Cracks in the Financial Fissure

So JP Morgan Chase & Co. is going to buy Bear Stearns. That may seem like a rescue, but it's not. This is yet another crack in the world's money foundation. First the UK government felt it had to take over North Rock, then the Fed was trying to support Bear Stearns through JP Morgan, but it has instead turned into an outright acquisition at $2 a share. Let's get some perspective on this. If you look at a chart, like this one from the Wall Street Journal, notice that the 52-week stock high was $170.23 and the low was $26.85. This isn't a "fire sale" as some in the media portray. This is bankruptcy and selling off the assets without the intervention of a court. And what is the Fed doing? Here's how the WSJ phrases it:

The Federal Reserve announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem a credit crisis that is engulfing the financial system and threatening a deep recession.

For the first time securities dealers, effective today and for at least the next six months, may borrow from the Fed on much the same terms as banks. The Fed also lowered the rate charged on such borrowings from what's known as its discount window by a quarter of a percentage point, to 3.25%, and extended the maximum term to 90 days from 30.

This is a panicked attempt to keep everyone from taking that final plummet that Bears enjoyed. There isn't money because many people are no longer trusting the systems. But to keep things afloat, the Fed has potentially opened the flood gates. After all, it was large investment houses and banks - and the greedy credulity of investors - that landed everyone here in the first place. So now the country is supposed to trust their judgment with even more money? Maybe it's necessary to keep the whole system from freezing up, like an engine without oil, but only at the risk of having so much money out there that they dollar loses a lot more value.

I know there's the theory that some institutions are too large to fail, because you can't afford to have them out of business. But I'm wondering if what we're facing is more like a case of fiscal gangrene, in which you amputate a limb or the patient itself dies. Those who worship at the altar of capitalism must realize that can't adopt a deity and then insist on only the friendly parts. That's like saying you want to be a fundamentalist Christian but believe in only heaven and not hell. and I'm afraid that we're only just beginning to see the literal hell that we'll all be forced to pay.

Blame the Home Buyers

I've heard a couple of broadcast pieces lately that note how many of the problems with the sub-prime market meltdown started with home buyers lying about their incomes on the mortgage applications. Although I haven't yet heard anyone come out and say, "It's all their fault," there's an undertone in the reporting and in the remarks from experts.

It's total bunk, in my opinion. The responsibilty for prudent lending isn't the customer's. Risk management is clearly the duty of the lender. Why did the people lie? Because they had poor credit and yet desperately wanted to own their own home instead of continuingly putting money into a landlord's pocket. That's not a hard psychology to predict. No one goes into this type of financial obligation consciously thinking that they are going to fail. They tell themselves that it will be tough, but that they'll be able to do it. And then they don't read the fine print of how rates can suddenly jump.

These were people motivated by the desire to get out from under. Why did lenders grant lans? Becasue they figured they could squeeze out that much more profit. It's a classic credit strategy: you get more return for risk that is greater. I can understand that, but you have a problem when the money you want cranks the risk up to a much higher degree. They lenders should have done projections to see how much danger loans were in from potential default at different levels of interest - not from a lack of inherent trustworthiness of the borrowers, but because they changed the economic conditions to make payback virtually impossible.

"But that's why we wanted a high enough income in the first place," they will claim. Oh, please, don't make me laugh. They wanted higher income and yet wouldn't verify? The only reason they did verify - or check enough - is because they wanted to do the business too badly. You'd think that a mortgage company would have all the power in a negotiation, but, ironically, they didn't. This is a perfect example of neediness in a negotiation (see my review of Jim Camp's book, No).

The entire credit industry wanted every penny it thought was out there, and so completely dropped all the barriers of logic, reason, and prudence. Last week, the Financial Times had a story about web sites that would charge people to act as income verification, even though the people had never worked for them. Yup, that would be financial fraud. But to trust the word of a phone call? Not to check what business the company was in? How long does it take to run a standard credit check on a company and how much does it cost? The answers are not long and not much. If the borrowers were literally criminal in their misrepresentations, the lenders were figuratively criminally stupid.

Although it will be painful for the global economy, I do hope that governments don't drop interest rates to effectively bail out the lenders. It's not as if they haven't seen the potential consequences of foolish risk taking in the past. How many lessons does someone need before having to pay for their actions? We expect poor individuals to pay at the first mistake. Perhaps it's time that business leaders do their own hard times.

Good Credit? Bad Credit? How About Smoke and Mirrors

The news of Countrywide Financial seeing more borrowers with good credit falling behind on mortgage payments sent the markets into a scurry. But, really, what have they been expecting?
The New York Times in the first graph of their story noted "that the housing market might not begin recovering until 2009 because of a decline in house prices that goes beyond anything experienced in decades." Well, folks, we had the most insane run-up of housing prices for, what, a decade? When will people start looking at history and nature? Nothing lasts forever: not reputations, not nations, and certainly not economies.

Housing prices went up giving people all sorts of wealth - on paper. So what did the mortgage lenders and banks rush to do? Get them to take out equity. As I was reading in the Financial Times (sorry, no link), what really caused the problems for Countrywide were home equity loans where deliquency rates had more than doubled over the period of a year. What compounded that problem was a practice that many lenders have entered: a form of credit washing. Lenders took combinations of loans, mixing different credit risks, and got large lump sums by selling the loans off to legally insulated subsidiaries and then selling high-yielding securities. They essentially washed off any credit taint by saying that even if some loans defaulted, the rising housing prices would ensure the ability to maintain cash flow. In other words, they were juggling numbers and betting that a rising tide would float their rears out of trouble. But it all depended on those prices going up. That's over:

a conference call with analysts that lasted three hours, Countrywide’s chairman and chief executive, Angelo R. Mozilo, said home prices were falling "almost like never before, with the exception of the Great Depression."

This shouldn't have been hard to see. Hell, I saw this coming and so did various people I know, because none of us think that the good times last forever. Prices were at a point that people could no longer afford to get more and more - there's only so much of your income you can devote to something like housing. So people stay put, buying drops, and of course the prices drop. Then people can't move, because they're in hock up to their eyelashes and can't get the price to clear them of debt, meaning that selling the family manse would leave them cowering in the financial basement, so to speak.

Now the experts are saying that it will take until 2009 for home sales to recover. I don't believe them. This is a precarious log jam. More payments will be late, panicky lenders will recall loans (because that's what they do), more houses will be on the market, driving prices lower, with even more people stuck. Every time prices drop, more people find themselves in this trap as the barrier to being dangerously financially leveraged gets lower and lower.

So, we heard in 2006 that it would get better in 2007. Then we heard 2008 earlier this year. Now it's 2009. By the time the finance types admit that there's a significant problem, it will be the next great depression. How depressing.