Friday, October 24, 2008

The Foreboding Crisis--Government Debt

If there is a silver lining to the ongoing financial crisis it is the much needed wake up call and financial education being thrust upon the American people.

The lesson we must learn from this crisis is that you can not manipulate reality, whether you are an 'intentions are good' liberal or a 'greed is good' Wall Street executive. The reality is not everyone can afford a home and and you can't make 100% profits on mortgages that pays 6%, no matter how many traunches you slice them in. 

In the long run,  there is no free money. For the last 50 years, Americans have been told they can have everything they want, without the sacrifice required to achieve it. We are told we can have lower taxes and more government spending programs.

But those days are over. And that is the silver lining. 

Unfortunately, the silver lining is surrounded by extraordinary toxic doomsday scenarios. It is called the federal debt, federal deficits and the burgeoning cost of the promises our politicians have made for the last half century. Our falsely held belief in the American Dream, defined as the ability to remove fiscal sanity and long term responsibility in exchange for short term rewards and Federal Government largesse, is about to end.

It is not something I want to go into in much detail, as I can not do justice to the severity of the problem. The only thing I can do is link to The Financial Report of the United States Government. I propose that every politician that runs for office, must have read this document, been tested on their knowledge of this paper, and the results of those tests should be published in every newspaper and broadcast on every television and radio station in America. Further, I believe that before any person should be allowed to vote, they should read this document, in English just for spite, and be tested on their knowledge of this document, and proven a general understanding of the financial condition of America.

And before any group dare ask for money from the government, I would challenge them how we are planning on paying for the $59 trillion of unfunded liabilities our government is facing.

Wednesday, October 22, 2008

Deregulation by President Clinton?

Democrats are blaming Republicans for our current crisis because of their cry for deregulation. Deregulation is part of the problem, but new financial derivative products were actually deregulated by President Clinton, at the recommendation of The Presidents Working Group of Financial Markets. You can bore yourself for an hour here.

Government is unable to regulate markets, they are only able to assign blame after a crisis. Never has this been so evident in the emergence of complex financial derivatives created in the last 20 years.

The financial derivatives market consists of hundreds of trillions of dollars. Credit default swaps, a portion of the derivatives markets, consist of over $60 trillion dollars. They are underfunded, unregulated bets between two entities regarding the failure of a third business entity. They are not a security such as a stock or a bond, nor are they an insurance policy. This is important to know since regulations apply to the trading of securities, and the selling of insurance.

Why isn't there regulation of these out of control derivatives. Simply because of a law passed in 1999, on the recommendation of the Clinton Administration, to clear up the concern members of the Department of Treasury, the Federal Reserve, and members of the Clinton Administration had regarding the gray area of regulation of these derivatives. They argued and created into statute, through the passage of the Commodity Exchange Act, CEA, new rules to prevent oversight from either the Securities Exchange Commission, or State Insurance Regulators in order to encourage continual growth of these derivative securities.

I am not suggesting the CEA is the entire cause of the current financial crisis. However, it is clear that this is not a deregulation issue of the Bush economic package. When Democrats suggest the crisis is caused by Republicans deregulation measures and that we shouldn't want "more of the same 8 more years of Bush economic programs," they are clearly deflecting blame on Democratic proposals.

Tuesday, October 21, 2008

Health Care is Not a Right!

How far has political rhetoric sunk, when intelligent human beings believe that the best of medical care can delivered to all citizens, in what they refer to as a "right" of every American to quality health care, as Barrack Obama has said.

Just where, exactly, does this right come from?

Certainly not the same place as the "unalienable rights of life, liberty and the pursuit of happiness," as those, we believe, come from God. So does God give us the "right to free health care?" No, because if you believe that, then you must believe that people in Bangladesh are entitled to the same quality health care as Americans have come to expect. Further, to believe Bengladeshians have a right to health care, you must believe, that the wealthy countries must provide money to pay for it. It may be hard to believe, but many in this world actually think America should provide health care and other services to poor countries.

But isn't it, or at least shouldn't it, be a right for all Americans to have access to the best health care? 

To answer that question, we need to define what it means to have a right. "Rights" were first laid out in the Declaration of Independence, which disavowed the notion that the King has dominion over their subjects, but rather, God gives each of us intrinsic value, "certain unalienable rights," that can not be denied by any other man (or woman) on earth. 

Rights were further enumerated in the Bill of Rights, the first 10 amendments to our Constitution. Basically, the Bill of Rights are a contract between the people and government and they outline the power people are willing to give to a government. It is important to know, that none of these rights, cost any citizen any money. They are free of charge. Why? Because these rights are based on human freedom as outlined in the Preamble of the Bill of Rights about the concern for potential "abuse of powers."

So does health care constitute a right? It is not "given from God", nor does it apply to human freedom and the relationship between all the people and their government. In fact, the opposite is true, a right to health care for one takes away the right of freedom to another. Therefore, health care is not a right, but rather a "proposed entitlement." Politicians are pushing health care for every American because we live in the richest country in the world, they argue, and the least we can do is provide health care for every American.

Before we begin the debate of taking money from one group of "wealthy" citizens and giving it to another group of  "poor" citizens, it is important to begin the debate with accurate terminology. 

Health care for all is not a right, it is a welfare program. Once we pass a law to provide quality health care for every citizen (or non-citizen), we create an entitlement. Entitlements cost an ever increasing amount of money, and as with all entitlements, the cost estimates are always less than the actual costs.

Quality health care for all is a very costly endeavor, and it is never a good idea to begin a costly conversation with the lie that "health care is a right."

Friday, October 17, 2008

Hedge Funds-Another Bailout for the Super Wealthy

Hedge Funds, consisting of $1.2 trillion of investments, are being forced to liquidate their assets as losses mount and investors begin to pull out their money, injecting fear at a time of severe market volatility. The next round of market instability will come as these funds dump their highly leveraged portfolios. Massive losses (and some say another round of bailouts) will occur.

Read this short story here.

Is Wall Street Worth Saving?

I have always wondered how great civilizations simply disappear, only to be excavated thousands of years later by archaeologists revealing impressive mathematical and engineering marvels and elaborate and advanced construction projects.

