceptance speech in Denver, he didn't even reference the financial crisis our economy was in, only that George Bush and John McCain caused the slowing economy.  But what if Fannie Mae and Freddie Mac are the root cause of the problem?  Who is responsible for these companies?  Shouldn't our elected officials, be held responsible?  And shouldn't Barrack Obama, Joe Biden, and all elected officials be held accountable?  After all, they have the experience.

There is enough blame to go around, but one thing is certain, there isn't one politician, Republican or Democrat that can point to their experience and say they could prevent what Alan Greenspan called the "worst financial crisis in a century."

No, Sarah Palin doesn't have experience.  She hasn't been tainted by the get nothing done Congress.  She hasn't been tainted by the money laundering and the revolving door of corruption that is a part of Washington politics.  

Sarah Palin simply has the experience of bringing common sense to government.  She simply has taken on corrupt government politicians in her own party.  She has only fought to clean up government on every level she has been involved.

Sarah Palin's experience may be different experiences than Barrack Obama, but Washington needs experience based on common sense, not on the politics of blame and corruption.

Monday, September 22, 2008

Credit Default Swaps-Read This!

You don't understand how messed up our financial system is until you read what Warren Buffett thought about these four years ago.  Read this article and prepare to have your blood boil. Buffet calls the credit default swap system a "ticking time bomb."

Heads need to roll.  People need to go to jail.  Whoever was involved in this, whoever thought this was legitimate business must be punished.

Hunch on Stock Market--Too Much Money in Market

Has anyone really thought the problem with the financial system could actually be there is too much money in the stock market?

As millions of Americans now invest their investment portfolios in mutual funds, trillions of additional dollars are invested in the stock market, pushing up the prices of individual stocks. This causes many problems.  As institutional investors such as mutual funds buy large blocks of stocks, their demand has the ability of increase the price of that stock.  When they sell, they can bring the price of the stock down.  More money creates a volatility in the market as the price of the stock is valued by demand, not the underlying strength of the company.

As more money is in the game, even larger problems are created as stockholders are increasingly concerned about short term earnings.  Shareholders in the company are meant to insure the company makes good decisions, but officers of the corporations are paid off of quarterly and yearly results.  Who is there to make sure companies make good long term decisions? 

Over the last decade or two, revenue growth became more important than debt.  Purchasing companies by large debt issues became the norm.  Revenue become more important than earnings.  And mergers and acquisitions became an easy way to grow larger and increase market share.  Many companies came to believe diversification was the key to growth and they lost their focus.

Investment banks pushed initial public offerings to their preferred investors.  Of the last 90 IPO's, only 1 has a share value that is higher today than when it was offered.  In the meantime, billions were made by taking companies public. It doesn't make sense how a private company can create 500 million shares, release 10% of the shares for public sale, and suddenly have a market capitalization worth billions of dollars.  The hype of marketing these initial public offerings are so powerful, but the reality is the company still needs to make money year in and year out.  But in the last decade, too many of these offerings were just hype.

A single analyst for a ratings company or investment company can drop the market capitalization by billions of dollars. Simply lowering a rating from hold to sell by companies such as Moody's or JP Morgan can affect the price of the stock. Further, when large institutions begin to sell, the value of the stock is crushed.  

Because of this, great pressure is placed on companies to "pad" their earnings statements. Enron became the poster child of creating separate subsidiaries to "hide" losses in order to meet earnings targets for Wall Street analysts. 

I wish I could say this is an unusual tactic, but one has to look no further than to the Federal Budget.  Social Security is held "off budget" but is included in the Congressional Budget Offices reporting of the federal budget deficitas seen here, in order to pad the books.  As of this writing, Social Security taxes are approximately $200 billion more than is needed in the program.  This money is transferred directly to the general budget, showing we have $200 billion more in revenue than we really do.  So when you see that our budget deficit is $400 billion, it really is $600 billion.  

Back to too much money in the stock market.  I will be accused of simple minded thinking, but I really believe there is some strange thinking in our accounting standards and our financial markets that just don't make sense.

Let me explain it like this.  

How much would you pay for a company that makes $100 per year? If it was guaranteed to make $1000 over 10 years, the amount you would pay would not be $1000, the sum of payments, because if you invested $1000 at 7% interest, and invested the monthly interest income, you would have $3000 after 10 years, so you wouldn't pay $1000 because you would have a better return just investing the money in 7% interest accounts.  

It is for this reason, that if I have a company to sell to another private party, I am usually paid 7 times earnings.

