Finance is Fun

I travelled outside the box this week.  A little art, some pop psychology, a couple of chart makers, and a self help guru that comes off sounding like a freak.  But it was, as usual, elucidating to say the least.

This first one puzzled me no end.  I couldn’t find an about page but it appears to be a blog about the egocentric meanderings in the lesbian life of its author (ess) and how it is connected to Jane Austen except through a life lived separate but equal I can only guess.  The pictures and attitudes are great though.  Invigorating. 

 Second on my week’s list is this rather odd and disbelievable blog that purports to be by being the port of disinformation.  A tool from what little I understand about the term of those of the political persuasion who want to confuse you with the wrong facts at the right time.  Gee, sounds perfect for our times.  Alls I know is there seem to be plenty of variations on the theme.

 Excited is the word for this third find.  Excited to find a mind that creates through pictures and words.  Excited to find another poet and one who uses the web exclusively.  Excited to think that maybe this time through this link I’ll find others who want to explore thinking through pictures and words.

Last, but not least, on this week’s list is this aforementioned weirdo.  Steve Pavlina is his name and I happened upon his blog by tracing a link at the Millionaire Mommy Next Door blog.  Direct to the point of being rude but certainly unafraid to say what he thinks, that’s how I’d characterize him.  Still, in the words of T, he’s a weirdo.

And that’s it folks, the week that was.

She had a smile in her voice as she told me, “Boy, I just saved $6.50.”

“What?” I asked.

“I told you I wanted popcorn when I went out to the lobby but when the guy told me, $6.50 for a small, I just laughed in his face.”

I can imagine this little scenario being reenacted all across America especially when someone asks for a family-sized tub at just $20.  Bio-fuel is messing with our movies.  But here’s the thing.  I don’t know much about genetics but it seems to me that if we can clone sheep and design our future children we should be able to come up with a super-sized corn that is designed specifically for fuel so that the regular white and yellow stuff could stay just for human, and sometimes cattle, consumption.  Maybe fix it so it could be grown in super fields that double or triple the yield per acre and will even grow in soil not suitable for anything else.  Heck, with just a little research I found this.  And this.

I had to laugh at the cartoon strip I saw yesterday, Lalo Alcaraz’s La Cucaracha.  A street vendor says,”My prices now reflect the fuel companies demand for Ethanol.”  The customer then points out, “This is just meat.”  To which the vendor replies, “Tortillas are ten bucks.” 

Si si.  It’s a case of follow the money.  Why are the prices going up on biofuel-possible products?  Because there is money to be made.  Look at the futures market and the commodity exchange reports.  But when you look at commodity futures keep in mind who and what controls those markets.  If the hedge fund investors leverage futures options what happens to the prices, they go up.  If the prices go up on futures, then the actual trade prices go up too because the futures prices are used as an index to reference what the producer should be selling the product for.  The deal is sweetened by the fact that a hedge fund by its nature always covers it own ass.  It buys short and long and collects the difference.  When we are talking world wide markets and billions of dollars, then it is not so hard to see why the cost of popcorn at the movies is moving up.

See it yes.  Pay it, well as T so aptly put it, “I just laughed in his face.”

Whirr, click, jangle jingle jangle, that’s the sound the new slots make that’s so much like the real thing that you actually look down to see if the tray is filling with quarters.  Luckily for us, within an hour’s drive from where we live there are eight casinos to choose from if you want to just spend the night gambling.  Five of them provide hotels if you can afford to stay over and vacate.  One is just a large but very popular card room.  And all of them have benefited from the new slot machines the voters have just installed. 

Of course, you have heard about the fabulous buffet, right?  Billboards show and celebrities extol the qualities that make all you can eat a suitable reward for taking a chance.  Instant winners, cash, cash, cash, and, oh yeah, the roll call of headline attractions coming to a stage near you.  Not to sound cynical but who are they kidding?  But on the other hand, if you are talking addiction then fat people and their gambling habits is not a bad place to start.

But all of that aside, I didn’t begin this post to berate the gambler within us, nor to make fun of the gazillions of seniors who live for the bus ride.  I am really just happy that the gambling industry has become the be all and end all of our nation’s retirement community.  As far as I know, Vegas and Florida now officially employ the most seniors per capita.  So, when it is time to take a break around here, there is nothing like heading out to our local (see the above) gambling den to remove the stresses and strains of ordinary living.