As I begin to understand how Wall Street and the world of high finance works, I have begun to understand how civilizations must all eventually collapse. Civilizations crumble under the pressure from the sheer size and complexity of the organism it creates--itself.

I beg anyone to try to read and understand this article by the the International Monetary Fund regarding hedge funds. Pay special attention to how hedge funds make their 50-300% returns on their investments. They leverage their complicated derivative investments through the utilization of margin accounts at investment banks to the tune of 30-50%. Let me put that into understandable language.

Hedge funds often invest in derivative securities. They don't buy a stock for $100. They buy an option to buy a stock at $10. This way, they could invest $100, but control $1000. This would be a 10:1 leverage position. But their leverage doesn't end there. Instead of buying their options for $10, they borrow $9 from investment banks, (who borrow it from the Federal Reserve) and invest $1 of their own. Now the leverage position is 100:1.

This is sheer insanity. I can't believe this is the underpinning of capitalism. By a 100:1 ratio, the Federal Reserve is financing gambling with incredible stakes-the future of western civilization.

I am scared to say this, but the world of high finance is going to bring America to her knees. I wouldn't even know where to begin regulating this fiasco. Do you eliminate leverage accounts? If so, where do you stop? Leverage is the key to the capital markets. It is the key to our banking system. Once you begin to regulate, the financial capital of the world will cease to be New York City, but Tokyo, Shanghai, Dubai, or somewhere that has less regulation and less taxation.

In summary, I think civilizations begin to crumble the moment investment moves from an advanced civilization that is focused on stability to a civilization interested in growth. 

Today, America is more interested in stability than growth. American politicians are more interested in the security of its citizens (Social Security, Medicare, Universal Health Care, etc.) than in exploiting its natural resources for job growth. Capital flows to the area with the lowest regulation, lowest taxation, and the highest safety. Unfortunately, America is failing on all three fronts. 

I wonder who will discover America in 1000 years and say, now there was a great civilization.

Thursday, October 16, 2008

Sen. Dodd Calls Hearings? Seriously?

Chris Dodd, the Chairman of the Senate Banking Committee is holding hearings to get to the bottom of the financial crisis. He begins his hearing by defending, that is right, defending Fannie Mae and Freddie Mac. He claims that it was Wall Street, not Fannie and Freddie, that created the sub prime crisis. 

View the You Tube video here.

Set aside the fact that Sen. Dodd is culpable in the collapse of our financial system, as he received more money ($125,000) from Fannie and Freddie, and hundreds of thousands more from executives of these firms. Set aside the fact that, Sen. Dodd, received special treatment from Countrywide Financial in a sweetheart mortgage. Set aside the fact Sen. Dodd only mentions a two year period from 2004 to 2006. Nobody disagrees that Wall Street greed is part of the problem. 

Sen. Dodd should not be holding hearings, he should be under investigation. He should be interrogated by a panel looking into how this happened. He should be sitting right next the the executives of Fannie, Freddie, Wall Street banks, hedge funds and government oversight committees. He is just as culpable. 

A hearing into a problem by one of the players who helped create the problem is laughable, except it has left the whole world in financial turmoil. And it is not funny. It is criminal. 

I didn't think the approval ratings of Congress could go lower than 9%, but even "relatives and paid staffers" (as Sen. McCain explains Congressional approval ratings), are going to turn against Congress with hypocritical arrogance like this.

Wednesday, October 15, 2008

And the Pendulum Swings Left

The Democrat Party will win big for two simple reasons, the war and the economy.

What are their strategies? Interestingly, their solution to the former is their solution to the latter. The billions we are spending on the war will be spent in our economy.

America is spending nearly $700 billion per year on the defense of our country. During the Clinton Administration, the military budget was cut by $70 billion dollars to just $300 billion. The budget was balanced by Clinton, in large part, by slashing the defense budget and retroactively implementing a huge tax increase, spending some of those additional defense cuts and tax increases on social programs targeted at inner city spending measures.

I believe this will be the model of the Obama, Pelosi, and Ried Administration. How much will be cut out of the defense budget is a real question. As of today, we are spending $140 billion per year in Iraq and an additional $40 billion in Afghanistan. Obama has promised to spend more money in Afghanistan, and less money in Iraq. Just how much can be saved and how quickly will Obama pull out out of Iraq?

On the economy, Pelosi has proposed spending $300 billion on another economic stimulus package in the form of tax cuts for 95% of Americans, money we don't have, directed at people who don't pay taxes in the first place.

The Democrats are going to buy votes of those that don't have money by taking it from people who have it. 

I guess America is ready for this social engineering. This has been tried so many times before in many different countries such as all of Europe, Russia and all communist countries, but I guess we need to try it here again to discover this simple truth...

If you take from one individual and give it to another, you create a system that discourages individual productivity and prohibits change-the very thing Americans wanted.

Monday, October 13, 2008

How to win against Sen. Johnson

Vigorously call on Senator Johnson to call for...

1) a criminal investigation of Fannie Mae and Freddie Mac and all executives including Jim Johnson, and Franklin Raines.
2) a criminal investigation of ACORN and all other community organizations that were involved in blackmail and enforcement of the Community Reinvestment Act
3) a criminal investigation of the political activities of these organizations
4) a thorough investigation into the lobbying activities of Fannie Mae, Freddie Mac and ACORN and related organizations.
5) a criminal investigation of Democrat Senators Christopher Dodd, Barrack Obama and Kent Conrad for the ties to lobbyist money received from these organizations.
6) demanding their removal from any oversight of investigations due to conflict of interest in hearings to the causes of the economic crisis

We need to hear an explanation of how we got into this situation directly from Senator Johnson. We need to understand if he still believes in the social engineering required of banks by the Community Reinvestment Act.

The press needs to understand this economic crisis was caused by a housing bubble through the creation of loan products to people who would otherwise not qualify for mortgages because of a law aimed at forcing banks to make bad loans that were guaranteed by government sponsored entities in bed with Democratic politicians looking to buy votes and gaining access to "get out the vote" activists as mortgage recipients were often required to perform political activities to assist Democrat politicians. 

