On Ecosystems, their Food Chains, Predators, and the Financial Crisis
Indulge me, if only for a little while.
Ecosystems are communities of living organisms, and non-living objects that live and serve/function together at a macro level. In a world of rational expectations, members of every ecosystem must function together in organized and predictable patterns, with some degree of mutual (as in two-way) benefits for each member of the ecosystem. This is a both a necessary and sufficient condition in order to sustain and to ensure survival of the ecosystem.
At its core, every ecosystem is in essence a Food Chain - a hierarchy and an ordered sequence of organisms, where every organism, at each level of hierarchy is more powerful than all those below it. For example, ‘Roshambo’, or ‘Rock-Paper-Scissors’ is a type of food chain. It happens to be circular - Paper covers Rock, Scissors cut Paper, and Rock smashes Scissors. Circular food chains do not have a vertical hierarchal power structure. Rather, they are closer to a lateral power structure, where every member of the food chain can destroy the member that is next in order. In other words, there is no ‘Super Creature, or object, in a circular food chain.
Most organic ecosystems, and their central food chains, are strictly linear (vertical), with crisply defined beginning and end points, and a vertically diminishing member’s power structure - the bottom most creature is the least powerful while the top-most Super Creature, in the chain, ‘rules’ over the entire chain. Whatever sits atop any chain, as the Super Creature, is capable of destroying every organism in the food chain that is below it. Theoretically that is true in an absolute sense. In normal practice, however, Super Creatures, and each organism below the super creature, seldom go after fellow food chain members that are more than 2 levels of vertical separation below. This protocol is seldom explicitly encoded in any rules of engagement of any food chain, but is vital to the long term survival of the ecosystem, and the food chain itself.
For example, our oceans are a very complex ecosystem, with an extremely well defined food chain (top to bottom): Killer Whales are the Super Creatures of the oceanic food chain. They are the ‘Apex Predators’ of the oceans because they have no natural predator capable of killing them. Killer Whales regularly kill even Great White Sharks - once thought to be the Apex Predator. If we think about Killer Whales feeding on Great Whites and keep going down the list, we end up, ultimately, at Planktons. Planktons are the very bottom rung of the oceanic food chain. So long as large quantities of Plankton exist, each creature all the way up to Killer Whales will always have food for survival. Another phenomena supporting long term survival of ecosystems is remarkable difference in how long it takes for organisms at every level to multiply. In general, organisms higher up the food chain take longer to multiply. Long term stability and survival of any food chain, and any given ecosystem relies upon balancing these two forces against needs of the members of the chain. If either of these two balancing forces get forced into a persistent state of imbalance, or are destroyed, then the ecosystem itself may become unstable, and may eventually perish, or self-destruct.
Despite the scenic route taken this far, and perhaps a mundane read for most, this discourse on ecosystems and food chains is directly and immeasurably relevant to Global Financial Systems – the food chain that is the lifeblood of human economic survival. Let’s face it: while humans can survive under extreme living conditions, physical and emotional stress, it is rather impossible for modern humans to survive when the engines of trade, commerce, and money breakdown – without resorting to criminal acts, or acts of violence. Thus, understanding the money chain (one of many food chains in the human ecosystem) is critical to understanding why the US, and perhaps even the Global Economy, is afflicted with such severe malaise today.
There are several complex food chains, in our human ecosystem, that co-exist. The human species is the de facto global ‘Super Predator’ on planet Earth. We control and rule our domain to our own liking, and at will. We have developed defenses and weapons to protect ourselves, and to annihilate those that threaten our existence. And, we keep getting even better at survival. Evolution and freak chance events have brought us immense power and wealth. The planet has never had to reckon with any other species that is capable of so much creativity and creation, and, paradoxically even larger acts of destruction and utter devastation. Often, extreme acts of humanity and human depravity have both happened at the same time, albeit separated by space and geography. Our love affair with money, and all that it enables, has been around for as long as money has served as the engine of economic activity. Starting with the primitive era when sea shells were used as currency, to our modern day, online-24x7-world money is what moves everything – goods and services, people, communications, etc., around the world. We fly extraordinary distances to meet with people we do not know, because we can trade with them and make some more money.
