Crime of the Century

A Story of Suckers, Dupes, and Crooks

A 700 billion dollar bailout and 318 billion dollars in stimulus packages; a trillion dollars above and in addition to the normal federal budget, all geared toward rescuing our economy. This is a number so huge that it defies our ability to truly conceive of just how big it actually is. The entirety of our national net public debt is just over five trillion, to give that number some perspective.

So how did we get here in the first place? The answer is complex, and, sadly, is a tail of gross incompetence and criminal mismanagement. Yet it is critical that people understand how this happened. Therefore, allow me to guide you on a journey through some basic economics, some history, and some dot connecting.

Expectation, the Foundation of a Stable Economy

It is a basic tenet of economics that the reason monetary policy works is because when the central bank announces a planned action, it actually does that action. Because the management of interest rates is a prime mover of how people invest in the economy, if people believe that the central bank will do what it says it will do, they will behave according to the announced policy. There is a temptation, then, for a central bank to make an announcement, and then not follow through. This sort of behavior frequently happens in countries experiencing financial difficulties in order to get a short-term alteration in investment and spending behavior; usually where the central bank is controlled by the government. However, once the trust in the word of the bank is broken, uncertainty is introduced, as expectations can no longer be counted upon. At that point the economy begins to break down.

That expectations drive behavior is important to understand in the context of the current economic crisis. When the Fed announces an alteration in interest rates, our expectation is that said alteration will take place, thus, there is a great deal of trust in the American banking system.

For people in the US who are currently approaching retirement age or have already retired, the expectation throughout their business life has been that the return on safe investments, such as government bonds, savings and loans, and bank CDs, will be between 6 and 8 percent. This rate is essentially the Fed rate plus 2 percent. Because these investments were considered safe, people concentrated wealth in these investments in such a way that they could live on the interest returns in retirement, hopefully without digging into principal too much, and thus leaving an endowment to their next generation. These investments were made based upon the expectation that the returns on these investments would remain consistent.

The Tricky Business of Controlling Inflation

Those of you old enough to remember the 1970’s may remember a term coined in that era: stagflation. Up until that period, monetary policy was largely set based upon a device called the Phillips Curve. The Phillips Curve was a product of Keynesian economic thought, and held that there was a persistent negative relationship between unemployment and inflation. As one went up, the other went down.

The economic shock of the oil embargo during that decade caused a circumstance in which both inflation was high and growing, and so was unemployment; a situation which, according to the Phillips Curve, could not happen. As a result, economists such as Milton Friedman strongly criticized the use of government intervention to control the economy, and advocated a return to more market based economics. This situation gave rise to the monetarists, whose prime motivation in monetary policy was to control inflation. Those who remember the Volker recession of the 1980’s will recall that this was a recession induced by the Federal Reserve Bank solely in an effort to reduce inflation.

Since that time, the Fed has used monetary policy almost exclusively to keep inflation in check. Occasionally it would use interest rates to create economic stimulus, but only so long as inflation did not rise as a result.

The problem, of course, is how do you measure inflation? It is done by measuring changes in the price of a certain basket of goods that consumers typically purchase, called the Consumer Price Index. And here is where we experience our first disconnect between the Fed and consumers. The CPI is based upon the consumption of urban dwellers only. Furthermore, it is not strictly a cost of living index, but includes the prices of recreational and electronic goods, which have a known negative cost to value relationship. Thus, the increase in the cost of bread and milk is offset by the decrease in the cost of that computer you purchased two years ago. Thus, while you and I watch our rent, food, and medical costs climb through the roof, the inflation rate appears to remain low.

Some studies have shown that if inflation were measured today using the same basket of goods as used in the 1970’s, we would be experiencing double digit inflation. (A good article on why this is can be found at: http://www.creditwritedowns.com/2008/04/cpi-understates-inflation.html).

Because of the perception that we have had very little inflation in our economy, the Fed has been all to happy to stand on the economic accelerator by keeping interest low, pretty much since the mid-1990’s.

The Housing Boom (As in “Here, Hold This Grenade”)

It’s oft been said that the American dream is to own a home. In bygone years, it’s a dream typically reserved for people who are able to save. But when inflation rates are low, money is cheap and there is an abundance of it to lend. When money stays cheap, borrowing becomes easier, barriers to entry get lowered, and speculators enter the market. Under these conditions, prices rise.

In our case, money stayed cheap, and as a result housing boomed. Because the interest rates were set by the Fed at such low levels for such an extended period of time, people began to conceive of housing not as a long term investment in their family’s future, but as a short-term commodity investment based upon the anticipation that housing prices would continue to rise. And rise they did over a period of a number of years. Some houses saw as much as a doubling of price in only a few years, a tripling in less than ten.

Because of the confluence of the tremendous rise in the price of homes combined with the over-abundance of cheap loans and available cash, loans began to be structured in more and more creative (read riskier) ways. Hence the rise of stated-income (i.e. no disclosure of actual income) and interest only (until that bubble payment hits) loans. Such loans were made with the understanding that no-one would be in them for the long term. They were made exclusively on the speculation that housing prices would continue to rise.