Further, Fannie and Freddie used extensive lobbyist activities to prevent much needed oversight and regulation of their business, even after being forced to restate earnings and proven illegal activities to financially benefit the executives at these firms. Corporations such as Countrywide Mortgage gave sweetheart loans to elected officials including Barrack Obama, Kent Conrad and Chris Dodd. Barney Frank needs to have a special cell in Prison Block A just for the arrogance to blame the failed Bush Policies of Deregulation when he knows it was Democrat Social engineering that got us into this problem in the first place.

McCain Plan on Housing is Wrong

Imagine you bought a $400,000 house 2 years ago and today it is worth $250,000. Let's say you put down 20%  so you owe $320,000. You pay $3000/month for your mortgage.

At the same time, your neighbor bought a similar house next door and financed 100% of his home. He owes $400,000. He pays $4000/month. 

He gets behind and defaults on his mortgage because he can't afford the payments. 

You make your payments on time.

The government writes down his mortgage to $250,000 and lowers his payment to $2500/month.

The government doesn't lower your payment, or write down your mortgage.

This is actually the proposal by Senator John McCain and Rep. Maxine Waters

Who do you shoot first? 

The neighbor, who has lived beyond his means and was just rewarded for it?

The bank, for making the loan to your neighbor and who was just taken over by FDIC?

Fannie Mae, because they encouraged the bank to lend your neighbor money because they guaranteed he would pay it back?

The executives that ran this Ponzi scheme, because they made millions knowing that if the economy crashed it would bring down the world as we know it?

Wall Street, because they bought his mortgage and traded it around the world making 30-100% returns on a mortgage backed securities where the underlying mortgage paid 7%?

Politicians, for being so arrogant and quick to call racism, they actually think they have the power to alter the laws of the marketplace through social engineering?

The McCain Plan to bail out mortgages is simply wrong and is a vote buying gimmick. It should be shot down. Fast.

The answer to this crisis is to foreclose on the homeowners who don't pay their bills. Put the house up for sale and let buyers buy homes at the present value. Banks need to loan money based on sound principles. No more social engineering. A message to Democrats: we are not the richest county in the world and we can't continue to pour money into social programs so you can get more votes.

Thursday, October 9, 2008

Dow 6000?

Many people have asked me what facts I base my Dow 6000 prediction and a prolonged 10 year recession.

The economy is heading into a recession. With dour economic news arriving on a weekly basis, every bad jobs report, housing report, missed earnings expectations report, bank failure, state government budget shortfall, terror attack will create instability in the stock market. Until people have a clear understanding of the problem, the stock market will continue to fall.

When will we understand the problem? Until the average investor understands the exposure every large company has with derivatives such as credit default swaps, we will have a shaky economy. I don't know how long it will take, but these are so complex that it could take years.

Government has failed. The long term obligations federal, state and local governments have made during the good years are going to crush the taxpayers to death. When an unemployed, single female Somali refugee with 5 kids can qualify for $36,000 per year for Section 8 housing allowance, $12,000 for medical expenses, $10,000 unemployment insurance, $5,000 free school lunches, $5,000 automobile and insurance credit, and many other programs, the system is broken beyond belief. We can not have a system that pays $68,000 just for living in this country. When we have refugees who lived on $300 per year in their own country, come to our country and cost American taxpayers the equivalent of 20 taxpayers IRS payments, something is wrong.

Until politicians stop calling America the richest country in the world, we will have a recession.

I predict it will take 10 years for us to figure that out.

I will add links to stories of impending collapse of the economy...

Wednesday, October 8, 2008

Housing Crisis-Good Solution vs. Bad Solution

John McCain proposes a mortgage bailout solution which would have the Federal Government buy bad mortgages from banks, then refinance the homes at the current market value and reduced interest rates. 

Of the 75 million single family, owner occupied homes in the United States, 12.5 million homeowners owe more than what the home is worth. Homeowners in a negative equity position are upside down by between $350 billion and $1 trillion. Up to 10% of these homes are in a default or foreclosure situation. The costs of foreclosure and sales commissions to sell these homes would be an additional $41 billion.

In many metropolitan areas, home prices rose by 100% in the last 5 years. Homes that were selling for $300,000 in 2002 sold for $600,000 in 2007. Now homes are selling for $450,000. These home values are still falling. Many people bought the homes at $600,000. Many others refinanced their homes, or took out a second mortgage up to their new appraised value of $600,000.

With all of these homes upside down, how does the government think it would be appropriate to simply reward the homeowners who are defaulting on their mortgages? Is this really what we want to reward? How would it be fair for the US government to bail out certain homeowners, without bailing out all of them?

When the government allows a person defaulting on their $600,000 mortgage to rewrite the loan at the current value of $450,000, the government rewards the irresponsible. The poor schlep next door, who is in the exact same position, but is making his payments on time, is being told they should live with their current situation. This is so immoral. The government should never, ever, punish the law abider. The rule of law is being thrown out the window. When a person signs a contract, that contract must be enforced. 

So what can be done to fix the housing crisis? First, politicians must understand the problem. Demand was artificially propped up by wrong headed Democrat programs that encouraged home ownership and low interest rates from the Federal Government. Increased demand artificially increased prices.  As foreclosures increased, demand began to fall and now supply is larger than demand. Until supply equals demand, prices will continue to drop. 

Prices must come back to pre bubble prices. The following chart illustrates the average home price has fallen dramatically, from $275,000 to $215,000. In order to fit into the historical, inflation adjusted average of $165,000, home prices have to fall an additional $50,000.

How can we increase demand? First, housing prices must stabilize. Prices have to reach a point where buying is a better alternative to renting. Second, the people have to have a firm understanding of the short term outlook on the economy. Third,  banks have a difficult time making loans in a falling market. Requiring a 20% down payment will once again be standard banking procedure. 

To understand how long this problem will continue, you must understand the housing bubble.

1. This plan punishes those that pay their bills by allowing their neighbors who got themselves into a position of losing their homes. 

2. The Federal Government can't be in the business of bailing out private industry. Banks lent the money, they need to stomach the losses, or else they need to fail.

3. Politicians are incapable of doing the right thing. Imagine the Internal Revenue Service forgiving the debts of the people that owe the money. It would never happen. But when it comes to forgiving the debts of private citizens, politicians are more than willing to forgive the debts of people who could potentially vote for them. This has to be against the law. We can not allow politicians to buy votes.


