What is going on in the Finacial Markets? LDN Oct 2008

When I am not playing the intrepid columnist for the LaGrange Daily News, I am the chief financial officer for a consulting company. I only say that because during the day I get a lot of questions from friends and co-workers on what I think about the economy and the Wall Street mess. I am by no means an expert but I do spend considerable time reading and monitoring the situation. I have tried to explain it to many of my colleagues. It doesn’t take long until my soliloquy leads to confusion and that blank stare which means that I have failed again to convey the scope of the problems in simple terms.

A few days ago, a colleague and I were discussing the bailout. He hung in there a little longer than most but like the others before him, he cried “no mas”. However he was not finished. His college-aged children wanted to know what was going on. He then wrote this response. I think it is a pretty good primer on what the meltdown is all about

How did we get here?
The current ‘crisis’ has its roots in bad mortgage loans (a loan made to somebody that wants to buy some property, like a house – where the property is the collateral – which means that if the borrower does not pay back the loan, the lender gets the property) made over the last 8-10 years, primarily for 2 reasons:
1. Loans that never should have been made to people with no chance of paying. Probably the best of intents – but as far back as the late 90’s the Clinton administration put profound pressure on Fannie Mae and Freddie Mac to ease the rules on loans low income borrowers. Probably noble – share the American Dream and all that.
2. Loans made for absurdly inflated values. The ‘bet’ was that property values would continue to escalate, thereby catching up with the inflated loan values.

BIG POINT – These mortgages were packaged up and sold as investments to other financial corporations and brokerage houses (i.e. Merrill Lynch, AIG, Lehman Bros, Wachovia and others). The original underwriter got paid and transferred the risk of payment to someone else.

So, where are we?
Now, fast forward to the last few months. Housing slows down. Property values stop increasing to the point of actually decreasing. Builders and other borrowers can no longer justify their inflated loans vs. the falling value of the actual property and they default (stop paying) on the loan. The investment houses (named above) that ‘bought’ these loans as investments, are now holding the collateral, or foreclosed property, which is worth a FRACTION of the value of the loan assets, so they have had to take what is called a write-down. In other words, their assets (stuff they own) are worth far less today than they were a year ago. That is assuming any other institution will even buy them.

Now it gets interesting. Since these financial companies are worth less, their credit ratings have fallen. With falling credit ratings, they legally have to have more cash. Cash???? Did somebody say cash??? You mean with all these high-falutin’ financial terms and fancy words, somebody actually has to have some cash to pay for this?? Darn right. So, these financial institutions are caught having to raise cash, and we get to:

The last straw:
Because the banks have had to tighten down, there is no credit/cash flowing through our financial system. The banks are simply not loaning any money to each other, or to any borrowers – which is a fundamental pillar of our financial system. Liquidity or the flow of cash from institution to institution to individual is what drives everything in our economy. All the fancy words in the world – but at the end of the day, somebody has to have cash to pay. And it all started with loans that were never going to get paid.

The net/net is that we are Americans and we will get through this. It is time for all of us to ‘bow up’, stop panicking, believe in our system and act a little less selfishly (buy only what we can afford). At some point intelligence will reclaim the market from raw emotion and investors, analysts and the press will realize that companies like Microsoft and GE and many, many more are fundamentally the same sound, solvent and growing enterprises they were 6 months ago. They are simply not worth half today of what they were – and the market will recover. The economy WILL recover.



Net/net – there are some other factors which I have not discussed (to avoid the glazed over eye syndrome) – but at its most basic form, this is a NORMAL AND NATURAL economic cycle, that has been grossly exacerbated by the fact that we artificially kept the ‘boom’ cycle alive for too long.