Saturday, March 14, 2009

Backroom Shenanigans

John Stewart’s interview with CNBC’s Jim Cramer elicited an interesting observation of the current financial situation we are in. Stewart took exception with CNBC over one of their hosts, Rick Santelli, ranting at the NYSE on “loser mortgage holders” unable to pay their loans while staying moot about banks and financial institutions and their 35 to 1 leveraged loans.

John Stewart commented to Jim Cramer that there appears to be two markets; one sold to us as long-term, leave it alone. The other market – the real market – is in the backroom playing fast and dangerous. This other market hurts the long term market we have all been told to support.
So, in essence, we are capitalizing their adventure, their game.

That’s how it started to look to me too, way before all the current problems manifested themselves. I did not understand it then, and I am still trying to better understand it now. Maybe that is how their plan is supposed to work. Make it difficult and complicated enough so that we naturally avoid it, then make it a necessary part of our lives. They control it, and as long as they through us a bone, in the form of a statement showing that our long-term investment is going up-up-up, we sit there quietly trusting in them even more.

As I see it, one part of the game started out based on a real need, the need for banks to have more money to loan. At the bank level, the money is made from the processing of the loan, not the 30 years worth of interest. The goal of the bank is to loan more; once it is loaned they can only rely on the interest and money deposited as their source for new money to loan.

Enter the investment mechanism of mortgage bonds. Investment bankers pool thousands of home loans and sell the bonds to generate capital. If I am looking for a long-term investment I can afford to wait so these bonds are attractive to me. I get an investment based on the continued payment of these mortgages that have been pooled. Win-win and the economy moves forward.

The problem with this system is that it is slow and is limited to the amount of fixed assists that can be used as collateral for the loan. That’s the problem with this model, you can only make a loan if there is collateral and the higher the value of the collateral the more the loan – they feed off each other. So who needs to borrow money? Traditionally it was those that wanted to buy a house or a car, or a business that wanted to buy property or equipment. With this model there are a finite number of folks needing a loan. I mean think about it, once the business buys the land and equipment they will not need to secure a loan for a number of years. Same with a homeowner, if the average stay is five years, then you will not see that person for five years. Too long to wait.

Enter the investment mechanism of collateralized debt (CDOs). What if we take the lowest rated pieces of bonds from other mortgage bonds, the risky ones, bundle them up together and sell them? Why would I want to buy a risky bond? Because everyone is doing it – you don’t want to miss out fool! This then requires that you have risky debt, enter home equity loans

Enter the investment mechanism of CDO–squared. If a CDO is selling like hot cakes, why don’t we take the even riskier parts of the CDOs, bundle them and sell them to investors? Why would I want to buy an even riskier bond? Because everyone is doing it – you don’t want to miss out fool! This then requires that you have even riskier loans, enter in sub-primes.

So if there is a good market for these CDO-squared bonds, I wonder if………Yes, there is a third CDO out there that bundled the riskiest parts of the CDO-squared and sold that to investors. Its OK, everyone is doing it - houses are selling right and left, which means these risky loans are being paid off, ride it baby ride it! Oh, and lets rate these bonds as high and we will get insurance through AIG to cover our loss. Only a fool would pass up on this opportunity! We need more loans! We need more people to buy houses - to sell houses!

Blame the homeowner or blame the investors who found these CDOs just too hard to resist. The investors wanted CDOs and the CDOs needed debt. Credit cards, sub-primes, leverage, flipping houses – all were designed to feed the CDOs. That’s where the money was being made and that’s where the energy was spent. That’s the backroom John Stewart is speaking about. They played fast with our future hoping to get out right before the bubble burst. Some people made a lot of money off this model, even if they lost money – they still came out ahead. It’s us little guys, the 95% that are paying the price for this.

The chickens would come home to roost and they knew it. You want to blame the guy that overbought or speculated, go ahead, but you had better also blame the ones that put the system in motion, the ones, like Cramer and CNBC, that perpetuated it or looked the other way.

source: Time March 9 page 30

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