John McCain will direct his Treasury Secretary to implement an American Homeownership Resurgence Plan (McCain Resurgence Plan) to keep families in their homes, avoid foreclosures, save failing neighborhoods, stabilize the housing market and attack the roots of our financial crisis. 

America’s families are bearing a heavy burden from falling housing prices, mortgage delinquencies, foreclosures, and a weak economy. It is important that those families who have worked hard enough to finance homeownership not have that dream crushed under the weight of the wrong mortgage. The existing debts are too large compared to the value of housing. For those that cannot make payments, mortgages must be re-structured to put losses on the books and put homeowners in manageable mortgages. Lenders in these cases must recognize the loss that they’ve already suffered.

The McCain Resurgence Plan would purchase mortgages directly from homeowners and mortgage servicers, and replace them with manageable, fixed-rate mortgages that will keep families in their homes. By purchasing the existing, failing mortgages the McCain resurgence plan will eliminate uncertainty over defaults, support the value of mortgage-backed derivatives and alleviate risks that are freezing financial markets.

The McCain resurgence plan would be available to mortgage holders that:

· Live in the home (primary residence only)
· Can prove their creditworthiness at the time of the original loan (no falsifications and provided a down payment).

The new mortgage would be an FHA-guaranteed fixed-rate mortgage at terms manageable for the homeowner. The direct cost of this plan would be roughly $300 billion because the purchase of mortgages would relieve homeowners of “negative equity” in some homes. Funds provided by Congress in recent financial market stabilization bill can be used for this purpose; indeed by stabilizing mortgages it will likely be possible to avoid some purposes previously assumed needed in that bill.

The plan could be implemented quickly as a result of the authorities provided in the stabilization bill, the recent housing bill, and the U.S. government's conservatorship of Fannie Mae and Freddie Mac. It may be necessary for Congress to raise the overall borrowing limit.

Friday, October 3, 2008

Let the Blame Game Begin

Nothing bothers me more about Washington politics than the atmosphere that nobody is ever responsible. 

I am continually amazed how Congress has a 9% approval rating and has a 98% reelection rate. It is because nobody is able to hold people accountable for their actions. We need to begin a new dialogue. Not only should we hold elected officials accountable, but we should hold our elected officials accountable if they don't go after the politicians that are part of the problem.

Here is a case in point. Stephanie Herseth had nothing to do with the current financial crisis. She has only been in Washington for 2 years. But she should be held responsible if she doesn't hold Barney Frank, (D, MA) accountable.

Barney Frank, more than any other elected official in the US House, is to blame for the current financial crisis. If you think I am being partisan, read this article by Jeff Jacoby, a Boston Globe journalist from Frank's home state of Massachusetts. Jacoby outlines Frank's pushing of lowered credit standards for Fannie Mae and Freddie Mac. In 1995, Jacoby predicts two things. First, this was going to end up in a systemic crisis. Second, he predicts that Congressman Frank would never take the blame for the problem. He was right.

This is Barney Frank's assessment of the financial problem this month, "the private sector got us into this mess, the government has to get us out of it."

The reason Congress has a low approval rating is that it is difficult to pin the blame on anyone. Look at this article by a journalist who called out Frank. Now look at Frank's rebuttal here. Frank makes it look like he was the one that wanted reform! How preposterous.

Everyone knows Fannie Mae and Freddie Mac were Democrat Corporations as is witnessed by who worked for the organization, who they gave political contributions, and how they funded political activities of the Democrat party to the tune of billions of dollars. You can read more of this corruption in my previous post here. Here is the actual story of corruption.

Make no mistake, Barney Frank is inextricably tied to Fannie, (pun intended) as you will see in this article.

If ever you should be outraged, this is the time. Barney Frank has to go. Stephanie Herseth better speak up against this buffoon or she needs to go too.

Thursday, October 2, 2008

Working Paper-Financial Crisis

Understanding the Financial Crisis Facing America 

(In Layman’s Terms) 

By Neal Tapio

September 26, 2008


This paper is written for those justifiably outraged by the $800 billion taxpayer bailout of Wall Street financial institutions in order to understand at whom to direct our anger, to prevent it from happening again and to hold those responsible accountable.

The American taxpayer was backed into a corner by a government that failed to properly oversee it’s own government sponsored corporations (Fannie Mae and Freddie Mac) that practiced social engineering; and a prevailing greed on Wall Street caught up in a Ponzi-like scheme in order to inflate their quarterly and year end financial statements, thereby pocketing billions.

Unfortunately, a bailout (in some form, not necessarily the current form) is necessary because the financial system of the world has become so interconnected. In forms of retirement accounts, pension funds, and insurance funds, the value of our stock market affects nearly every American and millions around the globe. If this crisis didn’t affect so many average Americans, I would say “hang the bastards.”

At the core of the crisis are falling home prices, defaulting home mortgages, and investments in securities related to the home mortgage and housing crisis in the form of bonds called mortgage backed securities. Home mortgages have been financed and secured through these bonds and the ability to sell these securities (liquidity) is crucial to our entire financial system. As home prices began to collapse, it became difficult, and almost impossible, to issue new mortgage backed securities and sell those previously purchased.

It is necessary to 1) prevent the collapse of financial markets and the stock market, 2) protect the liquidity of the mortgage markets by protecting the secondary market, and 3) infuse liquidity in financial institutions such as banks, investment companies and insurance companies invested in these failing mortgage related securities.

The American taxpayer has been asked to prevent a collapse of confidence in the financial system. But should we have confidence in the system? The answer is clearly “no.” Underlying the financial industry of the western world is a complex web of high finance which has become nothing but a Las Vegas style craps table as unregulated hedge funds, pension funds, investment banks and insurance companies have used credit default swaps, a complex version of dice, to create a complicated web of “insurance.” The American taxpayer should be and is outraged by having to bail out entire industries that gambled the confidence in the American financial system, and lost.

This paper is intended to help understand how we have gotten to the point of collapse and to understand the upcoming challenges we face as a nation. Before we pass a trillion dollar bailout, it is important to understand the underlying issues surrounding our economic crisis.