I don’t know how to say this so I’ll just say it okay.  Some people are just addicted.  Others apparently have too much time on their hands.  A few are just interested in the spectacle.  And one or two, like me, just tag along because that’s where their significant other likes to go.

When I first met my partner, we worked all the time.  As independent contractors, we filled the hours with multiple jobs since we both had put ourselves in debt for various reasons and now we were hard at work digging our way out.  So it was with some surprise, when we finally got a break, it was T’s birthday, that I discovered she had booked us rooms in Laughlin.  I was amazed.  She knew all the games, and really liked to play the roulette table.  Well, you know what they say, party hardy.  Only, when we got back home to go to work, she was more than a little depressed.  The fact that I don’t gamble had sort of acted as ballast but still she had lost all the extra money it had taken her weeks to earn in just three short days.

As she explained it to me, it was a family thing.  Everyone in her family; grandma, dad, mom, sisters, brother, cousins, aunts and uncles, all gambled.  They played puzzles, worked out sudokus, and couldn’t wait to think of another excuse to hit the nearest casino.  She even told me stories about how her grandmother taught her to read the tote board and pick six. 

But a funny thing has happened on the way to today.  T who used to need to gamble now can only handle it in very short doses.  Not because she isn’t still addicted, you know, once an alcoholic always an alcoholic.  But because she has replaced that need with something even more powerful.  She wants to be free from debt and semi-retired like me.  And I should say, she wants to stay free from debt because by dint of paying off her credit card debt, and starting her own business, she has been debt free for two years now.  So when we go vacationing at our local casino now, she may gamble a bit, but her need to keep her money makes it easy for her to get up and walk away.  We have even gone there and just spent our time at the pool, and dancing at night, and seeing a show, without once dropping even a penny in a slot.   These days, instead of gambling, it’s more likely we’ll be gamboling the night away.

No, I’m not talking about that “stimulus check”.  Nor do I mean those pennies, sometimes nickles or dimes, that you find spilled out of someone’s pocket in front of the 7/11.  I am talking about real found money.  You are going through the pockets of an old jacket, and there inside the inside vest pocket, folded up nice and neat, is a sort of crisp $50 bill.  A quick memory search reveals that a  couple of years or so ago, you don’t wear jackets that much, you put the bill there in anticipation of needing it to pay your share of some trip you and T were taking.  But that is all history now.

So what do I do with it?  Back in those spendthrift days, $50 was a night out dancing, or the movies for two, or dinner before a Laker game.  It was pocket money.  But that was before the plan.  And the monthly budget that developed from the plan.  I am semi-retired (more on that another time) and the plan is that T join me in that state as quickly as possible.  Hence the budget.

Budget for T

Monthly income less monthly expenses less minimal entertainment costs less coincidental repair or replacement expenses less automatic savings deduction to ING account and Ameritrade Save Yourself account less $10 pocket money = semi-retirement in three years.

Income stream = monthly paycheck + stoozed money market, CD, saving accounts, loan to the corportation interest earnings + off the book cash bonuses + 5 real estate rental property rents + part time real estate jobs.

Expenses = Share of  monthly rent + $25 towards weekly food + difference between monthly rental income and mortgage/insurance/repairs + medical bills for recent gall bladder surgery + ING savings + Save Yourself Ameritrade auto deduct + self-directed IRA + $ for occasional eat out/movie out/trip to casino out (more on this later too)

 So the first question is when should I share the news and let her decide about her half?  Because that’s the way it is now.  We share everything 50/50.  So now the question is what do I do with my $25?   Boy, I can tell you I am suddenly a lot less excited.  $25 is half a tank of gas, it’s a week worth of groceries, it’s my weekly expensed money, it’s the bill for two weeks worth of dry cleaning, it’s . . . not much in other words.  Wait I know where I can use it.  I’ll put into my newly formed freedom account, thanks JD.

It is a hard choice to trust our government these days.  Immense budgets, inefficient actions, regulatory nightmares, lowered taxes, deficit spending, incomprehensible debt loads and that’s just at the local level.  One of the main reasons for the swell of support for Obama is the hope that his election might change some of that.  So the final chapter of Charles R. Morris’ The Trillion Dollar Meltdown may prove to be just what the doctor ordered.

