Thursday, April 16, 2009
The perfect storm
The sudden calls to regulate banks should be taken with a grain of salt.
Let’s remember now, the cause of this crisis was a sudden, dramatic drop in home prices, the likes of which we have never seen. For 100 years, home prices never dropped. Who would have expected them to drop 30 percent in 18 months?
All these “toxic assets” you read about would not be toxic if home prices hadn’t plunged. The rating agencies did their job. The insurance actuaries did their job. They studied historical data and used quantitative analysis to determine risks. They were just wrong.
To be sure, the dramatic increases in home prices over the last few years should have been a warning sign. But previous surges were followed by years of little or no growth, not a plunge off the cliff.
With huge amounts of surplus cash being generated by the Middle East and China, the money had to be invested somewhere. Experts believed that increasing liquidity would continue to cause hard assets to appreciate. It just didn’t turn out that way.
We have to have a villain. We just can’t accept the fact that we are human and cannot predict the future. Life is unpredictable and complex. Risk is a fact of life.
Our lead villain is the caricature of the fat-cat Wall Street banker hyping worthless pieces of paper (collateralized debt obligations) and laughing all the way to his summer home in the Hamptons.
Many of these folks are now unemployed and will be living off their savings from the glory days. Wall Street jobs are high-risk. You can get fired in a heartbeat. There is zero security. That’s one reason they make more.
Collateralized debt obligations allowed millions of Americans to afford cars and houses for the first time, generating substantial economic growth. That’s why Obama’s treasury department plans to spend a trillion dollars resuscitating this dead form of credit, which represents over half of all the credit in the country.
There is nothing inherently wrong with CDOs. The problem was the big banks that bought the CDOs failed to study the 200-page credit agreements that controlled the pieces of paper.
When home prices unexpectedly fell off a cliff, the banks needed access to the collateral (foreclosed homes) underlying the CDOs. What they found was a bunch of credit agreement legal mumbo jumbo that made it far more difficult to foreclose than a traditional house lien.
This realization caused residential CDOs to drop even more than the properties they represent, becoming worth just 20 cents on the dollar. Indeed, toxic assets.
Normally, this would be very bad, but it was even worse because banks had become super leveraged. The treasury allowed this because banks had purchased credit default insurance from the biggest insurance companies in the world. Forget our leverage, the banks argued, we’re insured! But what happens when the insurance company goes broke? That’s called “systemic risk.”
If this all wasn’t bad enough, the Financial Accounting Standards Board (FASB) created a new accounting rule called “mark to market.” That means when the CDOs dropped in value, the banks had to immediately write off the loss.
In the old days, the banks would just keep the asset on the books at the original cost, making everything look rosy and allowing them to better weather the storm.
We had a perfect storm, caused not only by market conditions but by government regulations as well.
Have no fear, the government is here.
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