But if you look at the stock market, stocks are trading at 30-50 times earnings.  This just doesn't make sense.  Further look at the dot.com bubble.  We heard things like "earnings don't matter."  Stocks were trading at hundreds of dollars per share on companies that didn't have income and didn't have a plan to ever make money.

Because there was so much money in the stock market, rational discussions of the value of companies have turned to irrationality.  It was this warning that Alan Greenspan called "irrational exuberance."  When underlying common sense is overtaken by rushes to make money, problems are sure to follow.

It is my belief the problem we are experiencing is caused by too much money in the system and overpricing stocks. Combine too much money, with the corporate mentality of building their quarterly earnings statements on accounting tricks in order to show investors paper earnings over actual sales and a real mess is created.  

And this brings us to the financial crisis we are in.  Fannie Mae claims to have made $6.3 billion in 2005, $4.0 billion in 2006 and lost $2 billion in 2007.  The casual investor (or any investor, really) doesn't have any way of determining what the real value of this corporation really is.  Fannie is really an insurance company.  How much of the income they made was set aside to take care of future obligations related to insurance payments made to cover future crisis?  Should that revenue be stated as earnings or simply reserves to be paid out at a later date?  This is a complex question, but if you an executive and are paid on earnings, it is only common sense that executives would want to claim as much revenue as possible as earnings, thereby increasing the pay they received.

This is exactly what happened.  Executives claimed as much revenue as they could as earnings, thus increasing their bonuses.  When more money was needed in following years, they didn't have the appropriate amount of reserves to take care of their obligations.  Suddenly, they were losing money by the billions.  (on a side note, look at how much money Fannie paid in taxes. This isn't going to be there next year, along with many other financial businesses, and this will leave a huge void on tax reciepts--meaning more deficits)

I don't know how to fix this problem.  But when people talk about greed, they are talking about Fannie Mae.

South Dakota Media and National Politicians

In the wake of the largest economic disaster of the last 100 years, I have noticed a real void of coverage from local media.

Where is the Argus Leader explaining timely news and local investigation of this federal bailout?  Where are the tough questions of Senator Johnson, Senator Thune and Representative Herseth-Sandlin?  

Do South Dakota reporters who work for the Associated Press, the major newspapers, or television stations have any understanding of what is going on? Do they even know enough about the world of high finance to ask intelligent questions to probe the Senators and Representatives of our state about the affairs of the world?

Here is a list of questions we should be asking our elected officials to know if they were asleep at the wheel.

Please explain how we got to the point where we have to bail out entire industries?

How do you think we could have prevented it?

What can you point to, or that you have done, to try to predict this problem?

Some have said we were 50 trades away from shutting down the world's economy.  Why weren't you talking about this last month, last year, or the last 4 years?

What do you know about credit default swaps?  mortgage backed securities?  credit debt obligations?

Have you ever wondered how a mortgage would pay 6% interest, but the underlying value of the derivative could return 15% or more returns? Does that confuse you?

Who is responsible for regulating investment banks? Fannie and Freddie?

Were they negligent in their regulation?  or do you think Congress was negligent in their oversight?

There have been calls to overhaul Fannie Mae, why wasn't this done?  

How can a company be making billions of dollars a year just 1 year ago, now be bankrupt?

What other problems do you foresee in the next 2 years?

How can the Federal Government continue to spend money it doesn't have?

If you say you want to pay as you go for any legislative proposals, how can you support a Presidential candidate that calls for increasing the size and scope of government?

When has the government ever predicted accurately how much a bill would actually cost?  

When the prescription drug bill was passed in 2003, it was estimated to cost $230 billion over 10 years.  Two years later, the estimate was revised to $1.2 trillion.  How can the American people have any confidence in governments ability to estimate costs?

Are you for increasing the size and scope of health care for all Americans? Medicare? Medicaid?

Are you for increasing the size and scope of Social Security? Why can't you just come out and say Social Security is broken, and will be bankrupt in 2017?

Are you for increasing the size and scope of federal education dollars?

Are you for increasing the size and scope of veterans benefits, teachers pay, police and fire pay?

Understanding earmark spending is only 1-2% of the budget, have you ever opposed an earmark?  What have you done to take on your own party to fight earmark spending?

Have you ever told a group in South Dakota that wanted money from Washington, "no?" If so, who have you told and why?

Is now the time to run for Congress bragging about how much you brought back from Washington?

Have you ever said, "South Dakota needs to get it's fair share from Washington?"  What is our "fair share" and what do you base that on?

Do you agree that Washington doesn't have any money?  that we are truly broke?

