Risk Has Left the Building

The financial collapse of AIG wasn’t an accident. The conditions were just right for individuals of every walk of life to make a killing on the way the financial system reacted to the real estate boom. The basic mistake was the misallocation of resources. The world didn’t need all of this new housing, but it was very profitable to build and finance. The increased property values implied that the banks couldn’t lose on any loan. The tax base increased proportionally and government expanded (exploded). It was only "short bus" math to figure out that over 30 years, a person earning $35,000 per year was not going to have the resources to pay off, a 30 year, one million dollar mortgage.

All of a sudden it stopped, the bubble burst. AIG and several hedge funds collapsed. The side bets (derivatives/insurance/credit-default swaps) covering those exposed to loss came to the surface. These hedge funds were writing insurance on everything including the kitchen sink.

Risk had been removed from the business model. It’s hard to lose money if you place the right side bets (that’s without even including Fannie and Freddie in this mess). Too much “insurance coverage” had been written. The insurance premiums were collected and went into someone’s pocket. The estimated 40 to 80 trillion of derivatives written to insure against financial loss will never be paid.

For example, Greek bonds have a substantial risk, but buy insurance and your worries are gone. If you are the Greek government, buy the insurance (you can’t lose). If you work for the Greek government, why buy the bonds? Just buy the insurance and when Greece goes belly up, retire to the good life. Greece will make that glaringly apparent when they collapse (after receiving their bail out money).

The real fault with this "insurance" is that you don’t have to have a relationship to the asset being insured. There is nothing to stop you from insuring your neighbor’s home and then burning it down. Plus if the neighborhood has "a gut feeling about that house," there’s going to be several policies written on that home. Then when the expected happens, (it burns to the ground) everyone gets rich. It’s as if, AIG was the insurer for anyone placing a bet on that house. Geithner and Bernanke saved the day; everyone got paid on that one.

Three questions arise. Were the insurance rates too low for the coverage written? Should the contracts have been allowed to be written in the first place? Shouldn’t you have to prove your vested interest in the insured, in order to purchase the product?

The Panic of 1907 led to legislation that made this sort of "insurance" illegal; the bucket shops which sold it, were banned in 1909. And then 91 years later, Congress rolled that law back. We were smarter now and knew what we were doing. Just as a our person making $35,000 a year can't pay off that million dollar loan, the 50 trillion dollars in risk arbitrage can't be paid either. The risk in the market is real, the "insurance" isn't. And, as in all fairy tales, everyone lives happily ever after.

Mortgage Market Meltdown (reprinted)

This piece was written August 4, 2006. I thought it might bear a review.I get irritated when I watch the PBS feeds of the Congressional committees, who ask why no one saw this real estate mess coming? Congress has to assume the biggest share of the blame. If I could see it, they could too. Of course this was bringing in a lot of tax dollars, which they could spend on new toys; Spend-------ad infinitium.

Lets look at an organization named Fannie Mae. Picture it as a 4 x 4 x 4 foot black box with the words Fanny Mae printed in white on it. Envision Mr. or Ms. "Mortgage Market" dropping into the box all of their 80% finance loans and when the box gets to $1 million it spits out an investment certificate for 1 million paying 5%, face amount guaranteed, which is purchased by Mr. or Ms. "Unknown Entity," AKA "mark" or "sucker."

The little black box is a great transformer and redistributer of debt. Nobody wanted to touch that crap until they built the little black box. By God everyone is entitled to the American dream of home ownership rah! rah! rah!

So we have this box and the question arises, "What the hell do they do inside that box?" My guess--absolutely nothing.

There is really no problem with the design model aspect of the black box. It will perform within its parameters. After all, its rather absurd to have a real estate market drop 20% isn't it? (Believe that, and I have a bridge to sell you). What is not realized is that the market can drop 50 to 70 percent. In this scenario, the little black box fails to function as expected. It doesn't have the funds necessary to back the claims it made in the past. What funds does it have for back up of bad loans? My guess, is none. Say you need one or two trillion dollars to back up the investors who bought these certificates---total tax collections for the US of A is about 1 trillion a year. Sounds like someone is going to get short sheeted!

The question arises who's holding all of the crap and who is going to get burned?

My guess is mutual funds and IRA's and I could be wrong.

Off Track Betting

40 years ago I had a summer job working for Delco as an Engineer in training. It impressed me that there was this one guy that would get off early and go to the race track. Naturally everyone would give him a couple of dollars to bet on a horse or two. On one particular race day several of the requested bets won big. The guy didn’t come back to work for a while. It seems he had been pocketing the money and betting on his own tips. Two workers had asked for a Trifecta ticket of say 711. Those 3 horses won and the payout was astronomical; but no tickets for that combination were sold at the race track. So it got added to the payout for the next day.

This might seem unrelated to the stock market, but look at options. 90% of all options expire worthless. So a big brokerage, could take the orders and not place them, and cover them internally. And on expiration the brokerage gets the money. If there is a small winner, pay the guy off.

If you were to change your mutual fund holdings, and move from investment x to investment y, the question comes up; does the mutual fund go out and change what they are doing just because you move a few things around? Probably not.