Leveraging: Keep the Money Flowing

At this stage in the narrative a critical term must be explained; the concept of leveraging. Leveraging is essentially the borrowing of money for purposes of investing that money someplace in which the interest rate is higher than that at which it was originally borrowed. How much a bank is leveraged is a measure of how much it has borrowed for this purpose above its actual net worth.

In the case of the housing market, investment banks were borrowing money in order to invest it in the mortgage industry. Because low interest rates created a tremendous incentive to purchase housing, investment banks would borrow money at even lower rates to provide more available funding for home loans.

Here’s where we arrive at our first moral hazard. The incentive to maximize the return on these investments created an incentive to provide loans to riskier home purchasers because they could be charged a slightly higher interest rate. These riskier loans offset the lower rate loans, and thus made the overall mortgage backed investments look on the whole a lot better than they actually were. And, because of the influx of lendable cash, mortgage brokers were incentivized to generate borrowers and thus create loan deals that appeared attractive in the short-term and provide them to people who had utterly no hope of paying the loans in the long-term. It was simply expected that they could sell the property at a higher price in the very near term before they ran into problems.

Talk is Cheap, but Your Money is Worthless

So where did the investment banks get all this money to pump into mortgage backed investments? Remember all the folks at the beginning of this narrative who had invested all their lives in safe places?

When the interest rates are lowered, returns on investments like CDs and so forth also go down. This is not so bad if the rates are lowered for a short period, but when they stay low over a period of years, the returns that retirees expected to live on go down. In this case, way down. Those who invested all their lives expecting to see a return of 6 or 8 percent actually saw returns of around 2 percent. That 60 or 70 thousand a year they expected to retire on is now around 20. So people who made these investments are left with a stark choice: either eat away at the principle or find a new place to invest.

When interest rates are low, money has no value, thus it’s difficult to find safe places to invest that will pay a return worth the trouble. Because retired people have no capacity to recover losses, the stock market is no option. Their only option was the only game in town: IRAs.

An IRA, or Individual Retirement Account, is a form of retirement account that offers certain tax advantages, and gives the investor some control over where their funds are invested. And, dressed up as a bond investment, was the only high-paying secure rated investment around: mortgage-backed securities. Some IRA accounts were vested as highly as 80 percent in these securities.

Which gets us to our first mystery of criminal proportion. These investments were all rated AAA by the rating companies. This is despite the fact that in order to get the leveraged returns, the return rate depended upon the provision of riskier home loans to people whose only hope of staying solvent was a continued housing boom and the sale of their home within a year or two.

Unfortunately for investors, this information was either not disclosed, or obscured by the exuberance of salesmen anxious to cash in on the boom.

Expectation: Another Word for Trust

So let’s recap from the perspective of the safe investor. After working all of his adult life and investing steadily in safe places with the expectation that the return would be a consistent 6 to 8 percent, finds at the end, when he can no longer recoup losses, that his returns are no longer high enough to continue to live on.

But still trusting in the system, our safe investor seeks an alternative place to put his nest egg and finds it in IRAs vested heavily in mortgage backed securities disguised as bonds. They are rated AAA by rating agencies, so he has no need to fear volatility because he has an expectation that the ratings are trustworthy.

Nevertheless, the entirely predictable housing bubble collapse occurs, as the risky loans begin to turn into foreclosures. As this begins to happen, returns on investments in mortgage backed securities decline as the higher risk/higher interest loans begin to default. And what happens when the returns begin to decline? Divestiture by short-term investors (these folks are not our retirees, but money movers playing the markets).

Very rapidly we start to see bank failures. One must ask at this stage why the decrease in returns in a single market, mortgage backed securities, could have such a profound affect on the solvency of banks. As it turns out, it’s due to leveraging. Typically your local depository bank only leverages a maximum of fifteen times its net worth, usually in a broad portfolio. But as it turned out, investment banks such as Bear Stearns, Lehman Brothers, etc. were leveraged out as much as 35 times their net worth, mostly in mortgage backed securities. If that’s not bad enough, Freddie Mac was leveraged 70 times its net worth. By leveraging themselves so far into a single market, these investment banks were left holding the bag once the investment returns began to decrease and divestiture accelerated.

By now the trust of our secure investor has been violated three times: first by the expectation on return to his initial investment due to the past behavior of the Federal Reserve, next by the investment rating houses, then by the investment banks themselves. But then it really starts to get ugly.

And complicated. The first investment bank to have trouble is Bear Sterns. As we all know, they were the first to receive a federal bailout, setting up a new expectation. When the bailout occurred, bond values held though the firm actually increased in value. But then came Lehman Brothers.

Lehman Brothers was the next investment bank to experience liquidity problems, but in their case, the federal bailout was not forthcoming. Investors who saw what happened at Bear Sterns had reason to feel safe with the expectation that if anything happened to their investment bank, they would get bailed out as well. They were wrong. Here’s where things get complex… and murky.