Oil Rises on Falling Dollar

Today oil rose $25 per barrel on the falling confidence of the dollar worldwide.  

People must understand when our government spends money we don't have, we have to sell bonds to raise the money.  The more money we need to raise, the lower value our dollar becomes around the world.  All commodities, from oil to corn, will have a higher price because the dollar isn't worth as much.

We can't continue to spend money we don't have.  Our national credit cards are maxed out.

Let's not forget, that as we go through this financial crisis, our country is in the middle of the first of many crisis we face.  My earlier post from August, The Economic Challenges, explains all of the other problems on the horizon.

The value of the dollar is going to sink further as we start to address these other problems in the next two years.  I believe the increased personal debt/foreclosure and unemployment crisis is going to be rearing their head soon as we tackle how to get the economy moving again.

The worst way to address this problem is to finance an economic recovery by using debt.  If we have learned nothing else from Fannie Mae, we should have learned we can't keep pushing debt into the future and taking profits today. 

But that is exactly what we are going to be asked to do.

My Observations of Politicians During Crisis

I now believe our government is only able to respond to crisis, not prevent them.

To understand government, you must understand...

... that 537 elected officials can't agree on anything.  To get the attention of all of these elected officials requires the problem to be big enough to move their other priorities, of which there are many, aside. If you have ever been on a committee, you know how difficult it is to get enough consensus to accomplish anything of value. By the time an initiative gets to the end of the process, often you won't even recognize the original initiative. The bigger the issue, the more difficult it is to agree.

...that there are very few elected officials that are experts in any one area.  I bet if you asked elected Congressman and Senators to explain how a credit default swap or a mortgage backed security worked (the underlying causes of the current financial crisis), most elected officials would have very little knowledge and a shocking lack of understanding of these complex financial instruments.  Yet they are responsible for laws and regulations of these derivatives and how these complex financial institutions work.

... there are thousands of issues for which an elected Congressman or Senator is responsible, along with raising millions of dollars, campaigning for election, and providing earmark spending for the town pool or city park. To be an expert on any of these issues is impossible. 

... that compromise is a costly endeavor.  The support of every Senator or Congressman can be bought for a price, and it usually is.  Do you ever wonder about those Senators or Congressman that are "moderates" in the middle?  They are in the best position to get every project they ever wanted.  Both sides are willing to give them what they want.  Have you ever wondered why they called the person who counts votes, "whips?"  Their job is to whip people into shape.  When the votes get close, the people holding out will get calls like this, "I would really like to help you with the Lewis and Clark water project, but we need you to vote to increase taxes on our new budget bill."

... that reform is virtually impossible because of the sheer size of government and the entrenched interests, lobbyists and money in politics.  The chances of changing anything is very remote--unless there is a crisis.

...that legislative bills in Congress are massive bills.  Small bills, tailored to just single issues such as regulation of Fannie Mae and Freddie Mac, are always included into much larger bills in order for Congress to add all of the other pork programs and special interest group legislation in the mix.  Large bills are the problem.  Small, targeted bills should be a part of reform in Washington.

And that is why government works best to respond to crisis instead of trying to prevent them.

Oh, and of course you should know that government never, ever, never, gets smaller.  It just gets bigger and bigger.  And suddenly $1 trillion just doesn't matter that much anymore. 

And that pretty much sums up why I am cynical on politics.


As of right now, the national debt is $9,670,880,065,762.  Each day, we add $1.84 billion to our nations debt.  As a result of the federal purchase of bad debt, the debt ceiling will be upped to $11.315 trillion.

You can see the current national debt here

As you watch Treasury Secretary Paulson on This Week with George Stephanopolis here, make sure you watch Rep. Boehner's and Sen. Dodd's reaction here.  Listen closely to them as they explain the seriousness of the situation.  When Republicans and Democrats are "willing to work together" there is something to take note.  When spending $1 trillion is better than the alternative, the alternative must have been very bad.

Let's recap the last week.

Former Federal Reserve Chairman called this "a once in a century crisis."

Now Representative Boehner says, "this could be the most serious financial crisis that the world has ever known."

In 1992, candidate ran on a simple theme, "it's the economy stupid."  He claimed that last four years had been the worst economy in the last 50 years

If he thought economic conditions were bad then, what must former President Clinton be thinking today?

Saturday, September 20, 2008

The Housing Crisis

According to the article below, one quarter of the mortgages in America, an estimated 12.5 million, have negative equity, meaning more money is owed on the home that it is worth.  

