Friday, September 26, 2008

Trying to Unravel the Financial Mess

Everybody is talking about the big mess right now in the financial services sector, and how we need (or don't need) a $700 billion bailout to keep the entire US economy from slipping into a major catastrophe. But, as I have mentioned before about my no-doubt brilliant colleagues, we're all ignorant, just on different subjects. And the vast majority of us (including me, by the way) are not experts in big corporate finance--far from it! Therefore, we get lots of heat and very little light from all the talk.

If I may, let me share an article I came across that explains the current situation in very simple (indeed, overly-simple) terms. Don't let the fact that it comes from National Review trick you into thinking it's political in nature. It's a pretty fair breakdown of what's going on.

If you've digested that, let's add in a couple of other facts. First, the biggest root cause of this entire mess is the changes in the way home loans have been made for at least the last 15 years. Before that, the old joke was that a bank is a place that will give you a loan... if you can prove to them you don't need it. 20% down on a home loan was standard, and the rule was your payment couldn't be more than 28% of your gross pay, nor could your total indebtedness exceed 36% of gross pay. Getting turned down was common. But as far back as 1993, there was a move afoot to brand banks as racist or otherwise evil if they turned down too many applicants who were either minorities or lived in "redline" neighborhoods. It got harder and harder to turn people down for loans, even if they really didn't make much money or have much cash.

Then, to make matters more interesting, a great boom in housing prices began. I bought my first house under more-or-less the "old" rules (I had to pay a heft PMI premium to allow me to put down only 5%, but the ratios were the old ones). Over the next nine years, that house doubled in value, as did most real estate. Any worries about lending were swept away... after all, the loans were secured by rapidly-appreciating assets. If a loan went south, the bank could still foreclose, drop the price, and still recoup even a 100% note. At the top of this cycle, I sold a house after two years and made $70,000. Shows like "flip this house" began to go on the air. People began taking out no-money-down, interest-only, adjustable-rate loans. Any monkey could make money in real estate.

Meanwhile, the banks that had made these loans were selling them to the likes of Fannie Mae, who bundled them into mortgage-backed securities, what looked like a sweet deal. And then the housing bubble burst.

To make matters worse, after the bankruptcy of Enron a few years ago (and their criminal cooking of the books), congress wrote seemingly-sensible new rules that required assets to be "marked to market," or regularly re-evaluated based on current selling prices... even if they had no intention of selling and incurring an actual loss. Suddenly banks had big liabilities (these bad mortgages), secured by shrinking assets (the falling home values). Their balance sheets were out of balance, and otherwise "good" companies, like Bear Stearns, Lehman Brothers, even Merrill Lynch, were in trouble.

As tempting as it is to blame the "fat cats" on Wall Street (and we all love to engage in a little schadenfreude when those guys get theirs), more blame belongs on those who didn't mind the store at Freddie and Fannie. That's government, particularly congress. It didn't help anything that the senate banking committee (which bottled up attempted reform 2 years ago)is chaired by Chris Dodd, the largest recipient of campaign contributions from Fannie Mae. But blame also belongs with all of us who thought we could get something for nothing.

A really wise fellow named Solomon wrote about 3000 years ago not to hurry after get-rich-quick schemes. He also had some words to say (not positive, btw) about guaranteeing bad loans (the Old Testament called that "surety"), and about borrowing money: "The borrower is slave to the lender." (Proverbs 22:7)

Now we're told that unless we give these same goofballs three-quarters of a trillion dollars, the wheels are going to come off. I don't find that very reassuring. And, of course, politics is never far behind. For example, right now, there are plenty of votes to pass exactly the bill that the President, his Treasury Secretary, and the Democrats in congress want. But they won't do it unless they can get the conservatives (folks like me) to give them cover, so they won't own the whole kit and kaboodle when it blows up.

Meanwhile, I'm just happy that I have little use for credit. When it all shakes out, those of us who followed the good old biblical model will be the best off. (Or least screwed!)

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