Frederick Douglass

"Power concedes nothing without a demand. It never did, and it never will. Find out just what people will submit to, and you have found out the exact amount of injustice and wrong which will be imposed upon them..." Frederick Douglass

Sunday, November 21, 2010

The Grand Deception ( part three ), The Method

The purpose of this series of articles is to explain exactly what caused the collapse; who made it happen; and, if I achieve my goal, why. It is my contention that this depression, like so many others, is a scam. In order for the reader to learn what precisely happened, it's necessary to understand how the financial markets work.

If you don't have any background in economics, or have ever turned on CNBC and wondered just what language they were speaking, not to worry! What will follow will demystify marketspeak for you no matter how inexperienced you are with such things. What happened is really quite simple, you will have no trouble following along. I promise.

Warren Buffet called mortgage-backed securities ( MBS ) "economic weapons of mass destruction." [1] These ballistic missiles fired from the turrets of Wall Street's oldest and largest banking houses ultimately brought the world's economy to a standstill. The MBS were to the financial industry what tortillas are to Mexican cuisine in that they could be molded and cut into many different dishes. As tortillas are used to make tacos and burritos and quesadillas, so MBS came with different ingredients and formed into many different market-pleasing shapes and sizes. The problem was that the tortillas holding these creations together were disintegrating. The mortgages which "backed" these investments were going bankrupt at an alarming rate. And when this became public it caused a massive sell-off. This resulted in the sub-prime housing market collapse and the prospect of bankruptcy for those institutions, many of them respected Wall Street banking and insurance companies, which had invested large sums in these MBS. It was like yelling fire in a crowded theater, it caused a stampede toward the exits. The market was shorted so hard and so fast that it caused panicked selling of both the MBS and of shares in those companies which didn't make it to the exit in time.

That is how the collapse happened. To understand it in detail, it is necessary to understand what "shorting" is. To understand that one needs to know a little about how buying and selling securities or commodities work. If you know what a dividend is, or what going "long" or "short" is, then you don't need to read on. If you don't, please stay with me.

Let's begin with the life cycle of the average company on one of the stock exchanges. Say you have an idea for an business but don't have as much money as you need. You could go to the bank and get a loan, or, if you believe you are on to something big and think others might be willing to buy in, you can "go public."

"Going public" or taking your existing company public means that you will sell shares in your enterprise on the public market. You go to an investment bank[2] and they handle all the details and, for a fee or some shares or both, they put your shares on an exchange. ( Usually the New York Stock Exchange [ NYSE ] or the over-the-counter exchange known as NASDAQ. ) This is the initial public offering of stock ( IPO ), thereafter you can decide to increase the number of shares available on the exchange if you need to raise more money.

The term "share" means just that: It's a share in the company, a share of its ownership. If there are a million shares in a given company and you buy one, then you own one millionth of that company. Typically the people going public wish to retain control so they keep a majority of the shares. If there are a million shares then the original owner would keep 500,001 and make only 499,999 available to the public. Thus he or she would still be the majority owner.

Shares in companies are often called "securities" as the buyer has secured a share of the ownership, you have paid for it outright. If one does buy some shares in a company one is said to have a "position" in that company.

The IPO share price is fixed to what the investment bank thinks the public will pay. If you have an existing company and doing so well that you need capital to expand, then it's likely that investors will pay more. If your company is a start-up then your shares probably wont fetch much. On average, for new companies, the IPO price is about ten bucks.

Now you have a "joint-stock company"[3] The price of your shares will go up when more people want to buy then sell, and vice versa. Let's say you do really well, your company goes global and becomes the biggest player in your industry. While this is going on, your shares are going to be in high demand, but if you are very lucky and begin to dominate your sector, you cease to grow as quickly. Take Microsoft for example. They are so dominant that in order to keep growing they will have to find another planet that needs operating software. Now, just about everybody buys Windows, there just isn't anybody left to sell to. When companies reach this stage, they generally experience a sell-off as investors begin to look to other companies which are still growing. This creates a problem for even big successful companies like Microsoft as the value of their enterprise is determined by their "market capitalization."

