Financial BS

I got a well worded letter from a good friend of mine today. I say good friend with the loosest of definitions considering he comes from the second rate school of the Air Force Academy which we all know is enormously inferior to my own school in Annapolis. Nevertheless, I digress. My friend is a stock brocker or a financial manager. I'm not sure what they call themselves these days, but what I like about him is he is fairly conservative with my money.

His letter sort of described the turmoil we are in, and I cannot help but find myself giving him ideological high fives. I wish we could line up the people who got us where we are today and physically torture them to our heart's content. Without a doubt, we have thousands of morons in the financial sector and government today. Thank God I do not rely upon them directly to get me out of bed in the morning; otherwise, I would have found my bed somewhere adrift in the middle of the Pacific Ocean.

I will take the liberty of giving some people a short lesson in economics that begins with supply and demand. People are just like you and me; they buy things that they need when they need it only if they can afford it. When prices get high, people buy less, and when prices dip, they naturally buy more. It all makes perfect sense because each person as an individual will most of the time manage their own assets better than someone else: dope dealers, gang bangers, and societal leaches excluded.

What does supply and demand have to do with our current situation you ask? The answer to the question lies in the application of supply and demand to the lending market. How so? It's very simple. Mortgages are products just like apples, and a bank earns money with each mortgage product it sells. If a bank wants to grow, it has to generate more income, and as the Fed lowers its own interest rates in an effort to speed up the growth of the economy, the bank borrows more money so that it can lend money cheaper. How does this earn the bank money? Simple, half the banks don't even keep the mortgages that they make, so they sell them within a year of making them. They make their money on the loan origination fees along with a premium they place on the mortgage when they sell it to a higher tier financial organization: Lehman Bros, Morgan Stanley, Fannie Mae, Freddie Mac, etc. The kicker is the loss of accountability that goes with the sale of the loan. What does the loan originator care if the home owner defaults on the mortgage?

When you add the government's own stated policy of ensuring everyone in America can afford a home regardless of income, you have a recipe for disaster in the growth driven banking industry. I remember when I purchased my first home in 2002. My credit union required 20% down payment, no questions asked, as well as an appraisal. If the house appraised for less than the asking price, there was no loan. Contrast their standards to the way that the entire industry shifted their practices during the years following 2002. You could get 100% loans even on investment properties where you would never live. It is a beautiful world. Knowing that they could sell the loans to the next highest bidder, out the window they threw common sense and standard lending criteria: steady income--no bother, steady homelife--why worry, no collateral--who cares.

Where did the money go? I'll tell you where the money went, but first you have to hang with me because I've been working on this theory for a long time. It is a wild goose chase, but it does have an ending as abstract as it may seem to you. But I know I'm right. Let's say for starters that a developer starts with 10 units that he wants to offer to the market for $100K apiece to give him a gross of $1M. He would do this if the units actually cost him $50K to build per se. Since the buyers bought at preconstruction, they got a "deal" in that they avoided the final selling price of $150K. A bank is more than willing to give them the $100K to buy the unit. Later, they flip the unit for a quick profit of $50K and sell at $150K. The first bank gave $100K to buy the unit originally and is paid back by the second bank if the mortgage hasn't already been sold yet. As the units grow in popularity due to the rising demand for new units, each successive owner flips it a few more times, with each bank being out progressively more money, as they pay the previous bank back the loaned money, and the previous owner his profit. Are you following me? At some point, a company like Morgan Stanley bought a $250K mortgage on a unit that cost only $50K to build. Some kind of equity there huh? Talk about being upside down.

Why would Morgan Stanley do something so stupid? Because in a booming market, the $250K mortgage that they purchased ordinarily would be worth a larger and larger sum as the property appreciated. Even if the owners defaulted, the mortgagor could still sell the unit at a profit and recoup the cost of the loan in the process. Interject a bubble popping. Like a morbid cake walk, all these investment banks had bought up all the loans, that all the little banks had made using high risk methods, because all the big banks were buying anything and everything on the market. Back to the supply and demand model, the big banks were the customer and they were buying feverishly. The little banks did their part as the loyal supplier by loaning every dollar they could and selling it to the big powerhouses.

So where is the money? It's in the local banks, especially the ones with very conservative lending procedures. How can this be? Remember, there are two sides to every transaction. When the buyer of the overpriced unit made the purchase, he gave his money to the seller of the overpriced unit, and the seller of the overpriced unit did one of three things. He either reinvested the money, or he put it in the bank, or he spent it in the local economy. If he reinvested the money, you have to see the above to see where he ended up, but if he bought another property, some other lucky guy deposited the money in the bank. If he deposited the money in a bank, it is still there, albeit probably overlent out again. If he spent it, some small business owner perhaps put the income into his own bank account to pay the bills.

So how does it all add up? The large regional banks traditionally had the major capital to fund the expansion of any market in the US. When the real estate expansion started going strong, they shotgunned their money out on bogus, worthless mortgages. The money did not disappear, but it was definitely fragmented into a very decentralized system. You cannot track it, but you know it is there. Unless some mogul took it all overseas, the money resides in numerous banks across the country because everytime an overpriced piece of property was sold, the seller had to do something with the money. Even if he bought again, someone else became the seller, and so on.

Which brings me to my conclusion... Why would we bailout these large regional banks when they pushed the lending market to hand out more and more money with less stringent rules and regulations? I'll leave that up to you to decide. The results that we see today are not altogether different from every other time personal responsibility took a back seat to materialistic comforts.