I predict Democrats are going to propose forgiving this debt. If you give a break to a homeowner in trouble, there will be thousands of homeowners on the brink of trouble.  Big government programs to help individuals will never be fair, and will never work. Every homeowner in the country will demand to get help.  

As we bail out entire industries who were making billions of dollars in the run up to this mess, large businesses and their leaders, need to pay for the pain the little guys are going through, but the moment transfers of wealth are passed out under the umbrella of "fairness," a line in the sand must be drawn.  In the end, every person that took out a mortgage in the last five years is responsible for the purchase they made.  If you reward people who got themselves in trouble, you punish those that kept themselves out of the mortgage mess.  

At that moment, you punish the wrong person.

This will be a good time to see through the pandering of the Democrat politicians as they see a trillion dollars being spent, and an opportunity to funnel those dollars to "the middle class" who, just coincidently may vote for them.

New York Times September 18, 2008

The Pain of Selling a Home for Less Than the Loan

Many Americans are discovering an unfortunate twist to the housing crisis: even after selling a home and moving away, they might have to keep paying on it for years, even decades.

With home prices tumbling, millions of people owe more on their mortgages than the houses are worth. If a new job or other life change compels them to sell, their choices include bringing a pile of cash to the closing to make the bank whole, going into foreclosure or cutting a deal with the lender to pay off the balance of the loan over time.

How sellers will react when confronted with these unappealing options is one of the biggest questions hanging over Wall Street as it tries to move beyond the carnage overwhelming such venerable firms as Lehman BrothersAmerican International Group and Merrill Lynch.

A sale for less than the value of the mortgage on a property is known as a “short sale,” because the transaction leaves a homeowner short of the funds needed to settle the debt. Agents and lenders say the number of short sales is rising markedly.

Reluctantly, banks are agreeing to let some short sales go through. But instead of writing off the unpaid portion of the debt, they want homeowners to sign a note promising to pay some or all of the balance due.

This was the situation confronting Mike and Linda Kelly, who needed to sell their house in the foreclosure-plagued Central Valley of California when Mr. Kelly got a new job 75 miles away.

CitiMortgage said it would approve a sale at that price, but at the last minute told the Kellys they needed to pay $166 a month for the next 20 years, a total of $40,000.

“When you are ready to participate in the loss, feel free to call me,” a Citi loss mitigation specialist, April Easter, wrote to them in an e-mail message.

Moody’s Economy.com estimates that about 10 million homeowners have negative equity, a condition known colloquially as being upside down or underwater. By next June, the forecasting company expects the total to rise to 12.7 million — a quarter of all homeowners who have mortgages.

Owners in this predicament who must sell, like the Kellys, have few alternatives if they are not flush.

“The first wave of foreclosures involved a lot of investors who just disappeared,” said Lance Churchill of Frontline Seminars, which teaches real estate agents how to negotiate with lenders on short sales. “Now, homeowners with jobs and assets are underwater and want to sell. The banks want as much as they can get, today or in the future, and the owners want to get away clean.”

This clash is a central aspect of the financial crisis engulfing Wall Street. During the boom, millions of mortgages were bundled into bonds that were sold to investors and banking houses. But with real estate prices falling and mortgage defaults rising, it has become nearly impossible to calculate the worth of those bonds, and investors are fleeing them.

Lenders like Citi — which has already lost more than $50 billion in ill-advised real estate-related ventures — are walking a tightrope.

If they do short sales without trying to extract anything from the sellers, everyone in the country who is upside down could try to wriggle out. The banks and bondholders will take a fresh wave of hits; some might not survive. But if a lender drives too hard a bargain, the owner can default, leaving the bank worse off than if it had taken the short sale.

“It’s a game of chicken, with huge consequences for the banks, the borrowers and the economy,” Mr. Churchill said.

Lenders’ demands take many forms. Mary Gonzalez, an agent in San Jose, had to stave off a request from a mortgage company that her client take cash advances on her credit cards to settle a mortgage debt. That lender eventually agreed to settle for a few thousand dollars.

At the other extreme, JPMorgan Chase says it wants short sellers to sign a note for the full balance due, with interest, over 30 years if necessary.

While there are no authoritative national numbers on short sales, a related statistic — the number of people selling their homes for less than they paid — is rising rapidly, at least in California.

In August, 54.2 percent of Californians who sold their homes suffered a loss, a sharp rise from 16.8 percent in August 2007. Today’s number exceeds the peak of 53.2 percent reached at the end of the last downturn in January 1996, according to the research firm DataQuick. (In some of those cases, the sellers may have lost their down payment without necessarily incurring a cash shortfall at closing.)