Anatomy of a Meltdown: What Caused the Game-Changing Crashes of 2008?

8/14/2019 Anatomy of a Meltdown: What Caused the Game-Changing Crashes of 2008?

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C A S T L E A R C H REAL ESTATE INVESTMENT COMPANY

Anatomy of aMeltdown

How the events of the sub-primemortgage crisis created the perfect

storm for a market meltdown

What caused the game-changingcrashes of 2008?


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COPYRIGHT 2009 KIRBY COCHRAN. ALL RIGHTS RESER VED

TABLE OF CONTENTS

Anatomy of a Meltdown

1. Introduction

2. Irrational Exuberance

3. Follow the Money . . .

4. The Mortgage Broker Industry

5. Wall Street Enters Real Estate

6. Irrational Overreaction

7. Leverage and the Credit Crunch

8. Conclusion: Safety in the Long Term View

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1. Introduction

Although some factors in uencing

the modern nancial crisis havetendrils that reach way back intohistory, to the Carter administrationand beyond, this article focuses on theimmediate events which precipitatedthe current situation, particularlythose that have transpired over the lastdozen years.

2. Irrational Exuberance

As we entered the late nineties,

the Internet bubble was in ating fullforce and Internet-based companiesexperienced unprecedented growth.It seemed like you could not swinga cat without hitting an Internetmillionaire. At the close of the 20thcentury the stock market was the

contemporary equivalent of the 1849gold rush. Entire industries had sprungup in only a few short years (one of which was the stock day trader). Incontrast to the burgeoning market,veterans of the market cycles werestarting to get nervous.

On December 5, 1996, FederalReserve Chairman Alan Greenspan(Figure 1) gave a speech at the annualdinner and lecture of the AmericanEnterprise Institute for Public PolicyResearch, in which he said,

how do we know when irrational exuberance has unduly escalatedasset values which then becomesubject to unexpected and prolongedcontractions 1

The quote was obscure. Themarket acknowledged Greenspansdoubts with only a small slip, 2 ahiccough amidst the dot.com surge.But, the point was made to those whowere listening. Greenspan and others

were intimating that they believed themarket was overvalued.

For the next two and a half years,the bubble continued its recklessexpansion. People were talking abouta new economy where assets were

pass and the historical measures for valuing companies like price/earningsratio, price to revenue ratio, etc., were

being replaced by Internet valuations

Figure 1


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COPYRIGHT 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED

based on web site traf c, number of hits, or how sticky a web site was.

On March 6, 2000, AlanGreenspan gave a speech at theBoston College Conference on the

New Economy where he indicatedthat the markets were groping for the appropriate valuations of thesecompanies. 3 Greenspan cautionedthat speculating was not necessarilythe same as investing referring tothe masses of people buying into thestock market with the same zeal seen

around the roulette wheel.Unlike ordinary citizens, merespectators of the market, ChairmanGreenspan had the power to dosomething about this exuberanceand in 1999 he began raising interestrates. The Federal Funds Rate jumpedone quarter of a percent in June,followed by accompanying increasesin the Discount Rate in August. 4 Ratehikes continued in late 1999 and early

2000. 5 The Discount Rate had risenfrom 4.25% to 6% between August1999 and May 2000.

Through the 1970s and 80s,the Federal Reserve had exerted itsin uence primarily with the goal of

ghting in ation. Clearly, as the 1990sdrew to a close with in ation growingat a slower rate than it had in 1996 and

productivity increasing, the FederalReserve had adopted a new proactive

role and was involved in doing what itfelt was required to aid the economy. 6 Greenspan con rmed this when heclaimed that market forces assisted

by a vigilant Federal Reserve werethe answer to protecting the economyfrom economic instability. 7

Historically, there has always been a lead and lag to the impactof interest rate shifts on the pace of the economy. Usually the lag is aboutsix to nine months and interest ratesstarted rising in August of 1999.

Right on schedule, the market peaked early in the year 2000. OnJanuary 14, 2000, the Dow JonesIndustrials hit its highest valuationat 11,723. 8 The NASDAQ and theS&P 500 both hit their highest pointsin March at 5,049 on the 10th and1,528 on the 24th respectively. 9 As theinterest rate increases caught up withthe market, valuations started to falland they fell fast.

