As people try to digest what's happening in the global financial markets, and to make sense of where things went wrong...a common refrain is: "They'll think of something". Ah yes, the omnipotent "they", like Adam Smith's invisible hand. We expect some wise and all knowing "they" to stave off disaster and put us back on the road to growth and prosperity.
The irony is, while looking both for answers and for whom to blame, we're looking at the same individuals. The very crooks who orchestrated this mess are either closely aligned with those responsible, or directly responsible themselves. And now after they've destroyed people's retirement savings, decimated entire pension plans, wreaked havoc with the entire global economy...now we're asking them to fix the problem. And in yet another ironic twist, we're paying them major bucks to do it.
Imagine hiring someone to look after your house, paying beaucoup de l'argent to ensure the pipes, electrical, roof...everything, to make sure all is in proper order. Instead though this individual drills holes in the foundation, short circuits the wiring, reworks the plumbing in such a way that nothing makes sense. Then when you discover your house has been almost totally destroyed, this same person charges even more to fix the mess he's made....because after all, nobody else can even understand what he's done.
How did we get in this hole? In point of fact, we're all partly to blame. Our society is built on the notion that growth is a never ending reality, with only temporary pauses needed until we're back and growing larger and larger. Who wants to accept a reality where things are going backward? Where income and prosperity are in decline? Not I , and certainly not the politicians we elect. Imagine running a campaign with the slogan: "Its All Downhill From Here"!!!
Individuals loan money to financial institutions, and in return they expect a return. Banks, insurance companies, investment houses and the like put that money to work, seeking out greater returns so that they can pay for their operations, the salaries of their employees, interest to their depositors, as well as dividends to their shareholders. How can you do that in a marketplace that's dominated by people entering retirement? Fifty and sixty year-olds aren't starting businesses or buying homes, not the vast majority certainly. In fact they're the ones handing their money over, and demanding ever increasing returns on their investments....and if institution A can't deliver, they'll move their money to institution B.
So how do geniuses of finance create even greater wealth in a shrinking market place? The same way a hustler makes money when he asks you to guess which shell the pea is under.
Metaphor is a useful device when trying to paint a picture of something incredibly complex, in this situation it helps to liken the business of finance to building a house. Before pouring the footings a survey of the land is needed to determine whether or not the terrain will be able to withstand the weight of the planned structure. In the case of finance, before a bank puts money into something like a mortgage it "surveys" those borrowing the cash to determine if they'll be able to hold up under the weight 0f the interest payments.
Herein was a major obstacle for lending institutions. With boomers paying off their mortgages, the number of credit worthy borrowers seeking capital was shrinking, it still is in fact. The problem is mortgage lenders were sitting with all this capital on their balance sheets, money they're paying interest on...that's not delivering any return. How could they get that money working? The answer was as simple as it was stupid. With not enough credit worthy individuals to lend to, mortgages were given to people who were proven bad risks. We Canadians can drop the illusion that this was purely an American problem, 40 year amortizations with zero down were the Maple Syrup version of sub-prime lending.
The footings of our mortgage financing house were now being poured onto very unstable ground. Maybe we could have gotten away with it, if we kept the houses to just one story. But no...the need to garner even greater profits, bigger bonuses and heftier dividends compelled our wizards of finance to build another story on this weak foundation.
Lending institutions were now stuck with a bunch of crappy paper, mortgages given to bad credit risks. Wouldn't it be wonderful if there was some way to make a market for this toxic debt? As the old saying goes, where there's a will... Which brings us to the CDO, or collateralized debt obligation. You've heard of Rumpelstiltskin? The dwarf adept at spinning worthless straw into gold? He had nothing on the alchemists of Wall Street, in fact they could probably have taught the little guy a thing or two.
Ahhh the collateralized debt obligation...think of a CDO as a big envelope stuffed full of bad mortgage paper. Actually stuff any crappy debt into this CDO envelope, credit card debt, consolidation loans...whatever you like. Let's say you have a hundred individual pieces of crappy debt sitting in this stinking envelope. Think it smells like shit??? No no no emperor, that's not shit you're smelling...its roses. Now let's assume that each debt obligation is for $1,000 and that interest payments on each is $100 a month. That means that this lovely envelope "should" have $10,000 flowing into it every month.