Take gold and silver bullion storage facilities. It is not unreasonable to suspect that these companies only keep less than 10% of the demanded holdings in actual metal. It’s rather tempting to hold the rest as some sort of certificate, and invest the proceeds in selling puts and calls on the “bullion in storage?” Remember 90% of options expire worthless.----everyone is not going to ask for their gold at once. Hmmmm--- What happens if they do?

The amount of physical gold and silver in the world to date is a measured known amount. Just like everything else, as long as the system has no real stress applied to it, things function quite well. If everyone decided to take possession of their gold or silver, it just might not be there. It has been suggested that only one ounce of gold for every 100 under contract could be delivered, if demanded. The neat thing about gold and silver, is that the FDIC/Treasury can’t print either one.

The people we trust are not doing what we ask because they can buy an option to satisfy our requirements. The trouble is, these option tools may prove to be very inadequate in a panic. As Buffett suggests, we will see who was swimming nude, the irritating thing is, it could be us.

4 Trillion Dollars worth of Inflation

Let’s examine the housing bubble. For this example, we will use a million dollar home (before the bubble it was worth 300K). The buyer secures a 30 year loan for one million dollars. The home's seller puts the untaxed windfall gain in the bank.

The housing market tanks and now million dollar homes are worth 300K again. Each homeowner signed an agreement with the bank, to pay on the loan for 30 years. Assume these home owners walk and send the keys to the bank. The homeowner’s loss is probably negligible.

The bank now has a problem. Instead of a steady income stream for 30 years, they have many 300K homes and a loss on each home of 700K. The bank is now insolvent and the FDIC insurance will step in to make good on the bad loans.

At this point, two things are evident. The money that was to be paid back by the buyer, was to be done with earnings over 30 years. The money paid by the FDIC to the bank to cover the bad loan was printed money paid immediately. So the contract to pay on the home for 30 years has been canceled, this money if it had been paid, would have been real money, i.e. earnings.

In our example, the bank now owns the house worth 300k and receives from the FDIC the other 700K. Instead of the banks getting 1/30th of their investment (plus interest) back every year, they get 7/10ths back right away and the rest when they unload the home.

When you realize that a 30 year home loan has a payoff of 2 ½ times the amount borrowed, the 4 trillion dollar loss currently projected would represent 10 trillion of real earnings over 30 years. This would have been money that could not be used for consumption, it was already under contract. Under the FDIC plan, the banks get immediate remuneration with printed money and their depositors are still whole. It’s painless; no one had to work for it.

So, everyone that sold their house before the bubble popped is a winner, everyone that walked away from their bad investment, after the pop, is a winner and everyone with money in the bank is a winner (A real fairy tale ending). The government pours 4 trillion dollars into a banking system that expected that sum back with interest over a 30 year time frame. Now the bankers have all of this money to lend with no one credit worthy enough to loan it to. Where do the banks go next to lend money? Greece, Portugal, Spain, Ireland—they can’t lose, they’re FDIC insured. And of course there is no inflation, the person who sold his house for 700k more that he paid for it, gets to keep it. The bank that lost the 700k (when the new buyer walked), gets reimbursed by the FDIC. We have a bank owned house still worth 300k and 1.4 million dollars of new money in the banking system.

The thing to realize here is that the new homeowners never really had the earnings to pay these loans off, 30 years down the pike. But our government will pick up the tab on this failed dream of riches. Real estate was a get rich quick scheme and an obvious bubble. America is the new Wonderland; you wonder how we will pay for all of this. You won't have to wonder long.

Reading Between the Lines

With Friday's job report, the message is “We have turned the corner on the recession.” This reinforces my belief that in bad times people want to hear good news. There are some serious miscalculations here. A lot of the jobs that have been lost are not coming back; people will have to be retrained for new types of work. In the 1930’s we switched from an agrarian economy to a manufacturing one. The switch is happening again. We need computer skills to fit into the new world of Information Technology. The problem is trying to retrain those over the age of 45 with these new job skills.

Housing also seems to be picking up. It seems like savvy investors are picking up rental property. Think about that for one moment, if housing prices drop below what renters are paying for rent, why rent? Buy a house. So as housing prices decrease, the rental market goes to hell. In some places like Detroit Michigan or Helmet, California, home prices have hit $80,000, that’s the construction cost of the house with zero land value. The net result home builders disappear. $600 dollars a month would move you into a home. I hear Fannie and Freddie Blowin' In The Wind; get a free toaster with your purchase of a house.

Then we have state budgets and legislators on the road to nowhere. The recently elected New Jersey governor Chris Christie is starting to get the state moving in the right direction. Here is a Link worth watching, it's about 26 minutes . He has the right ideas. He knows what he’s doing, won’t get him re elected. Maybe some of the right people, to fix this mess, are getting elected.

And finally, public employee retirement plans are making the news. Taxpayers are beginning to realize the retirement benefits are a bit on the extravagant side. The state financing (nationwide) needed to keep these plans funded, are a couple of trillion dollars short, three to be exact (so far). It will be interesting to see where this money comes from.

If you are wealthy, you’re oblivious to today’s hard times. Some Indian father threw a $200,000 wedding in downtown San Diego yesterday. He even rented an elephant, see the picture below.

It kind of makes one wonder about the distribution of wealth in the world. Opulent consumption of this sort during hard times never sits well with the masses. The quote “Let them eat cake” comes to mind and we know how that turned out.