I'm copying and pasting my post (from trailrunnings) onto my blog so that I don't have to keep switching back and forth from my blog and trailrunnings. Original date Nov 8th 2007.
The following is ONLY my OPINION and does not mean anything more than that. Since my moto is unridable (sp?) with a flat tire and lack of truck, I have been forced to think about finance. Because this is what I went to the Red School for, I have a propensity to dwell upon the fate of money. The large financial institutions like "Investment" Banks, nationally and regionally expansive "savings" banks, large pension funds, insurance companies, etc. gorged themselves on cheap debt and those pesky little things called "sub-prime" mortgages. I'll leave a through dissection of why these entities did this for another blog entry (I know you won't be able to wait, but too bad) but it has to do with borrowing at a low interest rate and buying a higher interest rate paying device, using the low interest borrowed money, and making the "spread". This is only one of innumerable reasons for this sub-prime crisis, so don't quote me on this as the ONE and ONLY reason ;). So these institutions bought these devices, sometimes known as CDO's among other acronyms, to earn higher than "normal" returns on their money. Everyone thought they were smart and making "risk free" money on the spreads. Traders, investors, banks, etc. made big money in the form of bonuses, returns and fees from these instruments. It was in the individuals, if not the companies, interest to keep this game going. As in most things, the cycle has caught up to the instruments and the ones paying the monthly payments. You see, all of this was built upon a bad risk. The risk of a newly married couple making 50K in California defaulting on their $1,500 interest only monthly mortgage payment is relatively small. The risk of that same couple defaulting on their newly adjusted principal and interest monthly payment of $3,000 is much higher. Factor in that this same couple fabricated income to purchase this home next to their best friends or speculate that the price would continue to climb, and the risk of default is almost certain. Add in a declining real estate market so this same couple can't sell this burden and you have what I'll call the Cake of Disaster (can I trademark that phrase). This couples mortgage was most likely sold as soon as it closed and packaged into a financial instrument that pays out cash to the investor. These financial instruments were then "rated" based upon the quality of the mortgage credit by rating agencies. The ratings given were supposed to determine the risk associated with the stream of cash flows. The higher the perceived risk, the higher the return. These agencies at best apparently didn't do their homework and rubber stamped issues or at worst were persuaded to rate riskier issues better (this persuasion could take the form of cash, promised access, preserving relationships, etc.). Since many government pension funds, insurance companies, and other regulated entities can only buy investment grade financial instruments, the rating agencies may have been influenced to better the ratings by the firms bundling these mortgages so that the bundling firms could sell them easier.
The financial institutions feasted on the frosting of the cake, "the interest, fees, etc.", got to the next layer and thought this taste funny, but hey were all making amazing money and so will be able to afford the doctor, "the markets", and then got to the middle. The ooey-gooey middle where nothing had gone the way it should. All of the fancy financial models, "the recipe", failed. Eggs went un-blended, flour was in clumps, "the CDO valuation puzzle", and big chunks of salt, "defaulting loans", were the morsels left to chomp on. This of course necessitated a trip to the emergency room, "the Federal Gov't.", on what most likely will be all of ours dimes, nickels, quarters, and dollars. The financial losses that have been reported in the media are somewhat misleading. Some of what was lost is "real" money. Some is what is called balance sheet writedowns. The balance sheet writedowns came from being unable to value the financial instruments in a firm (desirable) way that the companies had as assets on their books. This inability to value these things is what is causing problems. Since the instruments value come's from the cash flows of the mortgage payers, when all or some of that cash flow disappears or is uncertain (the math behind what is termed uncertain boggles the mind, literally), the instrument is now very difficult to place a value on. This change in perceived value is what is being wrote down. Now don't take these writedowns and tell me they aren't real money (just see what happens to the stock price and your wealth when the writedowns are announced), I know they are and matter greatly.
What I'm about to write is not an endorsement nor suggestion to buy nor sell particular securities and/or their associated derivatives. Since few of these financial institutions have publicly announced their losses and balance sheet write downs (can Citicorp. really believe that a switch was thrown on Oct. 1st, the start of the "4th" business quarter, and that is when they started losing money????) you can actually bet that more problems will surface in the next six months and make some of those nickels and dimes back. The stock ticker SKF is an instrument (yes just like CDO's, kind of, in certain ways, if you look at it through squinty eyes backwards and upside down) that moves opposite of a basket of financial company stocks. This means that if this basket index moves up, the value of SKF goes down. But if you believe that the financial companies are still trying to hide losses that MUST eventually come out (unless the Gov't bails them out) then bad news for this basket of financial stocks is still likely. This bad news would be good for the value of SKF shares. For those interested in reducing their risk, SKF has a correlation to the DOW of -.85. This means that if the DOW goes down, then SKF goes up and vice-versa. Buy SKF and the DOW and make less but possibly lose less. One caveat to this scenario, SKF has only been around since Feb 2007 and not all market conditions and temperaments have been experienced and been taken into account.
For those who made it to the end of this post, I now will reveal why I wrote it. It wasn't to educate, nor to push an investment idea, I wrote this to put little ones, and possibly their parents, to sleep. Just bring up the blog post, start reading to them and within seconds they'll be asleep. For the little ones who perk up while you read this post to them, sign them up at the next possible moment to attend a Hedge Fund class and start making retirement plans. Hedge funds are where the real bonus money is.
Watch for more economy analysis' in the coming weeks (Lisa said it was OK ;)) if I am not forever banned from posting again (from the same person who gave me permission). Until next time (maybe I'll list some fascinating finance books to read, wow what an idea!!!)
Finance Red
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