THE WORLD OF FINANCIAL PRODUCTS: HOW TO TURN LONG TERM GREED INTO A SHORT TERM DISASTER

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THE WORLD OF FINANCIAL PRODUCTS: HOW TO TURN LONG TERM GREED INTO A SHORT TERM DISASTER

If you ever spend time with a politically energized group you’ll probably notice that they argue. Actually, that's an understatement: they argue all the time. The finger pointing never stops. Half the country seems to blame the current president for our economic despair, while the other half seems to blame the FORMER president. This non-stop parade of partisan identity is truly frustrating to the few who actually knew the source of the financial collapse of 2008. What’s most frustrating is that the source of the problem has enough blame to spread around to both the Democrats AND Republicans. This is a thoroughly bi-partisan problem, and I’m about to explain why EVERYONE is wrong.

Last week we talked about the financial industry and its history. With a newly de-regulated market, the world of financial innovation was at an all time high. The firms that ran this industry were fewer in number and doubled in size. We had a few major commercial banks, a handful of investment banks, two insurance companies, and three ratings agencies. All of these worked together to make the financial industry as profitable as possible. And the system they had worked out to help keep the new system alive: securitization.

Securitization is the new way America makes payments. In the old days you would barrow money from your local lender and pay that lender back directly. This is precisely why we wouldn’t give loans to just anyone. The people who lent the money were very meticulous and watched that money very closely. They had to: if they didn’t, the loan could default and they could lose all their hard-earned cash. With a direct-payer system we knew what was at stake.

In the now, the payment system works like this: we accept a loan and make payments to our lender. However, unlike the days of old, now the lender can sell our payments off to investors around the world. They did this buy lumping the payments of several debts together to create a much higher sum of money. They don't lump the amount they actually have on hand: they lump the TOTAL value of the loan before it even matures. So if you have one hundred $100,000 loans that have not received payments yet, they still think of this loan money as ten million dollars. Then they sell a piece of this ten million dollar pot to the investors who are willing to buy them. These financial products are called derivatives (they derive from payments), and they became VERY popular in the new millennium. The particular derivative I’m talking about here is called a Collateralized Debt Obligation (or CDO for short.) A CDO can consist of credit card debts, student loans, and mortgages. You can buy these products from investment banks like Goldman Sachs or J.P Morgan.

This was step one: take payments, lump them together, and sell the resulting product off to people for their investments portfolio. But it’s still the same amount of money, only dressed up for mass consumption. So the banks decided they needed to take this game one step further. They needed a way to make people believe in the same magical thinking that they were deeply invested in: that somehow these lump sum debt amounts were more valuable than a single mortgage. Even though the mortgages haven’t actually been paid off yet, the financial firm can make claims to its future worth.  So they can say that the financial product you paid $100 million for will actually be worth $200 million in 10 years after the mortgage matures. It’s a kick-the-can-down-the-road kind of thinking, but a lot of people bought into it.

Not only can you lump mortgages and not only can your firm claim that when these mortgages mature that they’ll be worth twice as much, but you also have ratings agencies that will verify that this financial product is actually a solid investment. Moodys, Standards and Poor, and Fitch were all the main players in this part of the financial charade. They evaluated literally billions of dollars to give the investment grades. These grades were rated as follows: AAA is the highest rating, and then there’s CCC at the bottom (known quite literally as a “junk” investment.) The financial products that had the best rate of return were usually the ones that yielded the least amount of money in the short term because it was a less risky investment. The “junk” investments, however, had high yields because they were much riskier.

But why would they want to do this? Doesn't this just make payments and debt more complicated? Well, yes it does. But it also solves two problems: first, you don't have to wait for a mortgage to mature. You can sell a financial product as if it has been paid off and receive a large sum of money RIGHT AWAY. You can also make bad deals and sell those bad deals to other people, stamping it with Moody's coveted AAA rating. Now you have the money for these house payments right away, and when they go bad it's now someone else's problem.

This magical thinking was the perfect trap for the future of our financial security. The cookie jar was opened wide, and most of the major financial firms saw the chance to manipulate the system. Here’s how they did it:

First, they thought it profitable to create as many mortgages as humanly possible so they’d have plenty of expensive financial products (CDOs) to sell to customers. The yield on these mortgages is now instantaneous because you’ve sold the risk off to someone else, and that same customer paid for several mortgages in one go.

