Now For Something Serious

Usually I write about things that annoy me in this blog but today I am going to take a step back and get intellectual on you.

I am sure most of you have seen the recent market debacles that have permeated through Wall Street and were preceded by an invisible Main Street melee that no one has been willing to talk about because it hurts to admit our shortcomings. For those not familiar with the events of the past weeks I will give you a quick synopsis. Basically all of the financial misgivings of Americans have come to a head through a small fissure in the financial system. For the last decade we have lived the American dream of free money. Nearly 65% of Americans own their own home (Of course this concept is a misnomer as very few families actually own their home or ever will). In comparison, our parents worked and saved to own a modest home and actually accomplished that goal. This was the backbone of America. The concept of owning something that took sacrifice to get.

Fast forward to the last decade and America is quite different. Now we own nothing. We simply lease or buy on credit. Then we continue to borrow money using the same asset that we don’t own, but is worth more than when we began our payment process. We use that borrowed money to buy more things that we cannot afford and essentially don’t need. We are a nation of debtors. Normally this would be a good thing for the economy. For credit and financial markets to work there need to be creditors and debtors. The concept has a foundation of one person borrowing from another with collateral being the basis for the security of the loan for both sides. The problem manifests itself when the debtor’s collateral is worthless. This can be seen in the use of credit cards and can be expounded to other areas as well.

People buy all kinds of worthless junk on credit. Obviously a home is not worthless but it is only as valuable as what someone else will pay for it. If you buy something with a non-collateralized loan, your desire to repay it is directly attributable to your value of the item purchased. Which is why so many people don’t pay their credit cards off, no one is going to come and get the stuff they bought because it is essentially worthless in comparison to the debt.

This brings us to the present. Markets worldwide have gone through a liquidity crunch in the last few weeks. This was brought about by two colliding forces. The desire for Americans to have everything they feel they are entitled to and the desire of business to make money in an environment of fewer customers. Just about every American believes they have the right to own a home. Even if they have zero credit or even worse, bad credit, they believe they will always make their mortgage payment. With the increasing level of home ownership in the last 7 years, everyone felt they should own a home. This sense of entitlement ushered out sanity and sound decision making. It lead people who should not be homeowners to demand it as an American right.

This demand for home loans coupled with lender’s hunger for an increased debtor pool, led to a severe loosening of credit standards and an increase in risky loans with low up front payments. So now we have a pool of clean, quality debtors mixing with a pool of toxic debtors. Three years ago this was fine because the toxic debtors could afford their artificially small payments and everyone was happy. More home buyers equals higher home values which led to more home equity borrowing which led to even more customers for lenders. Wall Street loved the continued increase in profits from these lenders as well as the increase in Debt obligations available for purchase. Debt obligations are instruments where lenders package up their loans into large bond issues that they sell to banks and institutional investors. The bonds are rated based upon the credit worthiness of the underlying mortgages and the rates they pay are based on those credit ratings. However as the pool of new debtors decreased, lenders had to loosen their credit restrictions in order to continue to profit from a now shrinking populace of new homeowners and re-financers. Wall Street drove this by continuing to demand these asset backed securities because they yielded solid returns and were considered safe because their origination was from something as rock solid as a debtor’s home.

The collision of the demand for credit by home buyers, demand for high yield “Safe” debt obligations by Wall Street, the decreased credit standards of lenders to meet these needs, and what was an inevitable collapse in home prices has arrived. Normally there is a small default rate built into these securities but when they increase due to foreclosures across the country, the securities lose intrinsic value. Since these were owned by institutional investors all over the world, the ripple effect is obvious, but this was different. We started to see these assets get dumped into the market, lowering their value.

This is exacerbated by hedge funds all over the world that are leveraged and own these assets. Why? Well when a fund is leveraged it is more volatile both positively and negatively. When the value of an asset goes down the fund needs to sell assets to meet its margin requirements. When a chunk of its assets are worthless in the current environment, it must sell assets that are valued. These tend to be equities or bonds that are fundamentally sound. This artificially deflates the values of “Good” investments, thus affecting the entire market. Compounding this is the fact that these debt obligations had proliferated all over the world into all types of funds, which is why we saw a global sell off of equities and a flight to sound investments like government backed assets.

With no one wanting to own mortgage backed securities, they had no inherent value. If investors could not rely on the underlying security of mortgage backed securities then what could they rely on? Who is to say who a sound debtor is? Who is to say that a financial institution isn’t holding a large amount of these securitized assets and thus could fall prey to the pandemonium? All of a sudden no debtor could be trusted and no one was buying debt, and without debt, the financial system worldwide stops. Panic sets in because all of a sudden the rules change.

This is a great example of how changing financial habits can crush the foundation of an economy. Our country went from one of saving and buying with cash to spending and never repaying. Consumption is good for economies but entitlement can be deadly.

I promise to write some dick and fart jokes next week.