For the longest time, our banking institutions formed the network of economic and financial pipelines through which we simply moved money. Banks were essentially passive institutions – taking our deposits, and lending the same money out to folks who needed to borrow. Banks made their money by way of the spread they charged between paying depositors (a lower rate) and what they charged borrowers. Everything worked like clockwork unless a forgetful banker lost a pile of depositors’ cash someplace in Bedford Falls. Mr. Banker in any-town-America was a powerful figure – George Baileys were often loved for their compassion and usefulness, while Mr. Potters of the banking world were reviled for their singular devotion to profits. Regardless, community bankers and their customers know each other by first name. There was a certain sense of decency, grace, and respect in bank dealings.
The Great Depression, of the 1930s forced Americans to become highly risk averse. Families, it is said, hoarded their money, or whatever was left of it, in mattresses (among other household belongings). Americans did not trust Banks (Not to mention that there weren’t a lot of viable banks left around the country in that era) because banks were seen as the root cause of the misery of the Great Depression. At the depths of Depression, the US unemployment rate was a whopping 25%, and the stock market had fallen a full 75%.
Progressive minds, in the federal government and in academia, realized (rightly so) that at least 3 things had to happen (many other Acts were enacted, and agencies like the SEC, etc. were established to regulate different sectors of the US financial economy), for the United States to bootstrap itself out of its economic rut:
1. The United States had to back-stop bank deposits by guaranteeing depositors’ money held at banking institutions with the full faith and credit of the United States.
a. This led to the creation of the FDIC (enacted by the Banking Act of 1933) – the Federal Deposit Insurance Corporation. FDIC operates as an agency of the US government, and insures all banking deposits, all 13 Trillion of it, held by US banks. In 1933 the FDIC started with insured deposit limit of $2,500. In 2007 that limit was $100,000. Today the limit on insured bank deposits is $250,000, having been raised to 250% amidst the financial meltdown of 2008.
2. Banking and Brokerage activities (or, Capital Market activities) had to be separated. Most of the bank failures, during the great Depression, were attributed to bank runs and banks gambling on stocks with borrowed money, and losing everything, including depositor funds, when the Dow Jones Index collapsed in October 1929 – between Black Monday (October 28) and Black Tuesday (October 29), the Index lost over 25% (30 billion in market value) – this led to passage of the “Glass-Steagall” Act, which was actually a set of 4 provisions in the Banking Act. Commercial and Investment Banks (Brokerage firms) were prohibited from certain cross domain activities.
3. The United States government has to encourage homeownership, and create a mechanism for injecting liquidity into the home loan mortgage markets.
a. Federal Home Loan Act, 1932 – established 12 regional FHLBanks (GSEs) as regulatory supervisor and also the lender for US Savings Banks. FHLB lending was intended to support home mortgage lending activities of the savings banks.
b. Federal National Mortgage Association Act, 1939 – created (FNMA) Fannie Mae – a Government Sponsored Enterprise (GSE) created to provide liquidity for secondary mortgage markets, as in creating a market for buying FHA insured loans from banks originating the loans. Fannie Mae became a stockholder corporation in 1968 but continued to implicitly carry the US government guarantee. In 1970 the federal government authorized Fannie Mae to buy private label mortgages – mortgages not insured by the FHA. At the same time, Freddie Mac was established to ‘create’ competition in the market for secondary loans. In 1981, Fannie Mae issued its first pass-through mortgage trust certificate, or the first Mortgage Backed Security.
American consumers’ propensities changed little until after the end of World War II. America and its Allies had won the war, and America’s global power, its reach and military might were firmly established. Within America, people could and would no longer live with sacrificing their desire for consumption and consumerism. US Corporations were happy to fill the needs, and we thus embarked on a 60 plus year journey of economic growth and prosperity that made the United States we have today. Trust me, I am not trying to gloss over huge policy and diplomatic mistakes America made during this time. There were plenty, but somehow, America always recovered and righted itself on its forward path of prosperity and economic dominance.
