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There's more to the subprime mortgage crisis than is being
told by the financial media. The problem is far bigger than
simply a relatively small amount of subprime borrowers are not
able to meet their mortgage payments. Yet, that's all you hear
about from the traditional news sources. This article will
explain how we got ourselves into such an incredible mess, as
well as exactly what that mess really is.
The problem is rooted in several decades of history. We'll begin
with a mathematician by the name of John Forbes Nash. If that
name sounds vaguely familiar, it's probably because his life was
portrayed in the movie "A Beautiful Mind" starring Russell
Crowe.
While the movie did a fantastic job of highlighting Mr. Nash's
mental illness, it did a lousy job of informing the viewers of
the important role his game-theory mathematical equations played
in the development of modern day finance.
The secondary mortgage market would not have been possible
without the mathematical equations that John Nash developed.
Before the development of the secondary mortgage market,
borrowing money for a mortgage was rather straightforward. You
applied for a mortgage loan at your bank, and if your local
banker determined that you'd be able to repay the loan, he would
loan some of the bank's deposits to you.
The bank needed to have the deposits in order to make the loan.
Likewise, if the bank didn't have enough money in its deposits
to cover the loan, it couldn't do it.
Rather than come right out and announce to the public that they
didn't have enough deposits on hand to make any more loans,
banks would raise the interest rate charged to borrowers. The
results of the high rates would be that people would choose to
apply at a different bank that offered lower rates. That's just
basic economics.
It was a simple example of basic supply and demand working
properly in the free market. If there weren't enough deposits at
the banks, interest rates would go up and borrowing would
decrease.
Conversely, if the banks were overflowing with deposits,
interest rates would come down as the banks competed amongst
each other for more loan business.
The free market would find the perfect equilibrium between the
borrowers and the banks. This would happen through the constant
adjustment of interest rates, which is nothing more than the
price to borrow money. Price is nothing more than a mechanism to
balance out supply with demand. Too much demand, price goes up.
Too much supply, price goes down.
Enter John Nash. His mathematical equations made it possible for
investment banks to combine mortgage loans into packages and
sell those packages to investors. The math involved is very high
level.
By being able to tap into larger pools of money besides just
deposits at local banks, borrowers seeking a home mortgage were
able to obtain lower rates on their mortgages. Again, that's
supply and demand at work. Nash's equations opened up a much
larger supply for home mortgage money.
Nash's equations simply made for more efficient means for
borrowers to tap into large pools of money that were available.
The loans were still being issued one at a time. But the banks,
with the help of Wall Street (which received a commission for
facilitating the transaction), could combine hundreds of loans
and sell the package to very large investors, such as insurance
companies, mutual funds, college endowment funds, foreign
companies, and even foreign governments.
At that point in time, there still wasn't a problem. The
equations of John Nash did not cause any problems. This was how
the secondary mortgage market formed and functioned in the early
1980's.
Wall Street Firms Want More
But the situation begin to change in the 1990's. Wall Street
wasn't satisfied with just getting a regular commission. As
usual, Wall Street wanted a lot more: more money, a bigger piece
of the pie, and lots more profits. How else could all those Wall
Street insiders afford to buy multi-million dollar homes in the
Hamptons?
And this is where our current economic problem begins.
Wall Street introduced some changes to what was up to that point
a very straightforward process. Wall Street mixed in financial
derivatives within the packages of mortgages that were packaged
together and sold to investors.
Instead of just putting together a package of say, 1,000
mortgages and selling them to an investment group for the
interest that they paid, Wall Street included complicated,
overly sophisticated, opaque derivatives within the package.
Why?
Well, the short answer is that a lot more money could be
made by Wall Street.
And Wall Street does what's best for Wall Street. That you
can count on.
The first instance of credit derivatives being used on Wall
Street was 1981 when Salomon Brothers arranged for IBM and the
World Bank to
swap debt payments in Swiss Francs and German Marks for dollar
obligations.
The practice spread like wildfire in a dry forest during the
decade of the 1990's and beyond.
It is important to understand that Wall Street firms
deliberately structured these packages to be opaque and
confusing. That way, the investors weren't really sure what they
were getting.
Let's take a look at a simple example to expose the truth.
Suppose 500 people each owe me $10.00. That makes $5,000 the
total amount owed to me. These people are paying me seventy
cents per year in interest (7%).
Suppose that I package those 500 loans together and sell them to
you. You would then be able to collect the interest as well as
the principal when it is paid back. We will label this a five
thousand dollar package.
I might sell this package of loans to you for $4,925 to allow
for approximately 1.5% of the loans not getting repaid.