The Dow Jones Industrials wouldrecover their bubble value again,

but not for almost seven years, untilOctober of 2006. The S&P 500, notuntil a year later in September of 2007. The worst story, however, wasthe NASDAQ. In just over a year, itdropped from 5,049 to 1,639, a dropof nearly 70% from which it has never recovered. (In contrast, the DJIA lost57% of its value between the crash of


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1929 and the end of 1930.) BeforeGreenspan began to lower rates again,the market had lost over $5 trillion invalue. 10 Greenspan had taught the daytraders a lesson: when he said therewas irrational exuberance in themarket, they had better watch out.

The Federal Reserve may haveunderestimated the impact of the

bursting of the dot.com bubble, andhistorically the Federal Reserve hasnot been prone to knee-jerk reactions.Unfortunately, its measured and

gradual approach to adjusting interestrates was simply not responsiveenough to help the economy recover.

In a delayed reaction, the FederalReserve nally began to lower ratesin January of 2001 and continuedreducing rates into the summer of 2001. By summer, rates weredown around 3.5%, the bubble hadutterly burst and the survivors wereregrouping. It felt like things were

improving, but then the marketreceived its coup de grce theterrorist attacks of September 11,2001.

Instead of the United Stateseconomy gaining strength, itcollapsed. The Federal Reserve triedto effect a recovery and dropped ratesto 1.25% by December of 2001, butthe economy was not reacting. By theend of November 2002, rates were

below 1% (a 45-year low) but thestock market still did not recover.

Investors were still reeling fromthe losses they had suffered in thestock market collapse. With themarket too weak to rally, money edthe equity markets like rats froma sinking ship. This capital wentinto cash and cash equivalents untilinvestors could nd a safer place toinvest.

3. Follow the Money

Who were these investors sittingon the sidelines and looking for a

place to invest? They were Pension

Plans, Mutual Funds, InsuranceCompanies, Private Investmentcompanies and the like. For themost part, these are bulk investorswhose investments are managed byfund managers. Often they do nothave a single decision-maker, but aninvestment committee with a coremandate around preservation of capital. In other words, dont lose themoney .

Money ed the equitymarkets like rats foma sinking ship


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Consider what was facinginvestors at the beginning of thisdecade. Interest rates were hoveringaround 1% and in ation was at2-3%. 11 Investors were desperatelylooking for something that offered

predictable returns with the primaryrequirement that the investments

be safe . In other words, they werelooking for protection of their

principal.Beyond this basic mandate,

these managers were looking to earn

returns great enough to stay aheadof taxes and in ation. The painfultruth was that the return of risk-freeinvestments (U.S. Treasury notes)would not yield enough to offsetin ation for the pension holders.The search for a new place to investwas fueled by the anxiety that manyinvestors had been burned in the dot.com crash and that they needed to ndsomeplace to put their cash that would

generate a return, even a modest one.The Federal Reserve was likewise

running low on options. With littleinterest rate left to cut in order tostimulate the economy, in the fall of 2001 Alan Greenspan encouragedthe nancial community to develop

nancial products that would makeit easier for people to buy homes. Hereiterated this position in a speech tothe Credit Union National Association

on February 23, 2004, saying thatAmerican consumers might bene tif lenders provided greater mortgage

product alternatives to the traditionalxed-rate mortgage. 12 The nancial

industry took this as a challenge andset to work developing more creative

nancial products around mortgagenancing.

Historically, real estate had beena low-risk investment. Real estate inthe U.S. had typically appreciated atabout 5.45% annually since World

War II.13

It is not the 7.8% average of the general stock market, or the 10.4%of the S&P 500, but it is perceivedas lower in volatility and safe . Theinstitutions (Pension Plans, InsuranceCompanies, etc.) thought if only theycould nd a way to sink money theyhad waiting on the sidelines into realestate, maybe they could still earnadequate returns to beat taxes andin ation, but do it within an industry

which had historically been steady,calm and safe.

What was the political motive behind Greenspans recommendation?President Bush and the Congress werein shock over the state of the economyafter the dot.com crash, the terroristattacks of 9/11 and the corporatescandals of Enron, WorldCom, and thelike. The country was starting to wagewar overseas and a budget surplus


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was turned into a raging de cit almostovernight.

Washington knew that low interestrates and easy access to moneywould increase supply in the formof increased gross domestic product(GDP), which would depress the valueof the dollar. De cits would be paid

back at the low rates, foreign countrieswould be encouraged to buy/importU.S. goods, and money would owthrough the economy. The money

people would nd in their second

mortgages and home equity loanswould pour into circulation. Theyhoped this would revitalize a post9/11 economy that was practicallycomatose.