Up until the end of 1980s, the average American had a mundane financial profile - had a decent paying job, a home mortgage, a car loan, and perhaps a bit of credit card loans. Banks were regulated, and banking – the business of deposit taking – was largely separated from Investment Banking, the business of underwriting and trading stocks, and bonds. But all of that was to change, beginning with the 1990s, when America embarked on a zealous drive towards de-regulation – giving our banks, and corporations more powers and latitude, and ultimately a date with destiny when it all collapsed, and nearly took the entire country with it, in the fall of 2008:
Starting with early 1990s, some banks (like WAMU – Washington Mutual) and Mortgage Loan Originators (such as Countrywide Mortgages) started experimenting with ‘non-traditional’ mortgage loans products, primarily in the State of California. These were ARM mortgage loans – Adjustable Rate Mortgages. Banks were trying to match the risk exposure between their income streams with their cost of funds – floating to floating, and the ARM sounded like a perfect product. In addition, short term rates were significantly lower than 30 year rates. So an ARM also passed on the benefit of lower rates to home buyers. The catch was that the ARM rate on the loan reset every year, and home owners were exposed to uncertain loan payments. Countrywide solved this problem with its Hybrid-ARM – an ARM with a fixed rate for the first 2 to 10 year term of the loan. Most home owners, given household mobility in America, did not need a 30 year fixed rate, and were likely to move and sell their homes within 5 to 10 years. The Hybrid ARM was perhaps the smartest loan product ever invented. Countrywide also figured that the traditional 20% down-payment required to secure a mortgage loan was absurd, and it was willing to originate billions of loans with less than 20% down payment. With lower initial teaser rates (albeit fixed for 2, 3, or 5 years) and lower down payments, demand for buying property went through the roof. Speculative real estate buying, and investors (not home owners) jumping in became the norm, first in CA, and then spread around the United States. Countrywide Mortgages was more than happy to oblige – further lowering the down payment requirements, eventually down to 0%. Countrywide also introduced the low documentation (income documentation) and the no-documentation loans. To be fair, many mortgage loan originators were essentially doing the same (including loan origination shops owned by Lehman Brothers, Bear Stearns, etc.), but we stick with Countrywide as the poster child. By the late 1990s, Countrywide had perfected the instrument of real estate speculation – the no-doc, zero down, hybrid ARM. Closing Costs? No problem, Countrywide was willing to finance them into the loan too. Potential home buyers, large swaths of which had never been able to afford homes kept coming in waves, bidding up prices of home, and bringing less than stellar credit history to the closing tables. Countrywide obliged, again, by developing the most toxic mortgage loan in the history of mankind: the zero down, no-doc, Option ARM (Hybrid, or otherwise). In a seductive (perhaps deceptive) marketing move, the ‘Option’ in option ARM was described as one, where the borrower has the option to make scheduled monthly P&I payments, or a reduced monthly P&I payment, or a zero monthly payment.
Imagine this from the home buyers eyes – what can be better than laying 0% out of your pocket as down payment, having your closing costs (between 5 and 9% of purchase price) financed into your loan, and having the option to make NO principle or interest payments on your mortgage loan? Leave your wallets home, come to the closing tables, sign on the dotted lines, and walk away with keys to your very own first, second, or third McMansion. Pure Bliss!
With property prices consistently rising at between 20 and 30% a year, one could flip their home (sell it to the next sucker) within 6 months (or even less), for a profit. Imagine, making money without investing a dime out of your pocket. Infinite returns! The promise of a quick profit, and greater riches ensnared millions of Americans, as they happily signed off, and took possession of their homes, made zero payments for the first few months, waiting to flip.
Option ARMs however did not permit indefinite postponement of P&I payments. Loan to Value ratio limit of 125% were typically the trigger at which the Option in Option ARM went out the window and bills came in fast and furious – you see, the zero payments actually meant the unpaid P&I amounts got tacked on to the balance of the loan itself, resulting in ever increasing P&I payments. In addition, because of the zero down, no-doc (also known in the trade as LIAR loans, because borrowers could lie about their real incomes) were at least 5% to 10% higher in rates that prime mortgage made to financially sound borrowers. On the flip side of this sordid sub-prime origination business where every loan broker was effectively screwing every borrower (sub-prime mortgage loans paid 3-5% in fees to the brokers), Wall Street was buying all the inventory of such sub-prime loans, and securitizing them into some of the most screwed up cash-flow waterfalls, aka CDOs - Collateralized Debt Obligations. Rating agencies in the US were complicit in assigning AAA ratings to most such securitizations. Moody's, S&P and others were happy to stamp financial junk with AAA ratings because they collected large upfront fees for their ability to model, analyze and assign unbiased ratings that the investing world relied upon. Wall Street made millions, perhaps even billions between 2002 and 2006, selling such junk disguised as AAA securities.
