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Making Horse Sense of the Financial Crisis

Dec 08, 2008

Credit is said to be "frozen" these days, mostly because the banks do not trust each other. So no bank wants to loan money to another bank. This is because the bankers themselves do not really know the extent of their own problem, much less the problems of another bank or financial institution. Most of them are up to their ears in bad loans, and to make matters worse, they have made other financial deals based upon their "assets" which turn out to be worth much less than they thought when they used them in their derivatives.

As I wrote yesterday, many financial "experts" do not even understand how derivatives work, so it is difficult for them to assess the condition of their own institution. Most of them seem to have outsmarted themselves into bankruptcy.

I am not a financial expert either, but I do have an advantage. I can go to my broker and ask him. He is largely uneducated, but he has a lot of horse sense. His name is Forrest. Forrest Gump. Here is what he told me when I asked about Mortgage Backed Securities back in September when the $700 billion bailout bill was being considered:

"Mortgage Backed Securities are like boxes of chocolates. Criminals on Wall Street stole a few chocolates from the boxes and replaced them with turds. Their criminal buddies at Standard & Poor rated these boxes AAA Investment Grade chocolates. These boxes were then sold all over the world to investors.

"Eventually, somebody bites into a turd and discovers the crime. Suddenly, nobody trusts American chocolates anymore worldwide.

"Hank Paulson now wants the American taxpayers to buy up and hold all these boxes of turd-infested chocolates for $700 billion dollars until the market for turds returns to normal. Meanwhile, Hank's buddies, the Wall Street criminals who stole all the good chocolates are not being investigated, arrested, or indicted.

"Mama always said; 'Sniff the chocolates first, Forrest'."

Forrest has a lot of horse sense. Horse sense is the ability to listen and to know which end of the horse is speaking.

If I understand Forrest correctly, it goes like this . . . The economy was in danger of collapsing, so Greenspan decided to make money cheap and easy. Government decided to bless the poor by encouraging Freddie and Fannie to make loans to those who really could not afford to repay the loans. Based upon their economic projections that housing prices would continue to rise rapidly, they issued sub-prime mortgages.

In fact, my first house in 1979 was done this way. For the first few years I paid less than the interest owed, so the principle that I owed actually increased for the first few years. Fortunately for me, the house increased in value by about 21% in just 18 months when I sold it and moved. But many people today have gotten into trouble, because the price of housing is on the decline.

The point is that those companies who sold the houses and drew up the mortgages were out to sell houses. The more they sold, the more money they made. Since they did not plan on holding the mortgages themselves, they knew that if things went sour, they would not be left holding the bag. In selling those mortgages, they passed the "old maid" to someone else, who put a bunch of these mortgages together and sold them as a package to investors around the world. They put good ones in the package, and sprinkled the bundles with a few bad ones.

Then they took these bundles ("turd-infested chocolates") to a rating agency like Stankturd & Poor to find one that could be hired to give the bundle a Triple A rating. If one would only give it a BBB rating, they took it to a different company. Only the company whose rating was accepted was actually paid for its rating service. The rating agency knew that it could make money only by giving out AAA ratings--so that is what they did, whether the bundled mortgages deserved it or not.

Not to worry. Each bundle is insured, so the problem was passed on to the insurance company. It is insured according to its rating. The insurance company (like AIG) took the word of the rating agency and gave it a low insurance price based on the AAA rating. After all, a BBB rating would raise the cost of the insurance.

None of the investors questioned the bundles, because each bundle was rated by a "reputable" ratings agency and backed by an "insurance giant" that could never fail.

These "chocolates" were then sold world-wide to investors with more money than knowledge of the American way of doing business in Babylon. They looked at New York and envied us, thinking that we surely know how to do business, since we were so successful at it. They did not realize that the Investment Banks were making money selling "toxic mortgages" as fast as they could.

Then on October 31, 2007, Meredith Whitney blew the whistle, and the train came to a grinding halt. The con game was up, and suddenly everyone pleads ignorance and points at the culprit upline. The only ones who were truly in the dark were the ones holding the "old maid," those holding those toxic mortgages when the game ended.

Many American Investment Banks were also left holding the "old maid." Meanwhile, they had used these "assets" as money and had leveraged them 30 to 1 or higher on derivatives. All based on worthless assets. Now these have to "unwind." As they do, the losses mount up 30 to 1. They unwind a little at a time, so that the Investment Banks don't have to claim all their losses at once. Ten billion here, eight billion later, and so on. So the market holds on, hoping for a Miracle on Wall Street that will never happen.

The problem is that the Investment Banks managed to sell their boxes of "chocolates" all over the world, so it is now a global problem. Perhaps they figured that the world economy is "too big to fail." Other governments would have to bail out their own financial institutions to prevent their own meltdown. In essence, these other governments have to subsidize the criminality coming from Babylonian headquarters.

They don't like it when they bite into a chocolate and find a turd.

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Category: Financial

Dr. Stephen Jones

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