If there was a broker involved, the broker might get a
commission of between 1 and 2%.
Now, what if that five thousand dollar package didn't contain
500 loans of ten dollars each? What if it only contained
something like 200 or 300 loans for ten dollars each, and of
those, more than half were subprime and of questionable ability
to repay, while the remainder of the "five thousand dollar
package" was used lottery tickets?
Would you still want to pay $4,925 for that package of loans? Of
course not! You would only be owed about half of what you paid,
and you probably will not receive even half, because so much is
owed by borrowers with poor credit ratings who have difficulty
making payments on time. There is no way that "package" would be
worth $5,000.
What if the the package only contained 50 loans of $10 each,
and the remainder was used lottery tickets? Would that package
be worth $5,000.00? At this point, you're probably thinking that
this author is out of his mind.
Let me tell you that I'm not.
Wall Street put packages exactly like that together. How else
could they get 50% commissions? Yes, that's right, commissions
of 50% or more! Please see the article
Derivatives Abuse by Wall
Street for a detailed example of how Wall Street took
over half the "value" as a commission. The article links right
to a recent new story reported by Bloomberg news.
When the general public finds out what has happened, there are
going to be mobs of angry people.
Over, and over, and over again Wall Street put together
packages very similar to the over-simplified example just
provide. Take 50 loans of $10 each, mix in some very confusing
speculative derivatives, label it a $5,000 package, and receive
half the proceeds of the sale as a commission.
Wall Street didn't do this for thousands of dollars, Wall
Street did this for billions, and billions, and billions, and
billions, and billions of dollars. And took half the money!
Folks, I couldn't make something this crazy up. Truth
sometimes is stranger than fiction.
And now here we are in 2008, and those packages aren't worth
the $5,000 that they are supposed to be worth. They are not even
worth half of what they are supposed to be worth.
It's no wonder that the entire financial system of the world
is teetering on the brink of collapse. They system has been
abused to such an extent that it is technically insolvent.
You see, derivatives are nothing more than speculative bets,
thus the example above of used lottery tickets.
CDO's (collateralized debt obligations) are made up of a
combination of mortgages and derivatives very similar to the
above illustration.
And therein lies the problem. The value of TRILLIONS of dollars
of CDOs is based upon complex, opaque derivatives of very, very
little real, tangible value. The latest figures provided by the
Office of The Comptroller of
The Currency show that the amount of derivatives
currently outstanding worldwide exceeds $540 TRILLION.
So here we are in 2008 and these mortgage-backed "securities"
have been created by Wall Street by the trillions upon trillions
of dollars in the last 20 years.
Amazingly, this system worked fine, until the housing market
turned down and just a few too many subprime borrowers begin to
default on their loans.
And when those borrowers stopped making their payments, some
holders of the mortgage back securities wanted to cut their
losses and sell.
And then comes the 500 trillion dollar question: sell to whom?
You see, every other holder of mortgage-backed securities was
experiencing the same thing: an increased number of defaults.
These packaged mortgage securities are not traded on an exchange
like stocks. They are unregulated by the government. The buying
and selling of them is completed privately.
The problem is that the largest portion of "value" in these
various mortgage-backed securities is based upon derivatives
that are "questionable" at best. When a hedge fund, bank,
or insurance company decided to sell their "investments" in
CDO's in the late summer of 2007, there simply were no buyers.
The genie was let out of the bottle, and now there is no way the
genie can be put back into the bottle again. Specifically, the
genie is the fact that the CDO's, MBS's, and most "structured
finance" products are not worth anywhere near what they are
supposed to be worth, or what Wall Street firms claimed that
they were worth.
The buyers of these fancy financial products have now realized
en masse that they have been sold a package that isn't worth
anything near what they paid. Oh sure, the computer models
produced by Wall Street claim these packages are worth "x"
amount of dollars. But in the real world, the real worth isn't
even half of "x".
So everyone, including investment banks around the world,
keep them in their portfolios and pretend like they are
worth what Wall Street initially claimed they were. It's called
mark-to-model. Valuing the packages at real world value is
called mark-to-market.
Needless to say, investment buyers around the world have stopped
purchasing mortgage-backed securities, resulting in the funding
for mortgages drying up. Everything from
first time home buyer loans
to jumbo mortgages are now much more difficult to obtain.
And this will cause massive changes to the economy through a
domino-type effect. The first area to be effected has been real
estate. It has already started, but what you are seeing is just
the beginning of the first inning, we've still got 8 and
one-half innings to go.
No amount of pretending by banks like they are solvent will
actually make them solvent, just as no amount of pretending by
an individual will make himself solvent. The situation with the
banking system is dire.