How in the hell a sub-prime pool (junk credit) of individual loans produced a pool of largely AAA rated securities is beyond me. Some called it regulatory capital arbitrage. That was enough reason for this author to call it quits in the world of financial engineering. Wall Street had unleashed a beast of the worst kind - it made enormous money, upfront for the banks and investment banks, and it was guaranteed to someday blow-up the entire financial food chain. But investors around the world couldn’t get enough of the 'high' yielding AAA paper. As investors bought CDOs (and in the ultimate perversion of yield chasing, the CDO squared) in massive amounts, Wall Street was buying loans, fast and furious, in even greater amounts to keep a solid book of inventory (dry powder) that could be securitized at short notice, and loan brokers were screwing every retail customer in sight as they originated new loan – refinance, equity takeout, whatever, just sign the damn papers! Mortgage companies, like Countrywide, were buying every loan they could from these loan brokers. Fannie Mae, and Freddie mac, not wanting to miss out on the piece of action, bought large volumes of sub prime loand from brokers, and from Countrywide, in addition to buying off Wall Street's own securitized sub prime deals.
All of this, in real money terms was the food chain – Wall Street (including Fannie Mae & Freddie Mac) screwing investors (Hedge Funds - probably deserved to be screwed, Mutual Funds and Money Market Funds - dysfunctional fiduciary compass bearing advisors) and loan brokers (greedy shits who didn't care so long as they got their commissions). Loan Brokers, and lenders such as Countrywide were screwing mom and pop borrowers, by peddling toxic loan products, and by using aggressive sales tactics to get anxious, ill informed buyers to sign on the dotted lines. This mass orgy of Americans (including institutions) financially screwing Americans was on a pace, and a scale never seen before.
With the ripping off of America, and its citizens, in full swing, Wall Street - the Super Predator - was effectively creating its own self destruction construct (it just didn't know that it was - Yes, money, particularly large amounts of it can be blinding) by actively setting up destruction scenarios for all human Planktons at the bottom of the US financial food chain, on a grand scale, en masse.
The entire US financial complex was effectively turned into a house of cards, waiting for someone, anyone, to default on their loan. Living on the edge of hope and prayers can be catastrophic, regardless of one's beliefs - spiritual or otherwise.
And boy, did those defaults ever come! It was only a matter of time that either some newer buyers balked at the astronomical asking prices and walked away denying home flippers a neat little profit before the Option ARM lost its Options, or there was a small economic turn and some people lost their jobs and were unable to make their mortgage payments. The resulting shock-waves, from mortgage defaults, with origins in the sub-prime markets were like financial Tsunamis, threatening to engulf and drown the the entire world. They almost did. The rest of the story – US Government bailout of banks, TARP, bankruptcies and seizures of Fannie Mae and Freddie Mac are known to all. Housing and property prices declined in excess of 25% around the world.
What we are seeing in Europe now is denial being exposed in slow, painful layers. European banks – in Greece, Spain, Italy, Portugal, etc. have been staggering in denial for the past 4 years. So have their national governments. Fact is that denial is very expensive, and these broke economies just cannot continue to deny anymore. The combined asset size of banks in these countries well exceeds the GDP of each country, and the banks themselves are essentially bankrupt. The amount of capital required to ‘provide life support’, FROB style, let alone save the banks, is beyond what any of these countries can afford. Europe and Euro Zone is in danger of a total meltdown. Despite the Grecian election results from this past Sunday, Greece is likely to become a Greek tragedy.
Of course, here at home in the US, things are better, but only marginally so. The government bailed out, and stabilized our largest banks and investments banks (that have since become bank holding companies). The economy remains sick with unemployment over 8%, and dismal GDP growth. Bank lending remains anaemic.
The US financial food chain is teetering on thin strings. All, because the Super Predator – Wall Street went on a reckless spree fueled by greed alone, in trying once and for all to destroy all the Planktons – We the People, and make as much money as loose or lack of regulations would permit.
But for the US government's bailout of privately owned banks and other financial institutions (in a definitive display of the rhetoric of free market principles) the US financial food chain would have been extinct 4 years ago.
Did Wall Street learn its lesson? More than likely, NOT. I will bet my last dime, it will happen again. History has a way of repeating itself, particularly when people do not pay it the attention it deserves.