They also made it insanely easy to GET a mortgage.  The old days of actually having to qualify for a home was all over: now, with a shady lending technique called “sub-prime” lending, lenders could sell a mortgage to a family with no money because the family didn’t have to have any equity in the house. They didn’t have to put that much money into it all, sometimes paying less than 3% on the total value of the house. So all they had to do was make payments based on the market value of the home. And if they couldn’t pay, they’d just re-posses the house. But who cares if the mortgage went bad? It’s now on someone else’s books.

But how did they convince investors that these CDOs were actually valuable investments and not just crapshoots involving mortgage payments from people who lived in houses they couldn’t afford? Fortunately for the banking industry, there was one more thing up for sale: the opinions of the ratings agencies. Moodys, in particular, was a huge pawn in this scheme. With enough money, the financial firms were able to buy favorable opinions about the financial products they were selling. Many terrible investments were now given the highest possible rating, rated as high as government securities.

To sum these complex ideas up: payments are no longer given to just the banks. The banks take payments and lump them together to sell off as “securities” to investors. Then they make a long term loan instant cash. This is so profitable that they start making mortgages widely available so they can create more securities to sell off to investors. But the only way they can sell as many houses as they need is to increase their sub-prime lending, where the borrower has basically no money in the house. And to hide this fact that they were selling off terrible mortgages, they paid the ratings agencies to give the securities comprise of crap mortages the highest possible rating.

If you can already see where this trail is leading, be prepared: the results were much more fantasical and much worse than ANY of us could have imagined…

Small Business: What is it really?

I was reading a couple of articles about how Gov. Romney said he was in favor of small businesses and he wants to create new jobs I could not help but think of how he thought of himself as a man of the people.  In today’s debates he constantly was saying how if elected, together we will bring a new generation of economic prosperity and he looked very confident up there as well.  I wonder what he means when he says he is for “small” business and in this very interesting piece by James Surowiecki, he writes how “Romney might be small when it comes to helping people, but big when it comes to big business”.  However, this isn’t groundbreaking news to anybody who knows about this country’s industrial beginnings.  Ever since the days of the railroads, government and big businesses has been to say the least, “intertwined with one another”.  Starting with a law that was passed in 1872 saying that the federal government can lease land for five dollars a month, and if the government or the mining industry  can find any gold, silver, uranium, etc, that they could keep all of it and get this...the individuals would not get a single dime out of it.  Not only that but they also allow tax breaks and subsidies to farmers, corporations, banks as an incentive to keep them here in the country.  This has been going on since the days of Vanderbilt, Rockefeller, and you would think that the public would have taken to action by now but it’s not that the people haven’t voiced their concerns its that the government follows where the money goes, which is big business.

Big beneficiaries of corporate welfare include the banks, and of course, the ethanol (oil companies).  The banks want you (the people) to think that the government will never allow the F.D.I.C to fail which creates the illusion that is safer for you to deposit money in the federal bank, as well as it allows them to borrow money at such a low cost.  But it seems that year after year we have another story about how the government has to bail out this bank after “risky business decisions” have almost run it into the ground, and our money has to help them out with that.  Well I have a better idea, how about that money is returned to their rightful owners?  Sounds crazy right?

This however takes the cake in regards to how government offers big businesses a helping hand, and it comes from an unexpected place: copyrights and patents.  The pharmaceutical companies make hundreds of millions of dollars off of federal copyrighting laws and those numbers increase year by year, and the most interesting thing about that is that it has little to no economic benefit to anyone!  In all with the election coming in a matter of weeks, I find myself skeptical in regards to what anyone says when they say the support small businesses, as everyday it seems that those words constantly change.  

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The History of Deregulation: Why Greed and Stable Markets Don't Mix

THE HISTORY OF DEREGULATION: WHY GREED AND STABLE MARKETS DON'T MIX

By Steve Thomsen

You’re in line for the bank. People are filling the building to the brim with stacks of cash to make deposits with. It’s a lot easier to have someone else keep a close eye on your hard-earned money while you deal with life, after all. So when you go and make this deposit, the assumption is that the cash you’ve put in magically goes to an over-sized safe somewhere. The bank keeps their hands off your money until you request for it back. Simple, right?