The precipitating event that led to this financial crisis is the bursting of the housing bubble in late 2006 and early 2007 as home prices peaked after appreciating in value for the previous 30 years. It is important to understand how this housing bubble was created and why the bubble burst. As of today, housing prices have fallen 35% in many metropolitan areas and it is unlikely to bottom out any time soon.

Understanding the mortgage business.

It is important to understand the complex business of mortgage lending and how it has changed over time. Local banks and savings and loans historically wrote mortgages and held those loans for the duration of the contract. The bank determined the ability of the borrower to pay, and assumed all risk associated with the loan.

Money deposited in the bank was used to fund the loan. These mortgages were “conventional loans” meaning that the borrower came up with a down payment of 20% of the home value. If the bank had to foreclose on the mortgage, the bank was able to use the borrower’s portion of the equity to recover their investment to sell the home.

Today, the mortgage business is dramatically different. Mortgages are still written by local banks or mortgage brokers, but the mortgage is often sold on a secondary market to servicing banks that send out the statements and collect the payments, of which there are large players such as Wells Fargo, Citibank, and Countrywide Financial. Servicing banks, in turn, sell the “rights” to the mortgages to government sponsored entities (GSE) such as Fannie Mae and Freddie Mac or other financial institutions. The purpose of the secondary market is to move investment money from investors all over the world, back to a local commercial bank, which allows them to make additional mortgages.

Fannie Mae and Freddie Mac are at the heart of the mortgage meltdown. Half of the mortgages in the United States are either owned or guaranteed by these two government sponsored entities. Their entire purpose is to create liquidity in the mortgage market. Fannie and Freddie, as they are known, purchases the “rights” to mortgages, then pool them together to create a large bond fund called mortgage backed securities (MBS) which are rated based on their risk and sold, all, or in part, to investors such as commercial banks, investment banks, hedge funds, private equity funds, insurance companies and pension funds in America and around the world. The principle and interest from the underlying mortgages, less servicing and guaranty fees, are passed directly to the bondholder.

Mortgage backed securities written by Fannie and Freddie are guaranteed, implying they were very safe investments. If the mortgage payment was not made, Fannie and Freddie would make the payments. Since these were government sponsored entities, many people believed the MBS was backed up by the full faith and credit of the United States Government. Since homes, the underlying security, had not decreased in value for over thirty years, they were considered very safe investments, were bought and sold with regularity and were a safe alternative to Treasury Bills, which didn’t pay as high of interest rates. Many pension funds, insurance companies, commercial and investment banks, hedge funds and international sovereign funds invested their available cash in Fannie and Freddie MBS.

Mortgage backed securities were also created by commercial banks and investment banks that purchased mortgages from the originating banks or brokers. These mortgages were pooled together and a bond fund was created and individual securities were sold to their customers. These bonds were given a rating, either by an independent ratings company like Moody’s or Standard and Poor’s, or by their own underwriters. These banks then bought “insurance” on these bond funds called credit default swaps (CDS).

The Housing Bubble

Although the ingredients of a housing bubble were already in place, for all practical purposes, the housing bubble started September 11, 2001. Desperate to stabilize the economy after the largest attack in our history, the Federal Government encouraged Americans to spend ourselves into prosperity and take us through a very difficult time as we went to war in Afghanistan and Iraq, as well on the broader war on terrorism.

The quickest way for the Federal Government to infuse money in the economy was to encourage home ownership and home improvement by lowering interest rates charged to banks, who in turn, passed on lower interest rates to customers.  Millions of Americans took out loans as a result and the Federal Reserve effectively pumped trillions of dollars into the economy.

As the Federal Government increased the pool of money available, they also attempted to increase the pool of buyers by allowing those with poor credit and little money to purchase a home.

The Community Reinvestment Act (CRA) was signed into law in 1977 by President Carter to create affordable housing. By forcing banking institutions to finance investments that otherwise wouldn’t be made, a socialist policy of taking from the rich and giving to the poor was written into law.

Fannie Mae and Freddie Mac are government entities created by Franklin Roosevelt in 1938 to purchase mortgages from land banks in order to provide cash to local banks struggling from high delinquency rates in the Great Depression, particularly farm mortgages. In 1968, Fannie Mae and Freddie Mac became a quasi private corporation called a government sponsored entity.

In 1993, President Clinton altered the course of mortgage lending by adding teeth to the CRA and altered the direction of Fannie Mae and Freddie Mac forever. He ordered new regulations that went into effect in 1995 demanding banks meet quotas for the amount of loans made to inner city neighborhoods and distressed rural communities. President Clinton’s policy enabled community organizers such as ACORN (Association of Community Organizations for Reform Now) to become quasi government bank watchdogs and used strong-arm political pressure and blackmail to force banks to comply with making risky loans. Because of this law, home ownership by minorities increased greatly during the late 90’s and early 00’s, but, as we shall see, at a very heavy price.

Fannie Mae and Freddie Mac were commissioned to purchase and guarantee mortgage loans to poor credit risk applicants in order to meet pre-established quotas for neighborhoods along racial boundaries. Further, banks were encouraged to lend to people with poor credit and little money by utilizing risky mortgage lending tools such as adjustable rate mortgages (ARM’s), interest only loans, stated income loans, reverse amortization, stated income loans and 100% financing loans.

As mortgage standards were relaxed, more buyers entered the market than any time in our nations history. These buyers purchased entry level homes, which set off an unprecedented chain of events. People moved from their smaller homes into much larger homes. This increased demand, caused by enticingly low interest rates encouraged builders to build a record number of homes. As more new homes were built, land prices doubled, tripled and even quadrupled in many areas. Vacant lots in metropolitan areas that used to sell for $50,000 were being sold for $300,000. More than anything else, land appreciation pushed the home appreciation rate to 20-30% per year in some areas.

Once the demand increased, home prices began to skyrocket.  As homes became more unaffordable to buyers, banks relied on even riskier loans called a reverse amortization loan, which allowed buyers to pay only a portion of the interest, and place the additional interest on the back end of the loan, the most insane idea of all.  For every month someone lived in a home, they owed more than when they moved into the home.

On a dual track, as home prices soared, homeowners were encouraged to take out 2nd mortgages to take out equity from their home up the new "appraised value.” Trillions of dollars of equity was removed--and spent in our economy.

