SPECIAL EDITION: A PRIMER ON THE SUB-PRIME MESS

Like Marvin Gaye, we are now all asking “What’s going on?” This edition will diverge from taxes. Instead, I will summarize:

1. How did we get into this economic hole?

2. Why do we keep digging?

3. Can the hole get so deep that we cannot climb out?

4. What will the federal bail out fix and what may not be fixed by it alone?

5. What have we leaned?

6. Why is the future not bleak for America?

1. How did we get into this economic hole?

Some factors contributing were:

a. All of the players were paid up front - the banker, the mortgage broker and the investment banker all were paid on the front end and therefore had no stake in the performance of the mortgages or securities backed by packages of mortgages.

b. No federal regulatory scheme was present and state regulators fell asleep on the job. The real estate housing market, fueled by home buyer naivety mortgage broker fraud, banker indifference and investment banker greed, spiraled into a frenzy of speculation. The resulting home values greatly exceeded historical appreciation rates and proved illusory. There was no new era of real estate – just another bubble.

c. Investors in mortgage backed securities ignored the complexities of these instruments and the axiom, “the risk assumed is directly proportionate to the rate of return offered.” Mortgages were packaged and repackaged with risk growing with each step removed from the underlying asset. Security rating agencies simply assumed that the large number of mortgages backing each security assured the quality of the group as a hole. They did not consider that most loans were adjustable rate mortgages or that the debt equaled 90% or even 100% of the collateral value at inception, or that no one was regulating the process.

2. Why do we keep digging?

It is not so much that we intentionally keep digging as that we don’t know how to stop? Let’s look at what is happening on Wall Street and on Main Street.

a. Wall Street runs on confidence. Investors believing in growth place bet on the future in buying shares and paying a price that is many times current earnings per share. As the housing market declined, assets held by banks also declined in value; but, no one knew by how much. Present accounting rules require financial assets to be “marked to market” or adjusted to the current value and the loss reflected as a charge to income. Banks began to report large write offs but investors believed the reports were only the tip of the iceberg. Confidence in the accuracy of reported earnings plummeted and investors fled financial stocks, sometimes as in the case of Wachovia, on false rumors. Still, depositors seeing the stock price fall panicked and withdrew deposits forcing the bank to fail and be sold.

b. Wall Street requires growth in earnings which requires borrowing for expansion. As the housing declined and mortgage defaults intensified, banks, not knowing what present assets were worth, tightened lending practices. Bank failures occurred overnight without warning and credit tightened more with banks refusing to lend funds overnight to other banks. These overnight loans are made among U.S. banks (to meet daily minimum cash reserve requirements) at the Federal Funds rate set by the Federal Reserve and by International Banking entities at the LIBOR rate (London Interbank Offered Rate). Both rates are low risk and normally therefore within a half percentage point of the prevailing short term U.S. Treasury Bill rate (considered the risk free rate of return because there is zero risk of default although some market risk). The gap widened to about 2.5 percentage points indicating the unwillingness of banks to lend. Similarly, commercial enterprises borrow short term funds through commercial paper to meet daily obligations like payroll as operating cash flow fluctuates. The commercial paper market has largely frozen with companies unable to borrow. Companies are also finding it difficult to renew established lines of credit with lenders demanding harsher terms or refusing to renew. The credit market freeze has resulted in job lay offs and the postponement of expansion plans. The bail out will save companies but it will also bolster employment benefiting Main Street as well as Wall Street.

3. Can the hole get so deep that we cannot climb out?

Imagine a group of people are climbing down a steep mountain trail in a snowstorm. They are tethered by a rope. It is getting dark and the trail is beginning to ice up. Some have temporarily lost their footing but the others were able to pull them up. But, sooner or later, all realize that absent some help from rescuers, they will all slide down to certain death.

The economy runs on confidence. When people are afraid they begin to make irrational economic decisions. They start to slide down the path. But, we are all tethered in this economic system. Sooner or later, the weight of those irrational decisions will pull all of us down into a severed economic recession (contraction) or depression unless the government dramatically acts to restore confidence and return the system to equanimity.

4. What will the federal bail out fix and what may not be fixed?

By removing non-performing assets from the books of financial institutions, the $700 billion cost will enable banks to determine asset worth and begin to lend to fellow banks and other businesses again. Banks will also be able to lend to home buyers again. What is less clear is whether they will be willing to lend unless prices in the housing market stabilize. For, if bankers feel that loan collateral will further erode, they will continue to offer loans to only the most credit worthy borrowers, and continue to demand harsh terms such as a 50% cash down-payment Thus, home buying money will remain largely unavailable unless mortgage foreclosures are reduced. In my view, the bail out measure ultimately enacted, must encourage or demand loan principal modifications with equity participation if we are to measurably reduce foreclosures and stem price deflation in the housing sector. Otherwise, the hole is dug deeper because the less banks are willing to lend, the more prices decline and the more prices decline the less banks are willing to lend.

