Financial Disaster, Foreseeability, and Frankenstein (greatest hits)

Mortgage securities rise and fall, a Story Mary Shelley would love...

Confluence is a great word.  It means, in essence, a "coming together."  Most often, the term confluence is used in connection with rivers.  Probably the most famous confluence of rivers is in Pittsburgh, where three major American rivers eventually merge somewhere around the Steel City's semi-famous (at least to geography buffs) golden triangle.  

One gold star goes to the first person who can name the big three rivers.  Comments are open below.  But we digress.

The confluence discussed in this post has to do with financial disaster, not rivers. This piece is about a very rare confluence of economic conditions, electrified by almost unbelievable opportunism and greed by investment banks and others, that pushed the world into the most serious financial crisis since the Great Depression.

Wall Street executives frequently blame the financial crisis on events that were impossible to foresee during the years they pocketed multi-million dollar paychecks and, at the same time, laid a foundation for disaster.  Former CEOs invoke terms like hundred year storm, or perfect storm, or act of god when they deny responsibility for jeopardizing the entire world economy.

Wall Street money is behind the low documentation, low quality subprime loans that defaulted en masse when interest rates rose and home prices stopped their race to the moon.  Wall Street leveraged itself to the hilt to enhance return on equity and, by extension, executive compensation.  The subprime crisis, RMBS crisis, and - ultimately - the credit crisis were foreseeable events.   They were, in fact, actually predicted by more than a few folks.  

If there was a hundred year storm, it was the confluence of unique economic conditions that Wall Street investment banks exploited to fuel the housing bubble.   

    *** 

Consider what happened to open the door that, in the end, was kicked in by Wall Street Greed (and where have you gone Gordon Gecko?) -

• First, the end of the internet stock bubble followed by the humongous shock to U.S. economy from the September 11 terror attacks resulted in the Fed taking interest rates to historic lows, and holding rates there longer than ever before;  

• Second, low interest rates meant Treasury yields were so low that pension funds and other major institutional funds needed investment grade instruments with significantly higher returns than United States bonds in order to avoid invading their funds’ corpus (principal) to make required payouts (expansion on this topic requires its own blog post).  For purposes of this post, it is only necessary to understand that fixed-income fund managers restricted by law or charter to investment grade securities were desperate for yield.  This situation, if not unprecedented (I am a lawyer, not an economist) is extremely unusual.  

 

• Third, Again thanks to low rates, money was so easy and cheap to borrow - especially for banks - that it was practically free.

 

• Fourth, Cheap money (low interest rates) almost always is manna for the housing industry. Easy credit and low interest rates (and a host of similar factors too long to spell out here) allowed people to afford monthly mortgage payments on homes they never thought they would be able to afford. Housing went through the roof, and people accumulated amazing amounts of home equity (sometimes called found money) due to the increasing value of their homes. In short, most individuals could tap into the wealth produced by their homes to avoid possible mortgage delinquencies (and to put in pools, surround sound, etc.).

• Fifth (and you thought the confluence of three rivers in Pittsburgh was impressive), broker-dealers like Bear Stearns and Lehman Brothers were very experienced with a set of financial products that they believed they could market and sell to “greater fools” – especially all of those fund managers desperate for yield.  These products – perhaps you’ve heard of them - have names like mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).

• Sixth, If Wall Street excels at anything, it is spotting an opportunity to exploit others for profit. In this case, subprime borrowers, many of whom would eventually face disaster, and institutional fund managers two classes of "fools."  As long as Wall Street banks could get investment grade ratings with securities made from pools of less than investment grade quality mortgages. Enter the quants (actually, they had been working on this stuff for a while already). With complex mathematical computer programs, and a lot of money in "fees," investment banks were able to bribe, err, "collaborate with" the credit ratings agencies to obtain the much needed "investment grade" stamp of approval.  

Now, all the pieces were in place and the money train pulled onto Wall Street.  It arrived regularly for about five years.  And then Frankenstein's Monster came along.  Read about that in part II.

By The Sherman Law Firm, Contact us

 

Comments

[Benjamin Frankline Pierce]

Is it the Ohio, the Missouri and the Delaware rivers?

[Vincent Rose]

You my friend are a wise little fellow. Seriously, love the Wall Street law blog. Keep on bloggin'