Under these unprecedentedconditions, the Wall Street InvestmentBankers took Greenspans counseland turned their attention to the realestate market, which precipitated afundamental transformation in the

world of real estate.

4. The Mortgage Broker Industry

Before 1990, banks and Savingsand Loan Associations would makemortgage loans and keep the debtthemselves, servicing it over theentire life of the loan. In other words,

banks would lend their own moneyand the borrower made paymentsdirectly back to the bank that loaned

the money until the loan was paidoff. As a result of a number of fraudulent loans taken out on largescale properties, the Savings andLoan industry threatened to collapse.In response, the U.S. Governmentestablished the Resolution TrustCompany (RTC) 14 to bail out the

banks and avoid a collapse amongthe Savings and Loans. The U.S.has a history of growing pains whenit comes to savings and loans andthe Government was taking steps to

ensure that the banking system in theU.S. would not fail.From that time forward, most

traditional banks almost completelystopped underwriting and carryingloans themselves. Instead, theywould sell the mortgages, or paper,to third party lenders, entities likeFreddie Mac or Fanny Mae. Thesetwo, which have been called thelinchpin of the housing bubble, 15

were private companies (chartered bycongress) for the funding and holdingof conforming mortgages that metgovernment standards.

Fannie Mae 16 and Freddie Maccomprise the lions share of whatis termed the secondary mortgagemarket. Essentially if banks weremortgage retailers, the secondarymarket were the wholesalers.These entities would actually service


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mortgage loans originated by the banks over the entire term. As of September 2008, Fannie and Freddieare no longer private companies,

but act as conservatorships of congressessentially governmentowned. (When these giants of thesecondary mortgage market wereseized last month by the U.S. Treasurydepartment, 17 they reportedly heldhalf of the entire $12 trillion U.S.mortgage debt.) 18

By selling off mortgages to the

secondary market, risks of defaultthat used to rest with the banks werenow passed on to those who actuallyunderwrote the loan. That meantthat writing loans was no longer thesole domain of banks with lots of capital, because there was no longer a requirement for companies writingloans to service them. A new industryof mortgage brokers emerged andgrew rapidly. It was apparent that

simply originating loans could be avery pro table business.

The typical process was that a person looking for a mortgage wouldsit down and ll out an applicationwith a local mortgage broker and themoney was provided by the third-

party lender at closing. The buyer was happy, the seller was happy. Themortgage company and the third-partylender were happy.

What about non-conformingloans? The application process wasone of evaluating borrowers on their creditworthiness, but there were

people who needed loans who couldnot qualify under standard terms.The banks could never afford tomake these loans in the past, becausethey were too risky. Sub-prime

borrowers were much more likely todefault (Figure 2).

Successive legislation designedto assist minorities and low-income

families get home loans put a crack in the dike that helped sub-primemortgages become more mainstream.In 1977, President Carter signed intolaw the Community Reinvestment Act(CRA). 19 This legislation sponsoreda program requiring banks applyingfor permission to merge, relocate, or obtain FDIC insurance to be examinedon whether they offered equal creditto the disenfranchised poor.

FORECLOSURES STARTED

Figure 2


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In 1992, a new act required FannieMae and Freddie Mac to devote a

percentage of their lending to supportaffordable housing targeting the samedemographic (in 2004 this percentagewas raised from 50% to 56%). 20 Whilethis requirement did not speci callycompel Fannie and Freddie buy sub-

prime loans (in fact, a greater number of sub-prime loans were purchased by

private companies), it threw the doorswide open to a secondary mortgagemarket that accepted sub-prime

mortgages.

In 1995, President Clinton revivedthe CRA fueled by studies 21 quoted

by the Federal Reserve which statedthat lenders who made loans to theless creditworthy segments of the

population could indeed be pro table,an argument against complaints thattaking on more credit risk was a threatto lender pro tability. 22 I am sure thatif they had looked into payday loan

companies they would have foundthem pro table as well. This doesnot mean that they are good for theeconomy.

Loans were typically not sold tothe secondary market one at a time,

but bundled together in a pool. By pooling their loans and selling themoff, the door was opened for lessthan A credit borrowers. Mortgage

brokers found that a bundle of mostly prime A paper could have a small percentage of B and C sub-prime

loans tacked on and the third partylenders would accept them along withthe conforming A loans.