5. What have we learned and what should you do now?

We have leaned a number of lessons:

a. Whatever one’s view of free trade agreements, all must now agree that we live in a globalized world economy that is inextricably interconnected.

b. Extremes do not work whether they are Karl Marx’s or Adam Smith’s. The USSR failed because large economies cannot be centrally controlled. Today’s economic debacle occurred because Reagan was wrong when he stated that the best government is no government. Laissez-faire economic policies and completely free markets lead to chaos. The government must get back on the job of overseeing markets.

c. There is no free ride. When someone offers you a rate of return above the risk free rate you are assuming greater risk. If Treasury Bills are paying a 4% rate of return, a money market fund offering 5% is buying short term investments that are riskier than Treasury Bills. If a bank offers CD’s above the going market rate, you are assuming greater risk because the bank offers the rate deemed necessary to attack deposits considering the alternatives available to investors. Don’t ignore risk simply because the bank has FDIC insurance coverage. The FDIC will of course pay if the bank fails. But, it may be more difficult for the FDIC to arrange a sale of the next big bank to fall as the big three Bank of America, JP Morgan Chase and Citibank have already made acquisitions. Thus, The FDIC may have to wait for federal funds to be injected to cover a very large bank or many small failures. Investors and home owners must become more respectful of risk and its relationship to rate of return.

d. There is no such thing as a sure thing in the investment world. Risk is present in every investment. Even the supposedly risk free Treasury Bill carries a market risk when interest rates fluctuate. It may not be a large risk for short term bills but it is a risk. The future is unpredictable. I have never yet seen an accurate long term projection of revenue. I am a financial not an investment advisor but I recommend the following:

(i) Make sure your bank deposits are in sound banking institutions.

(ii) Make sure your bank deposits are covered by the FDIC. The FDIC rules are counterintuitive and should be reviewed at www.fdic.gov. Pay on death accounts are an easy way to increase coverage but read the rules and consider the impact on your estate plan. The bail out bill (Emergency Economic Stabilization Act of 2008) signed today is said to increase FDIC insurance coverage to $250,000 but I have not yet read the bill

(iii)The federal government has proposed to insure money market funds but I have not seen the final regulations and the money market fund must agree to participate.

(iv) Question your stock broker who tells you the current situation is only cyclical in nature. The simplistic advice to hold fast may be damaging because many companies will not survive. As of October 1, the shareholders of Wachovia lost 94% of value from the high in February of last year. Lehman bondholders will lose. Be proactive and question the make up of your portfolio and the stock funds in your portfolio. Reduce your exposure in the financial sector. Consider reducing stock holdings by 20% and parking funds until the storm subsides and calm returns.

7. Why is the future not bleak for America?

Some have predicted the end of American dominance in the world. I would not bet on that occurring for these reasons:

1. Demographics. Our birth rate is 2.1 per family while Europe has a birth rate of about 1 child per family. Russia is a dying country unless they can stop population decline. A country needs babies support long term economic growth.

2. Innovation. America is still the world’s innovation leader. Most of the new ideas or germinated here. Innovation leads to new economic structures that are not predictable. Consider, the airplane and computer.

3. Productivity. The American worker is more productive than his or her European counterpart.

4. American Psyche. The American psyche is such that we identify and brutally assess and correct problems. The Japanese banking crisis festered for years due to an unwillingness to face up to and correct abuses. We don’t sweep problems under the table. We take our losses and move on stronger for the experience.

5. System flexibility. China has achieved remarkable economic growth and has the population to support continued growth. But, even the new market based system is centrally controlled and cumbersome. Most of the country is still living in poverty and lack of government oversight and rampant corruption has affected the quality of products exported.

6. Political stability. Why during this crisis has the dollar risen against the British Pound and Euro? Why are foreigners flocking to U.S. Treasury Bills? If the Bush-Gore voting dispute had occurred in most other countries around the world, a coupe would have ensued. Here the dispute was argued vociferously, in homes and in the courts, but in the end there was a smooth transition of power. Political upheavals often follow economic crises. Today it was reported in the Miami Herald that the remaining democracies in Latin American are worried about the political winds shifting as a result of the present mess. When governments change to authoritarian, they will nationalize private assets and freeze or devalue currencies. Every Cuban knows that government change is the ultimate risk. The greatest fear is that a populist like Chavez will zoom to power. Do Arabs want to leave money under the thumb of their authoritarian regimes? These concerns will continue to make the U.S. the first choice as a repository for funds, regardless of rates of return or currency fluctuations.