Indulge me, if only for a little while.
Ecosystems are communities of living organisms, and non-living objects that live and serve/function together at a macro level. In a world of rational expectations, members of every ecosystem must function together in organized and predictable patterns, with some degree of mutual (as in two-way) benefits for each member of the ecosystem. This is a both a necessary and sufficient condition in order to sustain and to ensure survival of the ecosystem.
At its core, every ecosystem is in essence a Food Chain - a hierarchy and an ordered sequence of organisms, where every organism, at each level of hierarchy is more powerful than all those below it. For example, ‘Roshambo’, or ‘Rock-Paper-Scissors’ is a type of food chain. It happens to be circular - Paper covers Rock, Scissors cut Paper, and Rock smashes Scissors. Circular food chains do not have a vertical hierarchal power structure. Rather, they are closer to a lateral power structure, where every member of the food chain can destroy the member that is next in order. In other words, there is no ‘Super Creature, or object, in a circular food chain.
Most organic ecosystems, and their central food chains, are strictly linear (vertical), with crisply defined beginning and end points, and a vertically diminishing member’s power structure - the bottom most creature is the least powerful while the top-most Super Creature, in the chain, ‘rules’ over the entire chain. Whatever sits atop any chain, as the Super Creature, is capable of destroying every organism in the food chain that is below it. Theoretically that is true in an absolute sense. In normal practice, however, Super Creatures, and each organism below the super creature, seldom go after fellow food chain members that are more than 2 levels of vertical separation below. This protocol is seldom explicitly encoded in any rules of engagement of any food chain, but is vital to the long term survival of the ecosystem, and the food chain itself.
For example, our oceans are a very complex ecosystem, with an extremely well defined food chain (top to bottom): Killer Whales are the Super Creatures of the oceanic food chain. They are the ‘Apex Predators’ of the oceans because they have no natural predator capable of killing them. Killer Whales regularly kill even Great White Sharks - once thought to be the Apex Predator. If we think about Killer Whales feeding on Great Whites and keep going down the list, we end up, ultimately, at Planktons. Planktons are the very bottom rung of the oceanic food chain. So long as large quantities of Plankton exist, each creature all the way up to Killer Whales will always have food for survival. Another phenomena supporting long term survival of ecosystems is remarkable difference in how long it takes for organisms at every level to multiply. In general, organisms higher up the food chain take longer to multiply. Long term stability and survival of any food chain, and any given ecosystem relies upon balancing these two forces against needs of the members of the chain. If either of these two balancing forces get forced into a persistent state of imbalance, or are destroyed, then the ecosystem itself may become unstable, and may eventually perish, or self-destruct.
Despite the scenic route taken this far, and perhaps a mundane read for most, this discourse on ecosystems and food chains is directly and immeasurably relevant to Global Financial Systems – the food chain that is the lifeblood of human economic survival. Let’s face it: while humans can survive under extreme living conditions, physical and emotional stress, it is rather impossible for modern humans to survive when the engines of trade, commerce, and money breakdown – without resorting to criminal acts, or acts of violence. Thus, understanding the money chain (one of many food chains in the human ecosystem) is critical to understanding why the US, and perhaps even the Global Economy, is afflicted with such severe malaise today.
There are several complex food chains, in our human ecosystem, that co-exist. The human species is the de facto global ‘Super Predator’ on planet Earth. We control and rule our domain to our own liking, and at will. We have developed defenses and weapons to protect ourselves, and to annihilate those that threaten our existence. And, we keep getting even better at survival. Evolution and freak chance events have brought us immense power and wealth. The planet has never had to reckon with any other species that is capable of so much creativity and creation, and, paradoxically even larger acts of destruction and utter devastation. Often, extreme acts of humanity and human depravity have both happened at the same time, albeit separated by space and geography. Our love affair with money, and all that it enables, has been around for as long as money has served as the engine of economic activity. Starting with the primitive era when sea shells were used as currency, to our modern day, online-24x7-world money is what moves everything – goods and services, people, communications, etc., around the world. We fly extraordinary distances to meet with people we do not know, because we can trade with them and make some more money.
