Smart Money with Keith Springer Saturdays at 1PM and Sundays at 6AM on NewsRadio KFBK 93.1 FM and 1530 AM

What killed our economy and crashed our Stock Market – In Plain English.

Posted At : February 17, 2009 10:28 AM

Typically when we have major booms like 1914 – 1929, in the latter stages we ultimately see extreme speculation, leverage and bad lending. Recessions and depressions follow as the bubbles burst and credit deleverages. The longer a boom goes on the less risk everyone sees and we act accordingly. In our current situation, businesses and individuals bought assets they could not afford with too little down and variable interest rates. The Fed decreased interest rates very low for a long time after the tech crash and helped fuel the housing, emerging markets and commodity bubbles. Up until 2003, investment banks were allowed to leverage 12:1. Then in 2004, the SEC gave five banks the ability to leverage up 40:1. I bet you can guess the five banks: Bear, Lehman, Merrill, Morgan and Goldman. Hedge funds also wanted in on the game and raised almost two trillion in assets and leveraged them as much as 40:1, hoping to keep the high returns going from the 1990’s tech and stock bubble when returns crumbled. Perhaps worst of all, was the credit rating agencies were totally remiss in not seeing the risks in these mortgage securities that are now blowing up.

While rates stayed low and stocks languished, Wall Street came up with a new group of securities that took mortgage and other debt as collateral.  They packaged them up in a way that made them look like a very low risk. They were offering 6% plus returns with AAA ratings vs. the 3% returns in risk-free shorter and longer term securities. That was an offer no one could refuse. The reason almost no one saw this massive crisis coming is that the CMO’s (Collateralized Mortgage Obligations) and CDO’s (Collateralized Debt Obligations) were AAA rated by the ratings agencies.

However, everyone’s loss of perception of risk and greed helped cause this crisis. Real estate does fluctuate, although not as much as stocks. It was significantly down in many areas from 1990 – 1996. It has been down in Japan 60% to 70% from 1991 – 2005. Many of the recent loans were made with little regard for income or ability to repay and the payments were based on low initial teaser rates. Diversifying the mortgages by packaging them together into a bundle with other mortgages only does so much, as does spreading them throughout the financial services industry and the world. Just the fact that you could get 300 basis points higher return than a T-bill on a AAA rated security should have been a clear tip off that these bundles of mortgages weren’t so “risk free”.  But it gets worse and much worse; to further reduce the risk of these debt obligations, a derivatives market was developed to insure against defaults. This was an unregulated market where any company could take on the obligation to insure these risks at a price with collateral that was not reviewed or regulated.

The hedge funds then used leverage to buy AAA rated CMO’s and CDO’s assuming they were very low risk, and “insured” them. If the industry had called this “credit default insurance,” then they would have had to go through the normal regulated channels. So instead, they called these contracts Credit Default Swaps (CDS), which meant swapping the risk of default on a credit item (mortgage) with someone else for a price. Hedge funds and other investment firms speculated heavily in this area; buying and selling the CDS’s with very high leverage because they could no longer make the returns they and their investors were used to in the 1990’s. Hence, the whole industry is leveraging and further speculating on what was listed as AAA quality securities. But when housing starts to fall significantly and many of these loans see their interest rates reset upwards, we get rising defaults and it becomes obvious that these securities are nothing like AAA rated T-bills.

So, what we have today is the $2 trillion hedge fund industry blowing up and melting down after leveraging to irresponsible levels. This is why selling on Wall Street is so irrational and persistent. This crisis began with the slowdown in housing, but its real cause was a new class of mortgage CMO’s and CDO’s that were rated AAA by the rating agencies. These packages were leveraged heavily by hedge funds and investment firms to take advantage of their “quality” and low volatility, then insured through CDS’s that were unregulated. These were then leveraged, growing into a massive market of $60 to $500 trillion dollars. Nobody is quite sure yet how much. Almost no one saw this coming as the securities that underlay this whole leverage scheme were AAA rated. But they shouldn’t have been.

So, as part of this plan to make bad securities look low risk, everyone insured everyone else (in an unregulated market), and as collateral they all ended up owning the same securities (often on leverage). Now they can’t pay back their loans (for leveraging their investments) to the banks. Well, the banks only have fractional reserves and their capital is quickly being depleted meaning they can’t make loans and credit has frozen up. That’s where we are. Our great leaders certainly put us in a pickle this time!

The irrational panic selling in the stock market is not coming as much from normal investors and mutual fund managers as in the early 2000’s. It is coming from highly leveraged hedge funds that are incurring huge losses and redemptions which force them to sell good stocks as well as bad to get liquid.

The massive stimulus now and ahead should provide an economic rebound. The thing to watch out for will be accompanying inflation and a possible commodity spike with it. If the government does nothing, the banking system implodes and we get a depression scenario. If they stimulate too much, we will get inflation, which will lead to a devaluation of the dollar. If left unchecked, it could even lead to a run on the dollar. This would force a halt of the stimulus which would cause another economic downturn. And you think you have to make tough decisions at the office.

It’s going to be a tough year as the markets continue to face two huge obstacles: Deleveraging and Demographics. As discussed in my Economic Tsunami Special Report, changing demographics will continue to hamper consumer spending. Every day, more and more Americans are passing their peak spending years, changing from net spenders to net savers. With consumer spending accounting for almost 70% of GDP, this will certainly have a dramatic effect to the economy. Since we are in a secular Bear Market, you should be positioned accordingly and looking for dividends where possible, but also being invested so as to participate in the eventual recovery. This environment is as hard as it gets, and we will do our very best to be ready for whichever scenario comes our way.

Regards – Keith Springer

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