The composition of the bonds is not only mortgage backed securities, but all kinds of other debt as well, such as student loans, and so forth. Thus, a bond can hold pieces of many different forms of debt, and many different instances of those debts. This is further complicated by the fact that portions of these bonds can be divided among several investors. There is no real visibility by the investor into exactly what the composition of the bond is.

The value of these bonds is stated as a mark to market. The stated value in the case of mortgage backed securities is the current appraised market value, which in this case, is the value of the cash revenue of people making payments. Because of that usage, the real value of these securities is continually in flux. If they go up, it was a good year and the government collects taxes. If they go down, they become write-offs. When the higher-risk mortgages began to default, the mark to market value of those securities went to zero. That does not mean that there is no asset, the house still exists after all and has some value, but because the borrower had stopped making payments, the value of the security became nothing.

When the mark to market value of those securities went to zero, Lehman Brothers experienced a liquidity problem. In other words, it no longer had enough cash to cover its debt obligations (that of the investor). For reasons that still remain a mystery, the US government apparently used a magic eight-ball to determine whether these investments were worth protecting. When no bailout was forthcoming, Lehman Brothers went into Chapter 11 Bankruptcy, and sold the assets to an investment group at eight cents on the dollar.

The investment group then turned to the insurer, since these bonds were, after all, insured, to make up the other 92 cents. The insurance company defaulted. By now we all know that the government then bailed out insurance giant AIG to the tune of 160 billion dollars. What we don’t know is where that bailout money went. Those who were invested in Lehman Brothers are getting nothing. Their bonds still have some value, but no one is too excited about cashing in at eight cents on the dollar. Meanwhile, the insurance and investment groups are now engaged in an exercise in trying to figure out exactly what the value of the securities actually is. Remember how mark to market values are determined? The process could take years and those unlucky enough to have had expectations of consistent government behavior can do nothing but sit on their hands and hope the process gets resolved. Meanwhile, ninety percent of their investment in AAA bonds has evaporated.

Trust violation number four is the failure of government to act consistently in its bailout policy, causing people to leave their investments alone when divestiture at a higher value would have been a sounder move. Trust violation number five is the bailout of insurance companies who then continue to default on the assets which they insured with no government directive to the contrary.

Solve the Problem: Screw the People

One critical element to remember in all of this is that a huge portion of our national savings resides in pension plans and retirement accounts. This is money that typically seeks safe investments. Why that is is easy to understand: once you retire you cannot recoup losses. The owners of these assets have had their trust in the system violated on a monumental scale. And now they see that in order to fix the system, unheard of amounts of money are being handed to the very people who violated their trust in the first place. It’s simply astonishing that anyone wonders why there is no credit available. When every safe investment has been taken away, then huge portions of asset portfolios are bilked, and perpetrators are handed huge sums of money in reward, what could possibly be a motivation to reinvest in the system?

Sadly, you’re not going to find many details of this event in the American press. Simply stated, American journalists are not sophisticated, educated, or even smart enough to put any of this together. Sadly, you’ll have to look to the foreign news sources like the London Times to find the details of all this.

At any point in time the Federal Reserve Chairman could have put a stop to this by bringing interest rates back up to a reasonable level. Instead, now they’ve lowered them even further, and soon to be lowered to zero. Not surprisingly, it’s not working. The federal government is pumping a trillion dollars into bailouts and stimulus packages. It, too, is not working and is unlikely to.

The reason is all too obvious. Our economy is in this situation due to either colossal incompetence or through colossal corruption; more likely a colossal amount of both. The only real solution is the restoration of trust, and trust requires accountability. So far we have had none of that.

The people who rated mortgage backed securities as AAA bonds either committed fraud or were criminally negligent. They need to be held accountable.

The Federal Reserve Chairmen who continued to keep interest rates ridiculously low over such long periods despite fore-knowledge that the CPI grossly underestimates the actual rate of inflation in the cost of living, and that these rates were causing a runaway boom in the housing industry should be investigated for corruption and held responsible for driving retirement savings out of secure investments and into investment banks.

The investment bank captains who leveraged their firms way beyond a reasonable amount (and paid themselves ridiculous salaries to boot, see this piece on Robert Rubin: http://online.wsj.com/article_email/SB122826632081174473-lMyQjAxMDI4MjA4MzIwNjM2Wj.html) violated the trust of their investors and must be held accountable.

The politicians who only two years ago were praising Freddie Mac, and legislated the seeds of this fiasco are just as, if not more, responsible than anyone else by cheering on the train wreck while it was happening instead of taking steps to halt it. And now they think the solution is to increase our net national debt by 20 percent in one fell swoop and hand the windfall to the very people who put us here to begin with.

Expectations are the key to a stable economy, and only trust in the system allows for reliable expectations. If we expect the system to be untrustworthy, and at this stage that should be exactly our expectation, then our economy cannot recover. Trust is the problem and accountability is the solution. So long as there is none of the latter, there will be none of the former.