For the longest time, our banking institutions formed the network of economic and financial pipelines through which we simply moved money. Banks were essentially passive institutions – taking our deposits, and lending the same money out to folks who needed to borrow. Banks made their money by way of the spread they charged between paying depositors (a lower rate) and what they charged borrowers. Everything worked like clockwork unless a forgetful banker lost a pile of depositors’ cash someplace in Bedford Falls. Mr. Banker in any-town-America was a powerful figure – George Baileys were often loved for their compassion and usefulness, while Mr. Potters of the banking world were reviled for their singular devotion to profits. Regardless, community bankers and their customers know each other by first name. There was a certain sense of decency, grace, and respect in bank dealings.
The Great Depression, of the 1930s forced Americans to become highly risk averse. Families, it is said, hoarded their money, or whatever was left of it, in mattresses (among other household belongings). Americans did not trust Banks (Not to mention that there weren’t a lot of viable banks left around the country in that era) because banks were seen as the root cause of the misery of the Great Depression. At the depths of Depression, the US unemployment rate was a whopping 25%, and the stock market had fallen a full 75%.
Progressive minds, in the federal government and in academia, realized (rightly so) that at least 3 things had to happen (many other Acts were enacted, and agencies like the SEC, etc. were established to regulate different sectors of the US financial economy), for the United States to bootstrap itself out of its economic rut:
1. The United States had to back-stop bank deposits by guaranteeing depositors’ money held at banking institutions with the full faith and credit of the United States.
a. This led to the creation of the FDIC (enacted by the Banking Act of 1933) – the Federal Deposit Insurance Corporation. FDIC operates as an agency of the US government, and insures all banking deposits, all 13 Trillion of it, held by US banks. In 1933 the FDIC started with insured deposit limit of $2,500. In 2007 that limit was $100,000. Today the limit on insured bank deposits is $250,000, having been raised to 250% amidst the financial meltdown of 2008.
2. Banking and Brokerage activities (or, Capital Market activities) had to be separated. Most of the bank failures, during the great Depression, were attributed to bank runs and banks gambling on stocks with borrowed money, and losing everything, including depositor funds, when the Dow Jones Index collapsed in October 1929 – between Black Monday (October 28) and Black Tuesday (October 29), the Index lost over 25% (30 billion in market value) – this led to passage of the “Glass-Steagall” Act, which was actually a set of 4 provisions in the Banking Act. Commercial and Investment Banks (Brokerage firms) were prohibited from certain cross domain activities.
3. The United States government has to encourage homeownership, and create a mechanism for injecting liquidity into the home loan mortgage markets.
a. Federal Home Loan Act, 1932 – established 12 regional FHLBanks (GSEs) as regulatory supervisor and also the lender for US Savings Banks. FHLB lending was intended to support home mortgage lending activities of the savings banks.
b. Federal National Mortgage Association Act, 1939 – created (FNMA) Fannie Mae – a Government Sponsored Enterprise (GSE) created to provide liquidity for secondary mortgage markets, as in creating a market for buying FHA insured loans from banks originating the loans. Fannie Mae became a stockholder corporation in 1968 but continued to implicitly carry the US government guarantee. In 1970 the federal government authorized Fannie Mae to buy private label mortgages – mortgages not insured by the FHA. At the same time, Freddie Mac was established to ‘create’ competition in the market for secondary loans. In 1981, Fannie Mae issued its first pass-through mortgage trust certificate, or the first Mortgage Backed Security.
American consumers’ propensities changed little until after the end of World War II. America and its Allies had won the war, and America’s global power, its reach and military might were firmly established. Within America, people could and would no longer live with sacrificing their desire for consumption and consumerism. US Corporations were happy to fill the needs, and we thus embarked on a 60 plus year journey of economic growth and prosperity that made the United States we have today. Trust me, I am not trying to gloss over huge policy and diplomatic mistakes America made during this time. There were plenty, but somehow, America always recovered and righted itself on its forward path of prosperity and economic dominance.