As home prices continued to rise, builders continued to build homes as fast as they could.  A speculative component sent home prices even higher.  Speculators--people who bought homes and just sat on them became 15% of the home buyers market.  Their goal was to hold homes for a year and sell it for the home appreciation profit.  These "flippers" had the effect of artificially increasing the price of homes.

All of this is bad, but it gets worse. Mortgage companies specializing in sub prime mortgages such as Countrywide Financial aggressively marketed Fannie Mae backed loans adding to the demand for homes and further increased prices.  Sub prime is a polite way of describing higher interest loans to people with a history of bad credit or who otherwise would not qualify for mortgages.  

Finally, the worst mistake of all.  Home prices began rising at such a fast rate, banks began to believe that homes were going to appreciate forever--and 100% financing was born.  Buyers were stretching into homes they couldn't afford and were not required to come up with any money for a down payment.  This is as far as banks could go to stretch to help people get into homes.  Or so we thought. Banks began to refinance loans up to 110% of their value.

And then people began to default on their mortgages and things began to unravel in the fall of 2006 as home prices leveled and began to fall. As of today, home prices have fallen drastically, in some regions up to 35%

The Housing Bubble Burst

In early 2007, the first shock to the banking system hit when sub prime loans began to see higher default rates. The defaults were, in part, due to large increases in the borrowers monthly payments as adjustable rate mortgages they were sold in 2o02 through 2005 readjusted to market prices.  Without the ability to refinance these homes at similar interest rates, their payments rose dramatically.  As borrowers began to turn in their keys, banks holding these loans began to get homes back through foreclosure.  

The matter got worse. Banks specializing in sub prime loans began to be watched by regulators, which began to demand stricter lending standards.  When these banks couldn't write more loans to outgrow the debt in their portfolio, they collapsed in the fall of 2007 and became the first domino to fall.

As a result of the sub prime mortgage business collapsing, a large portion of the buying public was taken out of the market.  As the bank regulators tightened up lending standards, specialty mortgages such as adjustable rate mortgages and 100% financing went out of fashion, more of the buying public was taken out of the market.  

Once the prices started to fall, another large segment of the buyers fell out of the market. Speculators no longer could make money in a level or falling market. Fifteen percent of the buyers of new homes withdrew from the market.  By the fall of 2007, new home values started to plummet adding to downward pressure on the price of homes.  Since builders were building spec homes at record levels, there was an oversupply of homes.  In order to keep their sales strong, special incentives and huge discounts were being offered.  By the spring of 2008, home values shrunk 35%.

The loss of home values placed the owners of 12.5 million homes in a negative equity position in their mortgage.  Buyers who purchased a home a year ago for $600,000, found builders selling the same home for $400,000.  Home appraisals became a large focus of bank regulators. With many people upside down in their mortgages, and in houses with payments they can't afford, homes no longer became a liquid asset like the previous 30 years.  Banks began to tighten up their lending standards further, effectively drying up the mortgage market. It got to such a point that banks stopped writing jumbo loans over $400,000 for over a two months.

With home values plummeting and foreclosures increasing, Wall Street and the world high finance became unraveled.  Fannie Mae, you remember, creates liquidity in the mortgage market. As defaults increased, Fannie was on the hook for guaranteeing half of the mortgages held in the United States.  This caused a run on Fannie, and they were not able to keep up with their loan guarantees. Fannie paid more than $12 billion to pay mortgages that were in default.

This sent a shockwave throughout the mortgage industry and the secondary market for mortgages began to dry up.  Fannie Mae was not able to purchase as many loans with their tighter lending standards, but more importantly, they were not able to bundle the loans and sell them as mortgage backed securities.

From the spring of 2006 to the fall of 2007, we saw a tightening of credit, less home buyers, higher default rates and a liquidity problem in the secondary derivatives market.  Add to that rising gas prices, an endless drumbeat of bad economic news, an expensive war in Iraq and Afghanistan, American consumer confidence hit an all time low, and we entered a perfect storm that further reduces the confidence in the home buying public.

Today, we have too many homes available for sale, less qualified buyers, and a frozen secondary market for home mortgages in the form of mortgage backed securities. Additionally, nearly $60 trillion dollars of exceptionally risky corporate bond insurance policies, in the form of credit default swaps, are under funded and many are unable to be traded. Millions of Americans are in homes they owe more than what it is worth. Hundreds of thousands of homes are going through foreclosure and millions more will be on the market because of foreclosure, and banks are going to be on the hook for all of those losses.

Let me be very clear. Although the housing crisis mostly affects larger metropolitan areas where land values skyrocketed, the housing crisis is going to take several years to fix as millions of cash strapped homeowners live in homes they can no longer afford, owe more than the home is worth, and can not find buyers qualified to buy. The double edged sword of real estate is that as a person buys a home, often they need to sell their home first.

To fix the housing and mortgage crisis, you first have to fix the financial industry in order to free up credit for credit worthy buyers. 

Understanding The World of High Finance

The creation of a secondary mortgage market brought national (and international) investors into local real estate markets. The benefit was so obvious. Since banks traditionally were only able to make loans using their local deposits they raised, allowing banks access to investment money from around the world allowed local communities to grow much faster than would have otherwise been possible, providing auto loans and home loans to millions that otherwise would not have had loans.

The secondary market has one big problem. It encourages risky loans.

When local banks and brokers were able to sell loans to others, they also sold the risk associated with the loan. Large amounts of money were made originating loans without an incentive to ensure repayment. Competition between these local banks and brokers encouraged unsound lending policies and fraud. If one bank wouldn’t write a bad loan, there were dozens of others that would find a way, legally or illegally. Local mortgage writers had incentive to write loans destined for failure.

As local banks sold their mortgages, the buyers of mortgages were more interested in profit goals than making good loans. In the short term, financial greed of Fannie and Freddie, and other buyers of mortgages, became all too common as executives were paid on stock options and bonus structures based on their quarterly and year end earnings. Quantity became more important than quality.

