Connect the Economic Dots Part II

We have set the stage for the economic meltdown, if one thinks back two to four years, or reads the previous post, Connecting the Dots Part I. 

Anyone could get mortgage financing, as long as they could fog a mirror.  Credit was extended to anyone and almost anything that would come in the door of the mortgage company, banks, car dealer, furniture store and so on.

The mortgage side was the worst of it.  Companies like Countrywide would package up their mortgage loans as "Asset-Backed Commercial Paper" and sell them to Wall Street.  Wall Street looked to Standard and Poor’s and the other rating agencies for a measure of the worth of the loans.  S&P said "Hell, there’s houses backing the loans up, so they’re good."

Now this makes a little sense, but only a little.  Everything depended on house prices going up dramatically.  All indicators at the time made it look that way, as the builders couldn’t get enough workers while banks and mortgage lenders were writing billions of dollars worth of deals every month.  It must be a solid investment?

Investment houses, like Lehman, Smith Barney, Goldman and the rest looked at the AAA rating and said why not?  AIG, who insured the purchases, looked at the AAA rating too and agreed to back the deal, just in case prices took a little wobble. 

The Securities and Exchange Commission, in 2004, took off all the controls over debt to equity ratios for banks and investment houses.  As long as you had the cullions, you could run as much debt as you wanted.

Meanwhile, down on Wall Street, the fund managers looked through whatever colour of glasses were popular that day.  Stories abounded about colleagues who made millions in a couple of hours betting against Wall Street, then suddenly selling everything and buying something different.

Remember E-Trade, or all the infomercials on hedging and options trading?  You too could be a Wall Street Winner, if only you bought and sold on a hourly basis, reading the runes with our specialized knowledge. 

There was a time, not that long ago, when you would actually meet people who said their profession was "I work from home, I’m a day trader"  These particular folks were the ones who prospered from the misfortunes of others, swapping options on FCOJ (Frozen Concentrated Orange Juice) by watching the Weather Channel and seeing that the temperature in Ocala this afternoon was a bit too low for the crop, so the price in six months will go down, as the quality won’t be as good, but we’ll bet that others will guess too low and we’ll make millions when the price stays up a bit.  I wish I was making that run-on sentence up, but I heard that statement, almost word for word, from a day trader I used to know. 

These were the kind of people who made money on Home Depot, Lowe’s and Weyerhauser stocks when Hurricane Katrina hit New Orleans.  The complete destruction of a major city, means a demand for lumber to rebuild, therefore; buy!  We’ll overlook the deaths, destruction and malfeasance ("Brownie, you’re doing a helluva job") at a high level, as long as we can make a buck.

That describes the problems of options and derivatives, at least in technical terms, but doesn’t quite get the economic weirdness across.  The closest Wall Street analogy is betting on sports at a high (and very fast) level.   

Wall Street is nothing more than betting a player in a basketball game would, or wouldn’t make a free throw. This we can understand, even if we’ve never owned a stock in our lives.

The derivative would be; would the ball bounce left or right? 

The derivative’s derivative is;  would the bounce be outside the key, or inside the key. 

The hedge would be that the bounce outside the key from a missed free throw would be caught by a player whose last name ended in a vowel. 

The derivative hedge would be that a spectator wearing a blue t-shirt would catch the ball and his last name would end in a consonant. 

There were even some who would bet against the Instant Replay, despite what they saw in the real world five seconds earlier. 

Most of it was fuelled by technically illegal inside trader knowledge, whispered numbers and tipsters who ‘knew’ something would happen.  There are more investing tip sheets and research companies than one could imagine.  Emailed hot picks and dead dogs are swapped hourly, with the buy and sell orders flying out within seconds, often automated sell or buy limit orders not even done by humans. 

Subscribe to Morningstar, or any of the other "stock research companies" and see what happens.  It’s the same game as The Racing Form tip sheet:  This horse did well on muddy tracks but can’t win on dry turf and today’s jockey only wins on horses with three names. 

At least with Morningstar, you don’t get these tips from a guy named Perry who wears a green check-print sports jacket and a genuine full-Winnipeg of white shoes and a white belt holding up polyester pants of a colour not seen in nature.  The quality of the information (innuendo and a light sprinkling of public facts) is the same, but the fashions are different. 

Investing became a hour-by-hour, then minute-by-minute game. In the Olde Days of 2001, mutual funds invested in companies for three months or longer.  There were reports of real humans who would invest in General Motors and hold on to the stock for a couple of years, knowing that over time the stock would go up nicely.  Not wild 25% swings, but a calm, pleasant, 5% to 10% increase in value without much fuss, or nervous scanning of the stock prices.

The downside to buying, then holding an investment for a period of time, meant you were a ‘non-performing’ investor, to the brokerage:  You didn’t generate much commission for the house as you weren’t in the frenzy of buying several times a day.  Remember, every buy or sell means you, as an investor, pay money to the broker for the pleasure of their assistance, even if the investment is a dead dog that is starting to smell. 

As a non-performing investor, you don’t get access to the special, platinum edition, ‘really, really good’ copy of The Racing Form.  Sorry, I meant investment research.  As a non-performing investor, your broker, who is compensated only on the amount of commission he or she brings in from you buying and selling often, considers you dead. 

The broker’s boss is compensated on a percentage of what his people bring in, therefore the broker’s boss considers you less than dead. 

The corporate management gets their bonus if they make certain financial targets, so you, as a non-performing investor, do not actuall
y exist in their Universe.

Into this multiplicity of moving parts and minute by minute madness, falls Asset Backed Commercial Paper, with a AAA rating.  The bettors had a new toy that they didn’t quite understand but sure seemed like fun and was backed by real estate, so how bad could it be?