Chapter Eight:  Recovering Balance

Less is more.  In a free market environment that dictom can and, according to Morris, has been taken too far.  For by trusting to the market place to be self governing, we have come to the possible unwinding of not only the US financial markets but the world’s as well.  The term writedown (the act of reducing the accounted value of an asset) has become commonplace to the current financial news.  To Morris the real disaster, the elephant in the room, is the danger that the rest of the world’s confidence in American financial markets may be lost.  To deal directly with this problem means,

Any program to restore confidence in American markets must start with the banks.  Loans to very highly leveraged parties should carry penalty capital charges.  Absurdities like prime broker loans to hedge funds that do not disclose ballance sheets should simply stop.  Banklike capital requirements should apply to all lending entities, including intermediaries like mortgage bankers who plan to warehouse deals for securitization.  Loan originators should always retain first losses, and put-back agreements should get much stiffer capital hits than they do now.  Accountants shouldn’t recognize credit insurance purchase from thinly capitalized entities, which would put leveraged credit hedge funds and the insurance monoliners out of the riskier portions of the credit insurance business.

Reading the list above reminds me of my own feelings about banks.  They always seem to be ready to help when you don’t need it.  See the barrage of credit offers when your FICO is good.  But don’t seem to know your name when the mortgage resets and a refi would really save the day.  In other words, banks give the impression of not taking risks but as the list above and the first seven chapters of this book point out, that really isn’t the case.   Morris cites, and he is not alone in this, the removal of Glass-Steagal Act controls in 1999 which then allowed the commercial and investment banks to comingle as one culprit that could be corrected.

As an example of another reason why re-regulation of the marketplace is a good idea, Morris takes a long look at the health care industry.  Just like with the financial market you might have to stretch your mind a little bit to deal with that idea.  See it isn’t about you and your doctor.  It isn’t about the best treatment for your family.  It is about how

America’s high-speed technology adoption cycles produce higher financial returns for drug companies, device makers, and aggressive medical practitioners, but often it is not good medicine and is very expensive.

Health care is a business, son.  What a business is about is ROI.  Patient care doesn’t rank very high in the listing of incomes next to manufacturing and producing cardiac stents or over-priced drugs.  Says Morris, “Much of the problem stems from the insistence that health care is just like any other consumer market.  It’s not.”

 I wont pretend to know exactly how the Pareto principle is supposed to work but I can see clearly how it can be used by the free marketeers to justify their financial outlook.  The claim however to this idea as being some sort of natural law of economics however begs the question.  If all the wealth is concentrated in one sector while all the debt is in another, that only makes the world work for the 20 percent.  The 15,000 who pull in 284 billion a year while the rest of us struggle to make do on an hourly wage.   We need a market place reset.  We need to stop worshiping at the alter of retirement luxury, of being rich, of having it all, and recognize the rule that says enough is enough.

Attacking the rich, maligning the poor, driving a wedge into the widening gap between the top and the bottom of the workforce, these are the topics of concern in The Trillion Dollar Meltdown’s penultimate chapter.

Chapter Seven: Winners and Losers

It is perhaps apt that this next to last chapter has this title since we have become a nation that lives and dies with the sports metaphor.  But just as the sports’ news has been dominated by spectacular betrayals of trust and honor so to has the world of finance.  Superstars, yes.  Superheroes, no.  What has become clear to the outside observer is that the last forty years have led us to a point where the idolization of the rich, and unfortunately their methods, is the major characteristic of our psychology.  Winning at any cost, walking away with it all, that is what we idolize.  We are number one in our admiration and acceptance of the rich and their apparent right to have it all.

So what if Blackstone guts Travelport of $4 billion while laying off 841workers.  We cheer as,

The private equity kings insist that they are management wizards, not financial engineers.  But, at least in its most recent phase, the numbers show that the private equity game, like subprime CDOs, is just another arbitrage on cheap money and rising asset markets. 

Billion dollar dividends to opportunistic takeover artists are just one wavelet in a long-term, and for many, increasingly dusturbing, tidal shift in American society - a widening disparity of wealth and income not seen since the Gilded Age.

Consider these wins:

• “the top 1percent, or the top centile, who doubled their share of national cash income from 9 percent to 19 percent.
• “the top one-hundreth of 1 percent, of fewer that 15,000 taxpayers, quadrupled their share to 3.6 percent of all taxable income.
• “the average tax return, of those 15,000, reported $26 million of income in 2005, while the take for the entire group was $384 billion.