In the worst form of Washington logic, Fannie and Freddie were tasked to make more loans to people that couldn’t afford it. This sounds like a joke, but Democrats in Washington tasked these “for profit corporations” to make more loans to those that had previously proven they were bad credit risks. On top of that, Fannie failed to set aside the proper amount of revenue to pay for foreseeable bad debt. Instead of putting larger portions of revenue into reserves, they continued to take exceptionally high amounts of revenue in profit, thereby making billions for the company-and for the executives that ran these companies.

Cooking the books became common place. Just two years before the Federal Government took over Fannie and Freddie, the top executives were paid $30 million in bonuses for meeting their income target. Freddie and Fannie overstated earnings by over $1 billion and were forced to restate their earnings. You would think this would be against the law, and executives would go to prison, but in Washington, the executives were given golden parachutes. In a six year period, the head of Fannie was paid $90 million.

Private Corporations faired no better in the greed department as they, too, considered mortgages a cash revenue cow. Every month, they generated large amounts of money, and banks and financial institutions were able purchase large amounts of revenue generating assets, which showed growth to their investors, thus raising their share prices. But they forgot there was risk associated with these investments.

The world of high finance was making 10-50% returns on their investment from mortgages paying 4% interest. How did they do this? The concept is leverage. If a bank invested in a $1,000,000 mortgages that paid 4% interest, they would invest $100,000 of their own capital (through deposits), borrow $900,000 at 3% from the Federal Reserve, and make 1% on the 1,000,000, which would be $12,000 per year. On their initial investment of $100,000, they made $12,000 per year, so on a mortgage that paid only 4% interest, they would be able to make a 12% return on investment. Not bad.

You have just learned the world of high finance. Leverage is how people with lots of money make even larger amounts of money. If we borrowed money to invest in the stock market, we would be crucified, but that is the world of high finance, high stakes gambling subsidized by our Federal Government.

I don’t have a problem with leverage. It is how all banks operate, and it is how I, as a business owner, borrow money from a bank in order to run my business. What I don’t agree with is the taxpayer subsidizing this system with a bailout. Their investment model comes with risk, and in regards to the mortgage market, they should have assumed the risk of defaults and falling home values as part of the 12% return on their investments.

Wall Street greed grew out of control when banks and other investment groups such as hedge funds selling “insurance” policies called credit default swaps.

Many banks compete with Fannie and Freddie and they issued or bought their own mortgages and created their own mortgage backed securities. Many of them even rated their bonds themselves, giving them a triple A rating, ensuring a market for their bonds. Another department in their bank would buy “insurance” on these bonds, called credit default swaps, by betting with another company that the underlying mortgage portfolio would pay their mortgages.

These credit default swaps are scandalous and here is how they worked. An investment bank would buy 1,000 mortgages worth $100,000 each that paid 5% interest, creating a bond fund of $1,000,000. To spread out the default risk of individual mortgages, which they assumed averaged 1%, they would create 100 bonds rated triple A and would sell $10,000 bonds yielding 3% to other banks or investors. Another part of their bank would buy a credit default swap to guarantee payment of the mortgages. They would pay 2% or $20,000 per year for five years for this insurance. The other company was often times a hedge fund that would bet that the mortgages would pay on time. For no investment, the hedge fund would be able to pad their income sheets with an additional 2% of earnings with “no risk.”

Credit default swaps are a very new product. Today, there are between $50 to $60 trillion worth of credit default swaps written in the financial system. In 1990, there were close to zero. They are unregulated, often under funded, and are ripe with fraud. Many are used simply as a way to boost sagging income and earnings statements. Because of this, trillions of dollars worth of credit default swaps began circulating amongst large financial institutions. Companies would buy swaps for short periods of time as they had excess capital. A very strong market was created to trade these derivative securities. Very little, if any, money was set aside in the event these “insurance” policies were ever required to pay.

This is the world of high finance. Nothing is created. Nothing of value is gained, except more money. This is really high stakes gambling, and it is completely legal.

Mortgage backed securities were also bought and sold with regularity. When the default rates on mortgages were low, financial institutions bought and sold these investments with regularity, as they needed to invest short term cash holdings. They either bought Treasury notes, which paid small returns of 1-2%, or they could invest in Fannie backed mortgage backed securities, which paid up to 3%. These were bought and sold based on the remaining amount of the original bond.

When mortgages started to default, and home prices started to fall, the mortgage backed securities market began to unravel. Banks never factored in a falling home market into the price of the mortgage backed securities. The longer a bond was held, good mortgages paid off, lowering the number of mortgages in the bond fund. An ever increasing amount of bad loans were left remaining in the bond fund. There really wasn’t a good way to find out how good the underlying mortgages in the bond fund were and how much the mortgage backed security was worth. Were 30% of the home loans delinquent? How many of the homes were in foreclosure? And the biggie, how much were the homes worth in a market that has fallen 35%?

Suddenly, the market of mortgage backed securities stopped. Nobody wanted to buy them. More importantly, nobody could sell them. So they sat on the books of banks, tying up credit lines used to make loans. Initial offerings of mortgage backed securities could not be sold, because nobody wanted to take the risk of mortgages in a falling market with defaults and foreclosures increasing.

With troubled assets tying up their ability to loan money, banks were further hampered by a federal regulation designed to prevent inflating assets in the aftermath of the Enron scandals. Enron overvalued futures energy contracts, and were found guilty of misleading shareholders over faulty accounting practices. The Federal Government responded by passing a regulatory law called Sarbanes Oxley. These new regulations required companies to mark their assets to accurately report the value of their assets using current market prices, not what they had paid for them, or the future value. This policy is called ‘mark to market.’

With the value of mortgage backed securities (and credit default swaps) plummeting because they lacked a market, financial institutions were forced to mark these to the market, meaning that they were marked down 40- 80%. The assets were written down, which lowered the amount of capital in a bank, which lowered the amount of money the bank could borrow. Banks suddenly had to raise billions of dollars of capital to cover their leverage requirements with bank regulators (as you remember, banks work on leverage-they have 10% capital requirements for all loans outstanding).

Banks couldn’t raise capital. They couldn’t meet obligations. They couldn’t borrow more money from the Federal Reserve. Banks were bankrupt.

When banks can’t lend money on mainstream, the whole economy shuts down. And that is why we have to bail out banks. Capital is the main ingredient of the capitalist marketplace. Without it, small business, big business, and government can’t conduct business. It is for this reason, we need to work on a way to use taxpayer money to bail out somebody.  We just don’t know who to bail out.