Okay, okay...I hear what you're saying, obviously with all these debt obligations coming from bad credit risks, that some payments will be missed. Yes, you're right. But, they're not ALL going to default in the same month...I mean that would be a one in ten thousand shot. So that means this envelope full of crap will always have money flowing into it. As a matter of fact a magical formula was invented to trick the skeptics at rating agencies like Moody's and S&P. Since money would always be coming in...a certain portion of this envelope should be rated AAA. And since that certain portion or "tranche" was rated AAA...bingo, the entire envelope goes from being a pile of manure to pure and solid investment gold because they're all bundled together.
And thus the second story of our house with the lousy foundation was built. With these toxic assets rated AAA, market players like pension fund managers could be brought into the loop. Institutional investors like insurance companies, precluded from engaging in risky strategies...they now fell victim, with their depositors and investors on the hook.
Think we should stop now? Don't think the swampland we've built two storeys on can withstand a third? Too bad...the market has to keep growing so the house has to climb even higher.
Everyone needs insurance don't they? We insure our homes, our cars...our lives. If something has value there's typically an insurance product on the market to cover it. Why should CDOs be any different?
And that brings us to the CDS or 'Credit Default Swap'. Now we had insurance companies like AIG providing insurance to holders of CDO's. Sure its like underwriting a life policy for someone with terminal cancer...but look at those premiums flowing in. So long as the housing boom keeps going the money train will never stop.
Of course we all know what happened. Nothing booms forever, and the housing bubble collapsed....the swamp finally gave way and all those lovely 3 story homes disappeared into the muck.
And who are we calling on to fix the mess? The same guys who decided to build on the swamp, and then insisted on building higher and higher.
Of course we could tell these shell game artists to take a flying leap, and let each of them be crushed under the house of cards they built up. But the end result would a depression, one which would rival the Great Depression of the dirty thirties. Instead we're paying them trillions (not billions, probably gazillions actually when you factor in the initiatives of the US Federal Reserve) of our great great great grand children's money. No...not our money, not our kid's money and not our grand kid's money, we borrowed that ages ago. The money we're borrowing now is from descendants who won't be born until sometime around the year 2300.
Who wants another Depression anyway. Sure most of us could handle it, the great unwashed would muddle along as we always have. But a depression now would devastate the finances of the uber-rich, and we certainly can't have that. The bulk of the tax burden will fall on the middle class as it always has, but at least Wall Street movers and shakers will get to keep their private jets.
As Bernard Berenson said long ago of governments:
The irony is, while looking both for answers and for whom to blame, we're looking at the same individuals. The very crooks who orchestrated this mess are either closely aligned with those responsible, or directly responsible themselves. And now after they've destroyed people's retirement savings, decimated entire pension plans, wreaked havoc with the entire global economy...now we're asking them to fix the problem. And in yet another ironic twist, we're paying them major bucks to do it.
Imagine hiring someone to look after your house, paying beaucoup de l'argent to ensure the pipes, electrical, roof...everything, to make sure all is in proper order. Instead though this individual drills holes in the foundation, short circuits the wiring, reworks the plumbing in such a way that nothing makes sense. Then when you discover your house has been almost totally destroyed, this same person charges even more to fix the mess he's made....because after all, nobody else can even understand what he's done.
How did we get in this hole? In point of fact, we're all partly to blame. Our society is built on the notion that growth is a never ending reality, with only temporary pauses needed until we're back and growing larger and larger. Who wants to accept a reality where things are going backward? Where income and prosperity are in decline? Not I , and certainly not the politicians we elect. Imagine running a campaign with the slogan: "Its All Downhill From Here"!!!
Individuals loan money to financial institutions, and in return they expect a return. Banks, insurance companies, investment houses and the like put that money to work, seeking out greater returns so that they can pay for their operations, the salaries of their employees, interest to their depositors, as well as dividends to their shareholders. How can you do that in a marketplace that's dominated by people entering retirement? Fifty and sixty year-olds aren't starting businesses or buying homes, not the vast majority certainly. In fact they're the ones handing their money over, and demanding ever increasing returns on their investments....and if institution A can't deliver, they'll move their money to institution B.
So how do geniuses of finance create even greater wealth in a shrinking market place? The same way a hustler makes money when he asks you to guess which shell the pea is under.
Metaphor is a useful device when trying to paint a picture of something incredibly complex, in this situation it helps to liken the business of finance to building a house. Before pouring the footings a survey of the land is needed to determine whether or not the terrain will be able to withstand the weight of the planned structure. In the case of finance, before a bank puts money into something like a mortgage it "surveys" those borrowing the cash to determine if they'll be able to hold up under the weight 0f the interest payments.