Seems fair to most conservatives apparently because they still claim that the poor through the government’s entitlement programs, and the middle class through tax-deferred savings, and the elderly’s social security and other retirement plans got more.  Only here are the facts of the matter according to Morris:

According to a 1999 Treasury study, 43 percent of the tax benefits from retirement savings programs went to the top tenth of households.  66 percent to the top fifth. and only 12 percent to the lower three-fifths.

Whiners and winners, that’s the net analysis.  Didn’t finish school, did your job get automated?  Well, that’s your lower class for you.  Didn’t understand that subprime mortgage contract, well that’s too bad, isn’t it?

There is no conspiracy against the poor and the middle class.  It’s more the inevitable outcome of our current money-driven political system combined with “the disposition to admire, and almost worship, the rich and the powerful,” which Adam Smith fingered as :”the great and most universal cause of corruption of our moral sentiments.”

Meanwhile, consider the drive to privatize.  Sallie Mae is an example.  Designed to be a government program to assist students in furthering their education has instead become a private company that  “was fully privatized in 2004, a year in which it made an astonishing 37 percent after-tax profit.”  See, say the free marketeers, that’s what business is all about.  When the government ran it, it just helped thousands of student learn their way to success.  But when it became a private company, and still retained the aspects of governmental protection from state usury laws, it made money.  As a matter of fact, it even spun off a separate SLM business line that racked up $800 million in debt management fees in 2005.  Imagine that.  The rich, CEO Albert Lord’s compensation package in 2003 was 12.7 million with options by 2005 up to 189 million, get richer.  While the poor (students) and the middle class (their parents) incomes stay flat.

We are apparently developing three kinds of services in this country.  The service industries that provide jobs for the lower class, the government and industry service which provides jobs for the middle class, and the financial services which provides wealth and leisure and privilege for the upper class.  Need proof, just look at Countrywide or Bear Stearns or Cit group or the K Street Project.  When they make money they are private and successful models for how to work the free market.  When they fail, the government, through the Fed or through pressure of other lenders/banks, bails them out.  Socialized capitalism is what we have.

The great consolidations of banking and investment banking into financial mega-players has proliferated armies of mega-income executives  Besides driving cash income shares toward the top of the payroll pyramid, it has greatly enhanced the political clout of Wall Street - as evidenced by steady cuts in taxes on capital gains and dividends and the persisitence of absurd tax advantages for private equity funds.

 It takes a certain kind of confidence, some would say faith, to believe that we can come out of this cycle with our overall system still intact.  Reading about the power of these forces and having watched what has happened even though the Democrats have assumed the political power for now, does not argue for success.  Those armies of execs, those walls of money strategies, those free market confidence games are not just going to go away.  America, you and I on the bottom may just have to do something about the top.

Next up:  Chapter Eight: Recovering the Balance

This has been a bear of a week.  As much as I have enjoyed coming to an understanding of this book, The Trillion Dollar Meltdown, I have also come to see that the amount of information that plays a part in these financial transactions is almost beyond what one brain can contain.  For one thing, we are a consumer economy but have become an investment dominated culture.  I remember waking up every morning to the sound of CNBC Market Week with Mario Bartiromo, when the commentaters were stars, and the line of ticker tape across the bottom of the screen, in reds and greens, was something we devoured along with every breakfast. 

But back in the early 90’s, in between volleyball games at the beach, I’d be passing the ball back and forth with someone while I could hear in the background these old guys who used to play discussing their Wall Street Journal and wonder WTF.  Since then times have changed and those retirement funds that are playing such a large part in our current story, those are yours and mine.  So get used to it, we share in the responsibility of this emerging disaster.  We have taken the free market ride and this has been our destination all along.

Chapter Six:  The Great Unwinding

Remember the perky little CDOs from chapter four, and the credit swaps that were used to create synthetic CDOs, well they are back in this chapter with a vengence.  As you might recall, the grouped mortgages were sliced horizontally to create tranches of funds with the bottom tier becoming the high risk but very lucrative high yield toxic waste.  The question then was who or what would buy into such an investment?  The answer now becomes clear,

Hedge funds are unregulated investment vehicles that cater to institutions and wealthy individuals, and promise extraordinary returns.

As of mid-2007, hedge funds deployed an estimated $2 trillion to $2.5 trillion of equity capital, and much higher economic capital due to their aggressive use of leverage.