This crisis affects all of us. Everyone invested in the stock market, through our investment plans and pension plans, are all involved in the world of high finance. The homes we buy are financed by large investors on Wall Street. The businesses we operate are financed by lenders on Walls Street. No matter who we are or what we do, we rely on Wall Street. When we want to cut out the heart of greed in Wall Street, we end off cutting off our own legs in the mean time. There is no getting around it. It is for this reason, that I reluctantly think we need to bail out our tattered financial system.

Why are banks and businesses failing?

This summer of 2008, commercial banks, those that collect deposits and make loans, as well as investment banks, those that sell investments and securities, have fallen on hard times. To understand the problems with the banking and finance industry, we must understand the changes in the banking industry in the last 20 years.

In the 1990’s, banks became bigger and bigger as they merged with each other and grew at exceptional rates. This was a direct result of legislation designed to help banks become more competitive as their business was previously restricted to the state they were incorporated. A new law allowed banks to conduct interstate commerce and add products to their offering. Banks now are allowed to offer insurance, investments as well as the traditional banking services such as deposits, and loans.

As banks became diversified and streamlined, and as the government was leaning on them to do social engineering, tradeoffs occurred. In exchange for allowing banks to get larger, government demanded they make loans to people that ordinarily would not be able access credit.

Banks held extremely large amounts of excess cash, as well as customers created investment accounts in cash. Banks began to offer money market certificates to customers and these money market certificates offered higher interest rates than traditional CD’s. Money market savings accounts became the rage.

With so much cash on hand, banks looked to get the best return possible. They not only invested their cash in Treasury Bills but also in “safe” Fannie bonds called mortgage backed securities. Banks held billions of dollars of Fannie issued MBS. These were bought and sold often to other banks and were considered nearly the same as money.

When foreclosures and mortgage defaults rose, nobody wanted to buy these Fannie bonds because nobody knew exactly how much they were worth. How much are they worth if the underlying mortgage was in default. Also, how do you value a bond that you can’t actually see what mortgages you have? These securities were not your typical municipal bond, where a city takes out $20 million in bonds and they make their payments in a timely fashion. Instead, these bonds were a collection of thousands of mortgages. Some mortgages paid on time, others did not. Some mortgages were paid off after a couple years. After owning these securities for 5 years, nobody knew if the mortgages left were good mortgages or bad mortgages. These MBS became toxic paper, and nobody wanted them.

Fannie Mae and Freddie Mac ran out of money as they paid billions in defaulted mortgage payments and owned tons of mortgages that were in default. The Federal Government stepped in to become the owner of the GSE’s, only now, we can call them GOE’s, government owned entities.

So if the Government owns Fannie and Freddie, and are currently guaranteeing the payments of the mortgages they owned, why do we need a $700 billion bailout? Good question, I assume that we are buying back all of the mortgage backed securities that were issued in order to get these bad bonds out of the hands of the banking industry, thus cleaning up their balance sheets.

You may have heard about commercial paper issued by banks and large corporations, and that the market in commercial paper has frozen. Commercial paper is a short term promissory note, similar to a line of credit, that allows banks and large corporations to raise money for short term capital needs. They are considered very liquid assets. They are comparable to a CD you would buy from your local bank, only on a much larger scale.

The commercial paper market dried up as banks and businesses exposed to the mortgage crisis began failing. Buyers of commercial paper were not interested in purchasing commercial paper if the business would file bankruptcy next week or next month since the

 have seen the collapse of Indy Bank, the nations 8th largest bank, Washington Mutual, the 10th largest bank, and several smaller banks. These banks are heavily exposed to the mortgage crisis as they hold actual mortgages, land development loans as well as the mortgage backed securities. Hundreds of banks are at risk of failure. The most secure job in America right now is a job with FDIC.

Investment banks have been hit hard. Lehman Brothers was allowed to file bankruptcy, JP Morgan was allowed to be purchased, Bear Stearns collapsed. Each of these fell because of severe liquidity problems. They did not have the cash to fund future obligations. From their exposure to MBS and CDS, to another problem, the inability to raise capital through the use of commercial paper.

All these problems, what are the answers?

Everyone should know we are in a serious crisis. Unfortunately, people in Washington and Wall Street have pushed our economic system to the brink of bankruptcy. No matter what we do, we are going to see a recession as the underlying housing crisis is years from correcting itself.  There are just too many homes on the market, and too many people owe more than what their home is worth. The economic model of consumerism, and spending beyond our means, has proven, once again, to be unsustainable. The stock market is about to collapse and it is going to hurt nearly every American invested in the stock market, regardless of whether we pass a bail out or not.

The Bail Out Parameters

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 to fix a bad decision.  

2. Never reward bad behavior.

People are creatures 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. Allowing banks to “sell” their bad decisions to the American Taxpayer is rewarding bad behavior

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.


 The economic outlook of the United States is bleak. The Big Three automakers have not made a profit in the last 6 years. General Motors lost $15 billion last quarter. The major airlines are not profitable. The Federal Government is spending $1 trillion more than it takes in every year. The dollar is falling on the lack of confidence in our economy. Health care costs are skyrocketing. Energy costs are at all time highs. The Social Security system is bankrupt. Unemployment is expected to hit 7%. The banking system is in collapse. The housing industry has yet to hit the bottom. The Federal Government is bankrupt.

 The growth of government is staggering. Our Federal Government is now in the security business (US Military and TSA), mortgage business (Fannie Mae and Freddie Mac), the banking business (FDIC and Indy Bank), the insurance business (AIG), the retirement business (Social Security), the health insurance business (Medicare and Medicaid), the energy business (ethanol, wind, solar, coal and oil), the education business (Public Schools), the road building business (Highway transportation fuel taxes), the pension business (Railroad pension fund), the farming business ($300 billion in subsidies) and many others.

 What began as a way to keep our economy going in the aftermath of September 11, the mortgage mess we are in highlights the problem we really have--all things go through Washington.  And we are headed for a centralized power based in a very powerful Federal Government.   

If you think we have looked to the Federal Government to take care of us before, you ain't seen nothing yet.