Up until the end of 1980s, the average American had a mundane financial profile - had a decent paying job, a home mortgage, a car loan, and perhaps a bit of credit card loans. Banks were regulated, and banking – the business of deposit taking – was largely separated from Investment Banking, the business of underwriting and trading stocks, and bonds. But all of that was to change, beginning with the 1990s, when America embarked on a zealous drive towards de-regulation – giving our banks, and corporations more powers and latitude, and ultimately a date with destiny when it all collapsed, and nearly took the entire country with it, in the fall of 2008:
Starting with early 1990s, some banks (like WAMU – Washington Mutual) and Mortgage Loan Originators (such as Countrywide Mortgages) started experimenting with ‘non-traditional’ mortgage loans products, primarily in the State of California. These were ARM mortgage loans – Adjustable Rate Mortgages. Banks were trying to match the risk exposure between their income streams with their cost of funds – floating to floating, and the ARM sounded like a perfect product. In addition, short term rates were significantly lower than 30 year rates. So an ARM also passed on the benefit of lower rates to home buyers. The catch was that the ARM rate on the loan reset every year, and home owners were exposed to uncertain loan payments. Countrywide solved this problem with its Hybrid-ARM – an ARM with a fixed rate for the first 2 to 10 year term of the loan. Most home owners, given household mobility in America, did not need a 30 year fixed rate, and were likely to move and sell their homes within 5 to 10 years. The Hybrid ARM was perhaps the smartest loan product ever invented. Countrywide also figured that the traditional 20% down-payment required to secure a mortgage loan was absurd, and it was willing to originate billions of loans with less than 20% down payment. With lower initial teaser rates (albeit fixed for 2, 3, or 5 years) and lower down payments, demand for buying property went through the roof. Speculative real estate buying, and investors (not home owners) jumping in became the norm, first in CA, and then spread around the United States. Countrywide Mortgages was more than happy to oblige – further lowering the down payment requirements, eventually down to 0%. Countrywide also introduced the low documentation (income documentation) and the no-documentation loans. To be fair, many mortgage loan originators were essentially doing the same (including loan origination shops owned by Lehman Brothers, Bear Stearns, etc.), but we stick with Countrywide as the poster child. By the late 1990s, Countrywide had perfected the instrument of real estate speculation – the no-doc, zero down, hybrid ARM. Closing Costs? No problem, Countrywide was willing to finance them into the loan too. Potential home buyers, large swaths of which had never been able to afford homes kept coming in waves, bidding up prices of home, and bringing less than stellar credit history to the closing tables. Countrywide obliged, again, by developing the most toxic mortgage loan in the history of mankind: the zero down, no-doc, Option ARM (Hybrid, or otherwise). In a seductive (perhaps deceptive) marketing move, the ‘Option’ in option ARM was described as one, where the borrower has the option to make scheduled monthly P&I payments, or a reduced monthly P&I payment, or a zero monthly payment.
Imagine this from the home buyers eyes – what can be better than laying 0% out of your pocket as down payment, having your closing costs (between 5 and 9% of purchase price) financed into your loan, and having the option to make NO principle or interest payments on your mortgage loan? Leave your wallets home, come to the closing tables, sign on the dotted lines, and walk away with keys to your very own first, second, or third McMansion. Pure Bliss!
With property prices consistently rising at between 20 and 30% a year, one could flip their home (sell it to the next sucker) within 6 months (or even less), for a profit. Imagine, making money without investing a dime out of your pocket. Infinite returns! The promise of a quick profit, and greater riches ensnared millions of Americans, as they happily signed off, and took possession of their homes, made zero payments for the first few months, waiting to flip.
Option ARMs however did not permit indefinite postponement of P&I payments. Loan to Value ratio limit of 125% were typically the trigger at which the Option in Option ARM went out the window and bills came in fast and furious – you see, the zero payments actually meant the unpaid P&I amounts got tacked on to the balance of the loan itself, resulting in ever increasing P&I payments. In addition, because of the zero down, no-doc (also known in the trade as LIAR loans, because borrowers could lie about their real incomes) were at least 5% to 10% higher in rates that prime mortgage made to financially sound borrowers. On the flip side of this sordid sub-prime origination business where every loan broker was effectively screwing every borrower (sub-prime mortgage loans paid 3-5% in fees to the brokers), Wall Street was buying all the inventory of such sub-prime loans, and securitizing them into some of the most screwed up cash-flow waterfalls, aka CDOs - Collateralized Debt Obligations. Rating agencies in the US were complicit in assigning AAA ratings to most such securitizations. Moody's, S&P and others were happy to stamp financial junk with AAA ratings because they collected large upfront fees for their ability to model, analyze and assign unbiased ratings that the investing world relied upon. Wall Street made millions, perhaps even billions between 2002 and 2006, selling such junk disguised as AAA securities.