I recall driving out to Vegas while we listened to real estate mogul, Robert Kiyosaki, explain how leverage worked.  Of course, we could buy one property with our $100,000 but wouldn’t it be better to use the money to buy ten properties.  With $10 k down, the banks would lend the OPM to do the rest.  This is the thinking that dominates in the world of finance.  Leverage your money.  Use your tranche of CDOs to credit swap up.  Buy a house for $200,000 in two years sell it for $500,000 use the $300,000 gain to buy a million dollar home.  It all works unless, of course, the market comes tumbling down.  Or you are using a subprime mortgage that resets in 3 yrs at twice the interest rate.  It is after all an immense illusion.   Everything depends on no one noticing that the king is still naked.  And just as million dollar homes aren’t really worth a million so to the CDOs aren’t really worth there original valuation either.

Think of it this way.  Your Wiley Coyote hedge fund is one tiptoe on the ledge and the rest of its body of mortgage liabilities teetoring over the cliff.  All it takes is one slight breeze of interest shifts upward to tip the mark to market balance.  Says Morris,

The hedge funds’ appetite for the riskiest positions has made them a major source of liquidity in the CDO and credit default swap markets.  Their willingness to employ leverage to maximize those positions amplifies their impact.  The funds’ demand for higher-yield products is pushing the industry up the risk ladder into CDOs constructed from second-lien loans, bridge financings, private equity, and other less liquid assets, often with minimal protections for higher tier buyers.

The shift in credit hedge fund investing wawy from cash-flow CDOS toward credit derivatives, Fitch reports, “introduces its own unique risks that have not been fully tested in a credit downturn . . . (and) could foster greater short-term price instability.”

Morris’ walk through of a leverage example on pgs. 111 and 112 shows just how high the ledge really becomes in one of these deals.  5:1 becomes 20:1 becomes 100:1 just like that.  “Now assume the CDO incurs a 3 percent loss.”  The deal value which started at $20 million hedge funds and $80 million bank loans for a total of $100 million is now only worth $40 million.  The hedge fund and bank have to raise another $40 million just to cover their losses.  Think Bear Stearns, which was credit default swapping in billions, then multiply that by the fact that there are 100s of hedge funds and you can see the problem.  Not only is this credit market teetoring and ready to fall but that is us at the base of the cliff waiting to get crushed.

Do you know what a Ponzi scheme is?  You collect money from one set of investors and use it to pay off a second set, then a third set, fourth set, etc, etc, etc.  As long as the money keeps coming in and no one regulates it but yourself, everything will appear to be fine.  But Morris concludes this chapter by referencing Hyman Minsky, “a Keynesian economist who became famous for his theory of financial crises.  Unlike the Chicago-based school of free-market ideologues, Minsky believed that instability and crises were inherent features of financial markets.”  Put a Ponzi scheme of  100’s of hedge funds and real estate subprime loans and credit card debt into his model and you can see where we are heading.  Morris would have us reveal all the deals and face the music but as he notes at the chapter’s end,

The American financial sector today is far more powerful than it was in the 1970’s (when the pendulum swung towards the free-market theory).  And to date, its response to the looming crisis has been, overwhelming, to downplay and to conceal.  That is a path to turning a painful debacle into a decades-long tragedy.

Tomorrow: Chapter 7: Winners and Losers

So here we are, halfway through, Charles R. Morris’s The Trillion Dollar Meltdown and it’s Friday.  Last night T and I hosted our monthly Cashflow 101 game and get together for about 15 people.  We had a guest speaker from the real estate world talk about lease purchase options.  I could not help but hear echoes and see the shadows of Morris’s book in his presentation.  Deals within deals, make a million using OPM, buy low and use the margin.  It almost made me eager to get back to our review.

Chapter Five:  A Tsunami of Dollars

Joel Grey as the stage manager in Cabaret comes to mind.  Money, money, money . . .  As you all probably know, everyone else’s currency is tied to the U.S. dollar.  How could you not know, since every financial report these days is headlined with a new comparison of how badly it’s doing.  The dollar is falling, the dollar is falling . . .  Ah well, what are we to do.  

After the meeting at Bretton Woods following WW II, “The value of the dollar, …, was fixed by a long standing commitment to redeem dollars for gold at the rate of $35 per ounce.  Virtually all prices in international trade were set in dollars.”  An agreement that lasted until 1971, when Nixon removed the US from the gold standard and we entered our current Fiat money system.   