Market capitalization is easy to compute: It's the total number of shares in existence multiplied by the share price. If there are a billion shares of a company, and their price is fifty dollars, then the company's market cap', or value, is 50 billion dollars. When there is a sell-off and the share price declines, the overall value of the company declines. That means their credit limit goes down; it means they would have to offer a larger number of their shares in order to buy another company; it means they are more susceptible to being bought out in a hostile take-over. In order to keep their share price up when they can no longer keep growing, many companies issue dividends[4] to share-holders. This is a sum of money per share, usually paid annually. For many, particularly those who dislike risk, these are good investments in that these companies are usually quite stable and fiscally sound, and one gets a better return on investment from these dividends than one would from a bank account. There's not much hope of making a lot of money from these shares, but they are a dependable source of income. Some people live off these dividends.

When investors buy securities, they are doing so in the hope that the share price will go up. If you buy at fifty bucks a share, and sell at 100, then you have doubled your money ( minus broker's fees ). Of course it could backfire on you and the share price could go down, that's the risk you are taking, but the hope is the price will go up after you take a position in a company. This is called being "long" in the market.

There is a way of betting that the share-price of a given company will go down. This is called being "short" in the market. Often this involves companies which issue dividends.

Say you own some securities which pay dividends annually. And let's say that they pay on the first of May. It's now the second of May and you have received your dividend and you are waiting 364 days until you get paid again. Now your broker tells you that somebody is looking to borrow some shares of the company you have a position in. The prospective buyer says lend me a thousand shares and I will return them to you before May of next year. He also offers to pay all broker's fees and, in addition, pay you a fee as well. Your broker says the guy is a good credit risk and You agree because it's a second payday for you, and you will have your thousand shares back in time to receive your dividend as usual.

The borrower is hoping that the share price will go down so he borrows the shares and immediately sells them. He now has until May to buy them back and return them to the lender. If the price drops in that time then he's made some money. Here's how it works: He sells the shares for say sixty dollars. He now has $60,000. If he's lucky and sometime in the next year the price drops to thirty dollars a share, he then buys a thousand shares costing him $30,000. He's made $30,000 in profit ( minus broker's and lender's fees ). He returns the shares to the lender and everyone's happy. If the share-price rises and he has to pay more than he got when he sold, then he loses money. This is shorting the market.

The lender now has shares that are worth half of what they were before the loan but that would have been the case anyway, and if you are holding shares for their dividends then the actual price isn't particularly important. ( That is after the initial purchase. ) If the lender collected the same in the fee from the borrower as he collects from the dividend payment, as is often the case, then the lender has doubled his yearly income from the shares he holds.

We have been talking about securities, there are also ways to short bonds. In the 1980s, Lew Ranieri of Salomon Brothers investment bank created the mortgage bond. It allowed purchasers to buy a piece of the debt owed by homeowners and access the flow of cash that resulted from mortgage payments. Basically, mortgage bond buyers were sharing in some of the risk the bank had assumed when it wrote the mortgage, and sharing in some of the profits when the mortgage payments were made. Bonds, which are loans made by buyers to the issuer at a fixed or variable rate of interest, are usually issued by governments or corporations. In this case these bonds were derivatives [5] issued by investment banks themselves and based on the long-term ability ( or inability, as the case may be ) of mortgage borrowers to repay their debt.

When a bond is issued, it is given a rating by rating agencies. The best rating is AAA and the worst/highest risk bonds are commonly referred to as "junk." This rating is the agency's evaluation of how solvent and able to pay off the bond the issuer is, an assessment of the risk the buyer is taking. Traditionally, there are only two parties, the issuer and the buyer. If a bank is issuing a bond, the rating agency is evaluating the bank itself. In the case of the mortgage bond, the issuer is an entity, usually the investment bank itself, which has bought mortgage loans from a commercial bank or mortgage company, and is offering a piece of it to the bond-buying public. There are now three parties involved: the issuer, the buyer, and the homeowners who are paying off their mortgages. The task of the rating agency is now much more complex, less mathematical and more subjective and interpretive. This alone made these financial investments risky, but the likelihood of getting a good appraisal from the rating agencies was diminished further by political developments.