Basically, the secondary mortgage market is barely
functioning, if at all. Banks now have to lend from their own
deposits. Needless to say, early last year, when banks and
mortgage companies could sell the loan as part of a package,
they were not nearly as concerned with the borrower being able
to pay back the loan. That would become somebody else's problem.
Now that banks have to loan from their own funds, they have all
of a sudden become very, very concerned about the borrower's
ability to repay. Banks don't want to take losses. They want
profits. And they are not going to loan to questionable
borrowers now that the loss will come directly from them rather
than a pool of investors funds.
That means that millions of people who previously qualified for
mortgage loans under the old, easy,
who-cares-it's-not-our-problem rules no longer qualify under the
new, I'm-no-willing-to-lose-any-of-my-money rules. Thankfully,
many states still provide
first time home buyer grants
to help first time home buyers qualify for their first mortgage.
The days of the "no-doc" loan are now gone. The days of the real
estate boom are also gone. We are now headed rapidly in the
other direction: real estate bust. The over building due to
super easy lending standards will now work its way through the
system. And that system has far fewer qualified buyers then
previously. We are left with high supply and low demand. That's
a recipe for falling prices.
In the coming months, billions upon billions worth of mortgages
that had low initial "teaser" rates will be resetting higher.
Much higher. Many of these people will not be able to afford to
keep their home.
Foreclosures are already increasing very rapidly. Just this week
a
news story
appeared detailing how foreclosures in Florida and California
are more than double last years rates. Expect this trend to
continue for at least the next 2 years. It may take 3 to 4 years
for the glut of foreclosures and extra inventory to be worked
out of the system.
Because of this, look for real estate prices to continue to
fall. Again, expect this trend to also continue for the next 2
to 4 years. But even when it does come back, without a
prosperous secondary mortgage market, real estate will never be
like it was in the late 1990's and early 2000's.
When you consider that construction and real estate accounts for
20% of the US economy, expect real estate to drag down the rest
of the economy. It is already happening. Millions of
construction workers, real estate brokers, mortgage loan
officers, as well as workers in related industries such as
appliance manufacturers, carpet manufacturers, window companies,
etc, will all be searching for other lines of work.
The level of business in real estate and construction will not
support the amount of labor and careers that it did 2 or 3 years
ago. It may not even support half of it.
Unfortunately, The Television Talking Heads Will Announce
Over and Over that the "Worst is Behind Us"
What else can they do? Do you think they can tell the truth and
announce that it is going to get worse? That would cause
consumers to prepare for the coming hard times by reducing their
spending, paying off bills and hoarding cash. Those very actions
of reduced spending would hurt an already critically-ill
economy even more.
You will not be told the ugly truth by the mass media.
The worst will not be behind us until the mess has been cleaned
out of the system, and that is going to take, at a very minimum,
2 to 3 more years. That's a minimum. It could be much longer,
depending upon how the government handles the mess. Early
government actions are not encouraging.
Governments usually don't do what's best for the population as a
whole. Governments typically do what's best for the few
well-connected. Expect big, fat-cat bankers and Wall Street
Firms to be bailed out, but very little in the way of real help
for the common man. Bear Stearns will not be the only one that
gets "merged".
Unfortunately, the common man will suffer the most. This website
is trying to reduce the amount of suffering that middle class
America will face.
Despite "official" government statistics that proclaim the
economy isn't that bad off, the truth will be, and is, the exact
opposite. The economy is in a downward spiral that will not be
stopped until it has run full course.
Lower interest rates will not help. The interest rates on
home mortgages could go to zero. But what good would that do if
the banks will not grant you a loan? It doesn't matter what the
published interest rate is. If the bank won't give you a loan,
the interest rate is merely for show.
The only way to stop it here and now would be for banks to
go back to their loose lending standards and for the secondary
mortgage market to go back to doing billions upon billions of
dollars per week in CDO's and MBS's (collateralized debt
obligations and mortgage-backed securities).
But investors no longer want to purchase CDO's and MBS's that
are full of toxic derivatives, now that the secret about the
true value of those derivatives is out in the open. And no bank
wants to make reckless loans with their own capital at
risk. That only leaves the U.S. on the path we are currently on:
a cleaning out of the real estate mess along with some massive
changes in the banking industry.
The changes to date in the banking industry are not
providing signs for any optimism. Instead of a return to honest
transactions, banks still want obscenely fat profits, complete
protection from their own mistakes, and more nearly-free bailout
money from the Federal Reserve, which in turn wants money from
the U.S. Government.
If this
moral hazard
doesn't stop, neither will the oncoming depression.
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