The Fed has two ways it can affect our money.  Interest rates can be changed and/or the supply of money can be increased.  Even my untutored financial mind can see that if a government, the one that sets the standard BTW, can flood the marketplace with untethered money bad things can happen.  As Morris points out, a country’s finances can be seen “through the status of its current account, a kind of international profit and loss statement.”  Money travels in via export sales, and out via import expenses.  The negative difference between the two amounts is called a deficit.  In the US,”The 2006 trade dificit was over $750 billion, and the total current account deficit topped $800 billion.  The accumulated deficit for 2000 to 2006 is about $4 trillion.”   

Think of it this way.  If you take a dollar and you devide it into 10 equal parts and then you call each new part a dollar, you may have more dollars but clearly they are devalued quantities.  When your economy’s GDP  is growing, then expanding dollar availability via credit lines or new dollars is one thing.  But when the economy is in decline, a deficit, or recession it is quite another.  And since, the dollar is the comparison standard for the rest of the world, so to speak, our actions pull the rest like the winning side in a tug of war towards a deep and muddy hole.  Yet, that is where we find ourselves since Bretton Woods II.  Our present Fed chair, Ben Bernanke,  took this position:

 Everything is the result of market forces shaping events toward a high-efficiency outcome.  The Fed’s free-money policy was predetermined by the tidal wave of foreign savings.   Alan Greenspan was an agent, not an independant actor.  America’s housing and debt binge was made in China, and for large and good purposes.

But,

On closer examination, the central premise of the BW2 hypothesis, that large foreign dollar-holders have no choice in the matter, is simply not true; indeed holding dollars is increasingly against their interests.

Morris’s grasp of the global marketplace must be trusted as he continues to discuss Russia’s, OPE C’s, Asia’s, and especially, China’s dollar-based economical development away from dollar dependence and toward a basket of currencies.

The rise of the Sovereign Wealth Funds was inevitable.  What country with enormous currency reserves wouldn’t want one?  “An SWF is a private investment fund under the broad control of a government but almost always outside of the official finance apparatus, free of the investment limitations that apply to official reserves.”  At this printing, “At least twenty-five surplus countries already have SWFs or are in the process of setting them up.”  If you are wondering where America is borrowing its money from these days you need look no further.

In this chapter, Morris returns to the main thesis of the book, unregulated free markets lead to a prideful fall.  This time with the facts and figures to back it up.

All in all, it’s hard to imagine a worse outcome - the United States, the “hyperpower,” the global leader in the efficiency of its markets and the productivity of its businesses and workers, hopelessly in hock to some of the world’s most unsavory regimes.  But that’s where a quarter-century of diligent sacrifice to the gods of the free market has brought us.

I have to agree with him.  At this point, “It’s a disgrace.”

Next up: The Great Unwinding

So far this week we have been dealing with the past, the history we should have learned from.  But as Morris keeps letting us see, Hudibras, was and probably still is, the god in charge.

Chapter Four: A Wall of Money

The oughts, as the English call them, have been tumultuous at best.  The dot.com bust, the Tower’s attack, Bush, Iraq; a list of ups and downs that just doesn’t stop.  The Fed, led by Alan Greenspan, responded to this in a way we should all recognize.  Starting with the dot.com bust, the Fed began to lower the federal fund rate.

The Fed did not start raising rates again until mid-2004, and for thiry-one consecutive months, the base inflation-adjusted shor-term interest rate was negative.  For bankers, in other words, money was free.

. . . banks embraced securitization.  Instead of holding their commercial mortgages, corporate loans, high-yield takeover loans, emerging market loans,and such on their books, the bankers had always done, they began to package them up as collateralized loan obligations (CLOs) or collateralized debt obligations (CDOs) and sell them to outside investors.  They could still collect hefty fees while encumbering little is any of their capital.  Lending, in other words, was becoming costless.