How in the hell a sub-prime pool (junk credit) of individual loans produced a pool of largely AAA rated securities is beyond me. Some called it regulatory capital arbitrage. That was enough reason for this author to call it quits in the world of financial engineering. Wall Street had unleashed a beast of the worst kind - it made enormous money, upfront for the banks and investment banks, and it was guaranteed to someday blow-up the entire financial food chain. But investors around the world couldn’t get enough of the 'high' yielding AAA paper. As investors bought CDOs (and in the ultimate perversion of yield chasing, the CDO squared) in massive amounts, Wall Street was buying loans, fast and furious, in even greater amounts to keep a solid book of inventory (dry powder) that could be securitized at short notice, and loan brokers were screwing every retail customer in sight as they originated new loan – refinance, equity takeout, whatever, just sign the damn papers! Mortgage companies, like Countrywide, were buying every loan they could from these loan brokers. Fannie Mae, and Freddie mac, not wanting to miss out on the piece of action, bought large volumes of sub prime loand from brokers, and from Countrywide, in addition to buying off Wall Street's own securitized sub prime deals.
All of this, in real money terms was the food chain – Wall Street (including Fannie Mae & Freddie Mac) screwing investors (Hedge Funds - probably deserved to be screwed, Mutual Funds and Money Market Funds - dysfunctional fiduciary compass bearing advisors) and loan brokers (greedy shits who didn't care so long as they got their commissions). Loan Brokers, and lenders such as Countrywide were screwing mom and pop borrowers, by peddling toxic loan products, and by using aggressive sales tactics to get anxious, ill informed buyers to sign on the dotted lines. This mass orgy of Americans (including institutions) financially screwing Americans was on a pace, and a scale never seen before.
With the ripping off of America, and its citizens, in full swing, Wall Street - the Super Predator - was effectively creating its own self destruction construct (it just didn't know that it was - Yes, money, particularly large amounts of it can be blinding) by actively setting up destruction scenarios for all human Planktons at the bottom of the US financial food chain, on a grand scale, en masse.
The entire US financial complex was effectively turned into a house of cards, waiting for someone, anyone, to default on their loan. Living on the edge of hope and prayers can be catastrophic, regardless of one's beliefs - spiritual or otherwise.
And boy, did those defaults ever come! It was only a matter of time that either some newer buyers balked at the astronomical asking prices and walked away denying home flippers a neat little profit before the Option ARM lost its Options, or there was a small economic turn and some people lost their jobs and were unable to make their mortgage payments. The resulting shock-waves, from mortgage defaults, with origins in the sub-prime markets were like financial Tsunamis, threatening to engulf and drown the the entire world. They almost did. The rest of the story – US Government bailout of banks, TARP, bankruptcies and seizures of Fannie Mae and Freddie Mac are known to all. Housing and property prices declined in excess of 25% around the world.
What we are seeing in Europe now is denial being exposed in slow, painful layers. European banks – in Greece, Spain, Italy, Portugal, etc. have been staggering in denial for the past 4 years. So have their national governments. Fact is that denial is very expensive, and these broke economies just cannot continue to deny anymore. The combined asset size of banks in these countries well exceeds the GDP of each country, and the banks themselves are essentially bankrupt. The amount of capital required to ‘provide life support’, FROB style, let alone save the banks, is beyond what any of these countries can afford. Europe and Euro Zone is in danger of a total meltdown. Despite the Grecian election results from this past Sunday, Greece is likely to become a Greek tragedy.
Of course, here at home in the US, things are better, but only marginally so. The government bailed out, and stabilized our largest banks and investments banks (that have since become bank holding companies). The economy remains sick with unemployment over 8%, and dismal GDP growth. Bank lending remains anaemic.
The US financial food chain is teetering on thin strings. All, because the Super Predator – Wall Street went on a reckless spree fueled by greed alone, in trying once and for all to destroy all the Planktons – We the People, and make as much money as loose or lack of regulations would permit.
But for the US government's bailout of privately owned banks and other financial institutions (in a definitive display of the rhetoric of free market principles) the US financial food chain would have been extinct 4 years ago.
Did Wall Street learn its lesson? More than likely, NOT. I will bet my last dime, it will happen again. History has a way of repeating itself, particularly when people do not pay it the attention it deserves.
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