Since 1980 when Ronald Reagan took office, there has been a steady erosion of regulation and oversight of Wall Street, and it hasn't mattered whether a Republican or Democrat was in the White House. Under Clinton, the Gramm-Leach-Bliley Act was passed in 1999. It repealed the Bank Act of 1933 ( Sometimes called the Glass-Steagall Act ) which had kept investment banks from owning commercial banks and ratings agencies. With the runway now clear, a great consolidation occurred with the result that investment banks now owned the agencies which were now assessing the mortgage bonds offered by the same investment banks. The point of Glass-Steagall was to prevent just this kind of conflict of interest, once it was out of the way, all kinds of shenanigans were possible.

Mortgage bonds were difficult enough to assess, now there was added pressure of pleasing the owner. It was in this murky, deregulated, derivative market that the MBS and other worthless investments that caused the current depression were spawned.

Further complicating matters was the legal question: What was the responsibility of the issuer of these mortgage bonds? As they were new, the law didn't address three-party bonds. If the bonds went bad due to the inability of homeowners to pay their mortgages, did the bond-holders have any legal recourse against the investment bank which sold them the bonds? The law was unclear in this regard.

For the first decade or two of their existence, mortgage bonds were a great success and made Ranieri a very wealthy man. However these bonds in recent years became "securitized." That is to say that they were repackaged and bought and sold like shares of joint-stock companies. The potential of these new derivatives, particularly in the then red hot housing market, combined with new liberal bookkeeping practices like mark-to-market accounting [6] which camouflaged just how dubious these MBS were, made these new instruments extremely popular with investors. They were the clinking-clanking sound that kept Wall Street world going around and around. When at last Meredith Whitney of Citigroup sounded the alarm by announcing that these MBS were worthless, they were shorted as were the companies which were holding large quantities of them. Thus did Lehman Brothers and other titans of high finance left holding the bag fall. Our economy fell with them.

There was one company in particular that guessed just the right time to short the housing market. It's a hedge fund called Paulson and Company. It shorted just before Alan Greenspan, head of the Federal Reserve Bank, raised interest rates. The housing market was hot because the Fed had lowered rates and kept them there thus making home-buying more affordable. Greenspan was also responsible for green-lighting MBS and mark-to-market accounting. His raising of interest rates was sure to slow the housing market down, Paulson anticipated this moment and placed the largest short ever in the history of Wall Street. As it turns out, his ability to read Greenspan's mind netted him personally about fifteen billion dollars. Estimates of how much he made for his fund vary widely but the actual profits must exceed 50 billion. It was later revealed by a Securities Exchange Commission ( SEC ) investigation that Paulson had been crafting some of the bogus derivatives for Goldman Sachs, the same worthless paper which he had been shorting.

Later, when Alan Greenspan retired from the Fed and, after finishing a tour for his autobiography, he was hired by Paulson. The terms of the deal were not released.

Is it possible that Paulson had more than a hunch as to when the Fed would lower rates and kill the housing market? Is it possible that the party who designed some of these MBS and made the largest bet ever against them actually intended them to fail? Is it possible that what happened was what was intended?

There's a lot more, dear reader, a lot more, details to come.

[1] He should know, he launched a few of his own. More on this in later articles in this series.

[2] As opposed to depository or commercial banks that you and I deal with. Investment banks broker stocks and bonds etc.

[3] So called because it is jointly owned.

[4] So called because they are the result of dividing the total number of shares by the amount being paid out by the company.

[5] Derivatives can be any investment which is derived from another. In the case of a mortgage bond, it's derived from the payments of homeowners.

[6] Mark-to-market accounting allowed companies to register the profits from a sale before they had actually received the payment. With mortgage bonds, investment banks' bookkeeping reflected mortgages as being paid when they were written. One had to dig much deeper than normal to find where the books reflected the actual status of the mortgages. This is what Meredith Whitney did.