CMO, CLO, CDO, RMBS, CMBS, ABS, CBO, SBE; these are just some of the names of the securitized instruments that came into being.  Take a look at this list from InvestorGuide.com,

security

An investment instrument, other than an insurance policy or fixed
annuity, issued by a corporation, government, or other organization
which offers evidence of debt or equity. The official definition,
from the Securities Exchange Act of 1934, is: “Any note, stock,
treasury stock, bond, debenture, certificate of interest or
participation in any profit-sharing agreement or in any oil, gas,
or other mineral royalty or lease, any collateral trust certificate,
preorganization certificate or subscription, transferable share,
investment contract, voting-trust certificate, certificate of
deposit, for a security, any put, call, straddle, option, or
privilege on any security, certificate of deposit, or group or index
of securities (including any interest therein or based on the value
thereof), or any put, call, straddle, option, or privilege entered
into on a national securities exchange relating to foreign currency,
or in general, any instrument commonly known as a ’security’; or any
certificate of interest or participation in, temporary or interim
certificate for, receipt for, or warrant or right to subscribe to
or purchase, any of the foregoing; but shall not include currency
or any note, draft, bill of exchange, or banker’s acceptance which
has a maturity at the time of issuance of not exceeding nine months,
exclusive of days of grace, or any renewal thereof the maturity of
which is likewise limited.”

Property which is pledged as collateral for a loan.

Remember Black-Scholes?  Now instead of investors using the formulas, we apparently had our trustworthy bankers playing the same game.  All with Greenspan’s “a new paradigm of active credit management.” Put’s blessing and the Fed’s help.  Leverage buyouts were back.  OPM, Other People’s Money, became the watchword for how to invest.  Morris uses this example,

Put up $1 billion, borrow $4 billion more, snap up a healthy company for $5 billion (after making a very rich deal with its executives), vote yourselves a “special dividend” of $1 billion, then as the buyout-fueled stock market keeps rising, sell the company back to the public, pocketing another couple billion, all the while taking no risk.

As I write, I can’t help thinking of the Bear Stearn buyout.  About how much we, you and I John Q. Public, don’t know about how all this works nor how we can do anything about it in a time where, to judge from the workshops being offered around the country, many people are still being sold on the idea that this is the way to get rich.  As we all sit here watching the real estate bubble burst, I won’t take the time to catalog all the stats for you.  Just know this, during the same time that LBOs were making a comeback, our economy was being fueled by the same sort of leverage being applied to home ownership.  While, Greenspan focused his put on stabilizing the financiers while encouraging the rest of us to go further and further into debt via the refi route, real real estate values were inflating at a rate of about 50 percent.

Refis jumped from $14 billion in 1995 to nearly a quarter of a trillion by 2005, the great majority of them resulting in higher loan amounts.

By 2005, 40 percent of all home purchases were either for investment or as second homes. (Experts believe that a large share of the “second homes” actually are speculations for resale; lenders don’t review vacation-home purchases as closely as investment properties.)

OPM.  Free market.  Caveat Emptor. 

By 2003 or so, mortage lenders were running out of people they could plausibly lend to.  Instead of curtailing lending, they spread their nets to vacuum up prospects with little hope of repaying them.  Subprime lending jumped from an annual volume of $145 billion in 2001 to $625 billion in 2005, more than 20 percent of total issuances.

The industry was awash in socalled “ninja loans - no income, no job, no assets.”

Meanwhile, things were, without us having any way of knowing it, becoming more and more insecure in the securitized world.  Remember all those security instruments mentioned above, well since there was so much money to be made at so little risk (ha ha), and with so little regulation, then why not just do this.  Think I’m talking small here.  Well, think again.  According to Morris, “The notational value of credit default swaps - that is, the size of portfolios covered by credit default agreements - grew from $1 trillion in 2001 to $45 trillion by mid-2007.  Synthetic (models emulating the real CDO created on a computer to simulate the real thing) SIV structures were now capable of being built and then put into play.  Unbelievably, entities that were called CDO2s or CDOs of CDOs, you get the picture.

Earlier in the book, Morris explained one of the guidelines that financial institutions were supposed to use to make sure that the investor was covered against loss was something called the Agency rule.  Under the Agency rule an institution’s officers could not recommend investments that acted against the investor’s interest.  But without regulation, remember Hedge funds are private, who’s to say what is in who’s favor, especially as the swaps make the distance between the real investor and his or her money increase exponentially.