Until very recently, you would be correct in this assumption. Depositor banks used to function just like the name implied: you drop your money off, they hang on to it. The banks were simply depositories, and your money was off limits to any of the institution’s riskier financial practices. This would include practices like investment banking (they weren’t allowed to gamble with your money), insurance for financial products (they weren’t allowed to use your money to keep theirs from going bad), and leverage for the firm (they weren’t allowed to pretend your cash is actually their net worth  or claim it as reserve capital). This was the safest possible way to keep the depositor bank from going bad.

There are actually three different types of banks: (WARNING: video is over an hour in legnth... if you have the patience, please watch!) These are, in a nutshell: commercial banks (where consumers deposit their money), investment banks (where investors buy financial products like mortgage payments and credit card debts), and insurance companies (where people buy policies to protect their investments from going bad.) These three institutions were separated by law to prevent a crisis. What I’m about to explain is how these were all combined and then used to destroy a massive amount of equity in the system, never to be recovered.

We learned our lesson about banking and its uses the hard way. You may have heard of a catastrophic financial emergency in the early 1900’s. It was called the Great Depression. We fell off a financial cliff due to unregulated banking activity. Banks were able to leverage their institute in much higher amounts than the actual money they had available. They were able to use depositor’s money to handle their own risky investments. And if anything went wrong… oh well, stuff happens. This careless attitude eventually caused the stock market to crash and millions of Americans to lose their jobs.

After this terrible financial tragedy, we were introduced to a new piece of legislation called the Glass-Steagall Act. What Glass-Steagall did was compartmentalize the banking industry to prevent certain elements of banking to interfere with customers. Specifically, it divided the banking industry into three very air-tight compartments: commercial banks, investment banks, and insurance companies. With this new piece of legislation, the financial industry was now strictly forbidden from speculating with depositors’ money. If big-shot investment bankers wanted to gamble, they had to do so on their own dime. And if they failed, they had to pay for the damage.

This is why we were able to avoid a single financial disaster for nearly 50 years. In that time, the American economy boomed. Part of that was because we had no major foreign competitors (Japan and Germany had been decimated from the war) but it was also thanks to the prevention of unregulated banking. We were safe, and so was our life savings.

In 1980, Ronald Reagan was elected the 40th president of the United States. Reagan’s aspirations as president were ambitious: he wanted to lower income taxes across the board, specifically through fixing the tax code and lowering corporate taxes (sound familiar?). The only way he could pull this off was with the help of then-Treasury Secretary Donald Regan, the former CEO of Meryl Lynch. Regan, who eventually became the White House Chief of Staff, was an investment banker hot-shot with a tenacity for getting the investment banks to go public. These formerly private firms were suddenly flooded with boatloads of cash, and people on Wall Street began making enormous sums of money.  Regan and Reagan came up with a saying: “turning the bull loose.” The bull, in this case, was the massive power of the financial industry.

Together, Reagan and Regan did just that: they de-regulated the once very-heavily regulated financial industry. Many things resulted from loosening the regulations: most notably, savings and loans companies didn’t need to sit on their hands with their depositor’s money. Now they were allowed to make risky bets with their holdings (AKA YOUR holdings.) The administration justified this practice by claiming that, in the hands of professionals, no foreseeable risk was involved.

Well, by this point we all know how well that turned out: out of the 3234 savings firms in the country at the time, 747 of them went bankrupt. The proverbial opening of the cookie jar was too enticing, and Wall Street got too greedy. They dug too deep into their capital reserves (AKA your money) and drove their firms into the ground. Consequentially, many people who invested their life savings into these programs lost it all. The S&L crisis ultimately cost tax payers $124 BILLION (!!) and, supposedly, our lesson had been learned.

In the 1992, Bill Clinton was inaugurated into office. A political mastermind, Bill Clinton was thought of to be the man who could fix everything with the economy. And in some regards people were right to feel this way. He was able to balance the budget and produce 4 surplus economic reports in a row. The deficit caused by the S&L scandal was being paid off. Surely, the Democrats had it right.

