Bubble and Meltdown - chapter 1

Over the last year I have read 10+ books on the financial bubble and meltdown. Much of the story is well known but there are some aspects that I don't believe have received the attention they deserve.

Here are some under-reported aspects:
- The Giant Pool of Money
- The Agency problem
- How the bubble lead to misplacing of resources and lower rates of unemployment that were unsustainable
- How the wealth and income disparity leads to stagnation
- Repeal of Glass-Steagal
- Global imbalances in trade and savings

Let's start with the Giant Pool of Money. I can across this from a Podcast, This American Life, which is the number 1 podcast on Itunes. http://www.thisamericanlife.org/radio-archives/episode/355/The-Giant-Pool-of-Money. The basic idea is that there is a global Giant Pool of Money available for investing - much of it looking for fixed income investments, e.g. bonds. The Pool of Money is always increasing in the long term but in the years leading up to the bubble it really expanded. Part of this was due to the increased savings in Asia as millions of Chinese and Indian workers climbed out of poverty and saved a large percentage (at least compared to Americans) of their income. In addition the US trade deficit with China lead to the Chinese banks to accumulate billions in USD.

So we had a huge increase in money available for investing at a time when the fixed income investment of choice - US T-bills and Treasury notes had very low interest rates. So investment managers all over the world were looking for investments with a better rate of return and Wall St. invented new investments especially mortgage and asset backed securities that paid higher rates of interest. But even these new securites could not match the demand so Wall St. invented an alphabet soup of financial derivatives that we have all read about - CDO and CDS and then more deriviates based on the derivatives - synthetic CDOs.

We all know what happened next. In order to create more fixed income securities the mortgage brokers made very bad loans. They borrowed money from Wall St. to make the loans but then sold the mortgages back to Wall Street where they were packaged into asset backed securities and sold to global investors. Why did these supposedly well-informed investors buy securities that consisted of bad loans? One, they were rated AAA by the ratings agencies. Two, the feeling was that even if the loans went bad they loans were backed by strong collatoral, i.e. houses.

Of course what most of us missed was that the home prices were based on a bubble.

If you read what those in the industry said at the time it was "housing prices never go down" (even though housing prices have gone down substantially in the past). Looking back it is easy to understand that housing prices in the long term have to be linked to income and income for most Americans was stagnating. If you plotted housing prices and growth in income you would see a huge and growing gap.

These securities were very vulnerable not just to falling housing prices but even if housing prices stayed flat the borrowers would be unable to pay off their mortgages once the teaser rates expired nor would they be able to refinance. Had prices remained flat there would have been a large amount of foreclosures but when housing prices fell the number of foreclosures increased exponentially.

What drove the market for mortgages was not demand by consumers for houses it was demand for fixed income securities from the Giant Pool of Money. So mortgages were offered with no consideration as to whether the mortgage could ever be repaid. More on that when I discuss the agency problem.

The Giant Pool of Money tells Lehman, Bear Stearns, Citi, Merrill Lynch, Goldman Sachs - find us more securities. Wall Street works with the mortgage originators and makes them short term loans to make mortgages. Local banks make short term loans to developers. Developers build more homes and work with the mortgage originators to find buyers. The house is sold. The developer pays back the local bank. The mortgage originators sells the mortgages to Wall St. and pay back their short term loans. Wall St. finances all of this with short term loans in the form of CD and loans from the large banks. The mortgages are packaged into securities and sold to the Giant Pool of Money. Wall St. pays back their bank loans.

Everyone gets paid mostly in fees. The risk has moved from the local banks, the developers, the mortgage brokers and Wall Street to the Giant Pool of Money.

Except that there are always more loans to be made. More construction loans, more houses, more bad mortgages, and more risky mortgage backed securities some of which are not sold to the Giant Pool of Money but are held by the Wall St. banks.

So where's the blame? Well kind of everywhere. Every one in this chain is making mistakes. It may be that the least informed about the risks are the consumers and the Giant Pool of Money. Everyone else is simply trying to skim off fees and trying not to be standing when the music stops.

More on the agency problem next time.