Next up, Chapter Five:  A Tsunami of Dollars

In re-reading Charles R. Morris’s, The Trillion Dollar Meltdown, I am reminded of one thing about the market place that we all know and still . . . forget.  Let the buyer beware.  In other words, no matter what the deal, you are on your own when it comes time to add things up.  With that said, lets continue with

Chapter Three:Bubble Land:Practice Runs

I think it is fair to say at the start, we never seem to learn that the money changers are playing a shell game and we are the pigeons.  This chapter cites three examples - The residential mortgage crash of 1994, the 1987 Stock Market meltdown of 1987, and the 1998 Long-Term Capitol Management crisis.  With hindsight firmly fixed, these three can be seen as the early models for our current sub-prime mortgage and credit bubble dilemma.  The advent of desk-top computing power, the use of mathematical modeling strategies, and the afore-mentioned leveraging quality of the pension funds, foundations, endowments, and hedge funds; all played their part.

Mortgage-Backed securities

The overview of the real estate lending business reads like this.  In the New Deal era, S&Ls were the base from which home loans grew through quasi-federal agencies called Fannie Mae, Ginnie Mae, and Freddie Mac.  These agencies bought up mortgages and then sold mortgage-backed securities or mortgage pass-throughs to maintain their own liquidity.

A pass-through is created by transferring a slug of mortgages to a trust, which in turn issues certificates representing a pro rata slice of all the principal and interest it receives.  A trust comprising $100 million in mortgages paying an average interest rate of 6 percent would sell a certificate entitling the investor to, say, 1 percent of the trust proceeds.

Big investors, however, found this format to be slightly cumbersome and not always rewarding.  In 1983, Larry Fink at First Boston bank came up with a solution.  The CMO, a collateralized mortgage obligation, an investment model that allowed a bank to transfer mortgages to a trust just like a pass-through “but the mortgages were then sliced, or tranched, horizontally into three segments, with different bonds for each segment.”  The top tier got first claim on all cash flows and triple-A ratings, the middle tier was rated lower but sold at a higher yield, and the bottom tier, or toxic waste, sold as junk bonds with high risks but higher returns.

As with the previous chapter, Morris points out that at first the new model worked well.  “An academic study concluded that by the mid-1990s, CMOs saved homeowners $17 billion a year.  It is a classic illustration of the social contribution of financial innovation.”  What followed, of course, is a classic reminder of free market competitions amplified by the new technology of computer power.

But by the 1990s, when Sun workstations were standard furniture, CMO shops gleefully spewed out phantasmagorical 125 tranche instruments that no one could possibly understand.  No matter how clever the structuring, however, a CMO was still a closed system: All the tranches drew their payouts from the same pool of mortgages.

Disposing of the toxic waste soon became the primary limit on growth. 

A market shift, a change in the Fed rate, and it all came tumbling down.

Next up, the 1987 Stock Market Crash and another new quant product called portfolio insurance.  Get ready to test your trading knowledge.  Are you familiar with your trading options, puts and calls and the futures market?  Did you know you can bet on the up side, a call, or the downside, a put, or even better yet, on the financial future of being able to sell or buy through a fixed contract, a commodity at a fixed and firm rate?  Did you know,

Synthetic trading strategies executed with options and futures are often more efficient and less expensive than trading the underlying instruments, and often easier to mask from the competition, so they became an essential tool of megaportfolio asset management.

and that “The portfolio insurance that so enamored big investors was actually a futures-based hedging strategy.” based on using a Black-Scholes type formula.  Black-Scholesis arguably “the most famous equation in the history of finance.”  since it solves for the price of a futures option.  And “Since any financial transaction can be cast in the form of an option, Black-Scholes became the tool for pricing everything.” 

With such an efficient tool in their hands who would be willing to bet that only a few managers would use it.  According to Morris, “By the fall of 1987, some $100 billion of stock portfolios were insured.”

The resulting crash, aptly named Black Monday, resulted in the New York exchange instituting “circuit breaker” rules to shut off trading and the newly named Fed chair, Alan Greenspan, to release tons of new money to keep the brokerages from collapsing.  Sound familiar?

Meanwhile, Morris offers us one more road marker to take a look at, the LTCM ( Long-Term Capitol Management) hedge fund that was created in 1993 by John Meriwether and by 1998 had forced the Fed into another miracle money rescue.

When Meriwether opened his books to Fed staff in late September, they were shocked.  No one had imagined the LTCM had positions in excess of $100 billion on an equity base that had shrunk to only $1 billion.

Morris leaves this chapter with one direct question and an implied answer.  Why did the Fed force the banks to bailout LTCM and coverup the scandal of the fact that a small number of financiers had been able to borrow hundreds of billion of dollars without any oversight in sight?   Friends help friends.

Maybe we will find out for ourselves in Chapter Four: The Wall of Money