Unfortunately, this isn’t the whole truth. The Fed Chairman at the time was Alan Greenspan, who also served under Reagan. Alan Greenspan was an economist and former disciple of the infamous Aynn Rand. An objectivist, Greenspan did not believe in regulation in any way, shape, or form. He believed in self-motivated greed and the benefits it had on society. This was reflected very thoroughly by his policies and the ways he carried them out. And the biggest giant blocking his way to an unregulated economy: Glass-Steagall.

In October of 1998, Citibank broke the law. They merged with a financial giant by the name of Travelers. The reason it was illegal for Citibank to acquire Travelers was because A) the two firms were too large to be combined without putting the market at risk and B) its combining of various financial services like insurance and investment banking. Though this was blatantly against Federal law, Alan Greenspan turned a blind eye to the practice. The man in charge of monetary policy in this country was not going to pay any attention to a blatant crime. And that’s when the policy makers started scrambling to make the illegal Citibank-Travelers merger, well, legal.

And they succeeded. Glass Steagall was deemed outdated to the modern financial world. Instead, it was replaced with a new piece of legislation called the Gramm-Leach-Bliley Act. Senator Phil Gramm was one of the sponsors for the bill (hence the name), and he and his wife Wendy benefited tremendously from this new law. What G-L-B does is tear down the restrictions previously held on financial institutes that prevent it from gambling with depositor’s money. It’s a new day and age, they thought. They knew the modern world would be able to let professionals handle large sums of money, even if it wasn’t there’s, and come home with greater capital positions than previously held. It made mergers like Citigroup legal. It let banks leverage their firms at much higher rates. And, most importantly, it opened the floodgates for several new financial products to storm the market. It laid the red carpet for the ticking time bomb that was now the American financial institution.

We had learned our lesson. Then, as time passed by, we forgot. Then we went back to the same money games that led us into the Great Depression. And now, even after crashing the whole system yet again, we still haven’t seemed to learn our lesson.

In the next post I’ll go over what exactly happened when we let these floodgates open. We’ll learn that when we turn a blind eye to the hand in the cookie jar, we’ll be left with nothing but crumbs.

Great Blogs to Help You Understand Why You're So Poor

BLOGS THAT WILL GET YOU STARTED:

Here are some great thinkers about the economic state we're all in. Some of them are analytical, some of them angry and less reverant, and one of them completely insane. But they all are great thinkers who have all expanded my own thoughts on these subjects. I hope you'll check these out because they all contain a wealth of information.

So let's get started, shall we? The six questions answered for the instructor are contained in the "what you should know" sections of each.

Enjoy!

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Matt Taibbi: "Taibblog"
What You Should Know: Matt Taibbi, the author of Taibblog, is a Rolling Stone contributing editor with one of the angriest yet funniest voices in the world of economics. And he still remains one of the most intellectual contributors to the world of financial journalism. His blog tackles tough issues, but is always completely un-apologetic in its tone. What drives Taibbi is a desperate desire to call Wall Street out on their BS and hopefully raise awareness to the "vampire squid" (AKA the financial industry) that wraps its tentacles around the face of humanity to suck it dry. He probably makes a little bit of money in this endeavor, but I can tell it's his personal passion that drives him. Taibbi contributes monthly to Rolling Stone and updates his blog about once a week. The comments in his field are generally extremely angry, and people who he's written unflattering things about have sent him several death threats in the past. A testimony to his effective writing style, no doubt. He also has a Twitter and a Facebook page.

Charles Ferguson: Charles Ferguson @ HuffPost
What You Should Know: Charles Ferguson is a filmmaker and writer who has tackled some surprisingly deep subject matter. Both of his documentaries ("No End In Site" about the Iraq war and "Inside Job" about the financial crisis) were nominated for academy awards and Inside Job won the best documentary of the year award. His blog continues to tackle many of the issues addressed in "Inside Job" and he is very acute to the actual nature of the recession. He has stated that his interest in this field is fueled by his need to "lift the veil" and show everyone the true nature of things. He considers himself an investigative journalist, and his chops in this field are uncanny. Unfortunately, he doesn't update his blog more than 3 times a month. But all of his contributions are certainly deep, fascinating, and revelatory. He is also a member of Twitter and Facebook.