Herein was a major obstacle for lending institutions. With boomers paying off their mortgages, the number of credit worthy borrowers seeking capital was shrinking, it still is in fact. The problem is mortgage lenders were sitting with all this capital on their balance sheets, money they're paying interest on...that's not delivering any return. How could they get that money working? The answer was as simple as it was stupid. With not enough credit worthy individuals to lend to, mortgages were given to people who were proven bad risks. We Canadians can drop the illusion that this was purely an American problem, 40 year amortizations with zero down were the Maple Syrup version of sub-prime lending.
The footings of our mortgage financing house were now being poured onto very unstable ground. Maybe we could have gotten away with it, if we kept the houses to just one story. But no...the need to garner even greater profits, bigger bonuses and heftier dividends compelled our wizards of finance to build another story on this weak foundation.
Lending institutions were now stuck with a bunch of crappy paper, mortgages given to bad credit risks. Wouldn't it be wonderful if there was some way to make a market for this toxic debt? As the old saying goes, where there's a will... Which brings us to the CDO, or collateralized debt obligation. You've heard of Rumpelstiltskin? The dwarf adept at spinning worthless straw into gold? He had nothing on the alchemists of Wall Street, in fact they could probably have taught the little guy a thing or two.
Ahhh the collateralized debt obligation...think of a CDO as a big envelope stuffed full of bad mortgage paper. Actually stuff any crappy debt into this CDO envelope, credit card debt, consolidation loans...whatever you like. Let's say you have a hundred individual pieces of crappy debt sitting in this stinking envelope. Think it smells like shit??? No no no emperor, that's not shit you're smelling...its roses. Now let's assume that each debt obligation is for $1,000 and that interest payments on each is $100 a month. That means that this lovely envelope "should" have $10,000 flowing into it every month.
Okay, okay...I hear what you're saying, obviously with all these debt obligations coming from bad credit risks, that some payments will be missed. Yes, you're right. But, they're not ALL going to default in the same month...I mean that would be a one in ten thousand shot. So that means this envelope full of crap will always have money flowing into it. As a matter of fact a magical formula was invented to trick the skeptics at rating agencies like Moody's and S&P. Since money would always be coming in...a certain portion of this envelope should be rated AAA. And since that certain portion or "tranche" was rated AAA...bingo, the entire envelope goes from being a pile of manure to pure and solid investment gold because they're all bundled together.
And thus the second story of our house with the lousy foundation was built. With these toxic assets rated AAA, market players like pension fund managers could be brought into the loop. Institutional investors like insurance companies, precluded from engaging in risky strategies...they now fell victim, with their depositors and investors on the hook.
Think we should stop now? Don't think the swampland we've built two storeys on can withstand a third? Too bad...the market has to keep growing so the house has to climb even higher.
Everyone needs insurance don't they? We insure our homes, our cars...our lives. If something has value there's typically an insurance product on the market to cover it. Why should CDOs be any different?
And that brings us to the CDS or 'Credit Default Swap'. Now we had insurance companies like AIG providing insurance to holders of CDO's. Sure its like underwriting a life policy for someone with terminal cancer...but look at those premiums flowing in. So long as the housing boom keeps going the money train will never stop.
Of course we all know what happened. Nothing booms forever, and the housing bubble collapsed....the swamp finally gave way and all those lovely 3 story homes disappeared into the muck.
And who are we calling on to fix the mess? The same guys who decided to build on the swamp, and then insisted on building higher and higher.
Of course we could tell these shell game artists to take a flying leap, and let each of them be crushed under the house of cards they built up. But the end result would a depression, one which would rival the Great Depression of the dirty thirties. Instead we're paying them trillions (not billions, probably gazillions actually when you factor in the initiatives of the US Federal Reserve) of our great great great grand children's money. No...not our money, not our kid's money and not our grand kid's money, we borrowed that ages ago. The money we're borrowing now is from descendants who won't be born until sometime around the year 2300.
Who wants another Depression anyway. Sure most of us could handle it, the great unwashed would muddle along as we always have. But a depression now would devastate the finances of the uber-rich, and we certainly can't have that. The bulk of the tax burden will fall on the middle class as it always has, but at least Wall Street movers and shakers will get to keep their private jets.
As Bernard Berenson said long ago of governments:
"Structures that will last as long as the under-taxed can defend themselves against the over-taxed".
Yeah, I know this is a little heavier than a lot of my regular blogging. When you read articles like The Big Takeover, it makes observations about things like Twitter seem inconsequential. By the way, I'm up to 12 followers (from 2 on Friday) so feel free to add CanukGord if you're of a mind and tweet away.
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