Paul Krugman: Krugman Blog
What You Should Know: Paul Krugman is a New York Times Op-Ed contributor in the field of economics. His mission is to help people understand the true nature of political economic rhetoric and how well it holds up to real-life economic statistics. He famously called out the ratings agencies of the financial services market for having committed "chutzpuh" by downgrading the US debt rating after turning a blind eye to the real estate market. He also regularly appears on TV shows on cable news to help sway the arguments about the national debt in an intelligent direction. His blog, as it appears in the Times, is updated almost every day. The comments he gets are mostly positive, although every now and then a blood-red Republican comes on and tries to call him a socialist (the best possible insult from the right.) He also has a VERY active Twitter feed, although his Facebook leaves something to be desired.


Doo-Doo Economics (A Tea Party Economics Blog): Doo Doo Economics
What You Should Know: I had so many sort-of liberal blogs about economics, but I decided to balance out my reading list with one from the right. More specifically, the FAR right. This blog his here to prove to you what a horrible president Mr. Obama is and how bad of a job he's doing. And also about how he's lied about every economic issue put out there. They claim that the jobs created under Obama were all the result of the house Republicans (and not just fortuitous timing) and that a second term would destroy America indefinitely. It's kind of frustrating to read such a biased opinion on economics, but still, it's a counter-balance of sorts. This guy does not have a Facebook, and I haven't found a Twitter yet either. And so far it seems I'm the only one willing to comment on his page. But it's still a different view, so I'll stick with it.

Matt Taibbi's Taibblog
1.   Matt Taibbi is a contributing editor at Rolling Stone Magazine and frequently writes political blogs on their website as well as the magazine.
2.   Matt Taibbi's main focus is on politics on the domestic sphere, as well as the occasional piece on foreign policy.  He mostly focuses on commentary and tries to keep an unbiased point of view but rather wants to educate the masses about what is going on in the world of politics from a magazine that is more focused on popular culture.
3.  Matt's main focus is to bring about educating people who are not normally interested in politics by writing about it in a popular culture magazine.  By giving the audience a holistic approach on both foreign and domestic politics we can paint a better picture of the world around us.
4.  He publishes his blogs on a bi-weekly basis.
5.  The comment threads that follow his blogs mainly consist of people either disagreeing or agreeing with what Matt has to say.  For the most part it is monitored closely and the comment do not seem to stray from the topic at hand.
6.  The website has a Facebook, Twitter, and an RSS feed.

Paul Krugman's The Conscience of a Liberal
1. Paul Krugman is a contributing editor at the New York Times and a Professor of Economics at Princeton University.
2.  Krugman's reputation rests mainly on issues of international trade and finance and he is credited as one of the founders of the "new trade theory"which deals with international trade.
3.  His primary goal is for his readers to gain an increased understanding and comprehension about currency and financial affairs.
4.  He publishes on a daily basis.
5. His comments vary from strongly disagreeing with him, and saying how progressive his ideas are.
6.  There is a twitter, and a RSS feed.

IMFdirect
1. The IMFdirect is a compilation of the International Monetary Fund, consisting of over 180 countries which highlight debates over the financial crisis.
2. The IMFdirect mainly consists of highlights over policies that tend to help solve the global economic crisis.
3.  Their primary goal is to help solve the global economic crisis, as well as promote high employment and sustainable growth, facilitating international trade.
4.  The blog gets comments on a daily basis.
5.   While reading the threads I was really impressed on how civil the comments were.  If one of the users did not agree with what was posted, they did not go on a tirade but rather offered their point of view as well as respected the other side's argument.
6. The site has a Twitter and RSS feed.

Naked Capitalism
1.   Naked Capitalism is a compiled database of multiple contributors that try to take on the economic crisis on subject at a time.
2.   Naked Capitalism is a compilation of highlights, news, blogs, and how to change the financial policies all across the globe.
3.  Their primary goal is to educate those who want to be educated about the idea of capitalism and the economy when it's stripped down to the bare bones.
4.  Published on a daily basis.
5.  While reading some comments I noticed that it was a little bit more casual than some of the other websites that I looked at.  Probably because this one had more of an inviting feel to it than the other websites.
6. They have subscriptions to podcasts, emails, and Twitter.