Borrowers qualify for loans basedon ratios that compare their incomewith the monthly payments required.With interest rates at historic lows,many borrowers were nding thatthey could qualify for bigger loans.In order to get borrowers to qualify,lenders offered buy downs, balloons,

interest only and AdjustableRate Mortgages (ARMs) where the

payments were tied to interest rates(Federal Reserve or LIBOR) thatwere at 45 year lows. New home

buyers were everywhere; currenthomeowners were either upgradinginto luxury homes or taking the newlyfound equity out in home equity loans.

Quali cation standards wererelaxed and there was little or no

it threw the doors wide open to a second-ary mortgage market that accepted sub- prime mortgages.


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scrutiny when someone wanted toqualify for a mortgage. People with

bad credit were even given teaserloans which had adjustable rates,which ballooned in three to ve years.Mortgage brokers wrote these loansknowing that the borrowers could

not qualify for the regular payment.The market was rife with advertisingclaiming Good credit, bad credit, nocredit: no problem (Figure 3).

People could qualify for basicallyany size of mortgage using whatis known as a stated incomeloan, where paying slightly higher interest rates waived requirementsfor thorough checks on employment,income and assets. Many people

lied about their income or assets, butqualifying restrictions were so lax,that mortgages were available for

people who simply stated their incomeor assets without veri cation. Thistype of loan became known as a liarloan.

Lenders were offering homeequity loans for over 100% of thehomes value and new homes weresold with 100% nancing. This meantthat where mortgages used to requiresigni cant down payments, now

borrowers could get into a home withlittle or no skin in the game at all.

The real estate industry wastransforming.

MORTGAGE ADVERTISING

Figure 3


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5. Wall Street Enters Real Estate

The dot.com era brought its own

changes to Wall Street. In the olddays, traders and Investment Banksmade money from commissionsas their customers bought and soldstock. The Internet changed all that

by ushering in an era of ease andconvenience via electronic trading.Investment Banks could not competewith the likes of E-trade or Ameritradewhich were charging around $10apiece for electronic trades. There

were limited placed for InvestmentBanks to make money. They focusedon insurance products, moneymanagement, advisory servicesand the most pro table avenue,underwriting Initial Public Offerings(IPOs). They were adapting to a newrevenue model, and were lookingfor additional places to earn pro tsto make up for the lost revenue fromcommissions that they previouslyhad when customers bought and soldstock.

As the Investment Bankers gotinvolved, they started applying themethods of the stock market to themortgage market. They needed away of inviting that cash sittingon the sidelines to come back intothe market. Against a historical

background of real estate investments

as safe territory, they said, Why dont

we bundle the loans that the third- party lenders are buying and put theminto a pool of mortgages and createa new nancial instrument. Theycreated the idea of CollateralizedMortgage Obligations (CMOs).

The investment committeesat these Pension Plans, InsuranceCompanies, Mutual Funds, etc. aretypically made up of people with aneducation and background in nance.These are people who have attendedthe same top-notch universities for

their graduate nance degrees or MBAs. At almost every school, thesame historical growth models andrisk evaluation tools like the CapitalAsset Pricing Model (CAPM) aretaught. For these graduates, investingis a number-crunching science andevaluating risk is no more than simplyfactoring a Beta () score. nowrepresented the risk associated withthe (potentially hundreds or thousands

of) mortgages in a CMO. It purportedto assign a risk value that accountedfor all the variables, credit scores,loan to value ratios (LTV), term, rate

uctuations, etc. in its constituentmortgages.

In order to make these CMOsmore attractive to investors, theInvestment Bankers set out to createa bond offering. Their thought

process was, Lets sell these CMOs


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to Pension Plans, Mutual Fundsand other entities that are lookingfor long-term secured paymentswith predictable long-term paymentschedules and both protection of andreturn on their principal. Investorswould be able to purchase a bond ina CMO. 23 Armed with scores, theInvestment Bankers took the newinstruments and got credit ratingagencies like Moodys or Standard& Poors to give a credit rating toeach CMO. With a credit rating, the

only remaining requirement wasinsurance. They obtained monolineinsurance 24 through companies whoconsulted their actuarial tables for the probability that a few mortgageswould default. They had no way toestimate the probability of systemicwidespread defaults. This meantthat although the insurance satis edthe investment requirement, it wasessentially worthless because it had no

capacity to cover multiple defaults.But the Investment Bankers had

done as Greenspan requested, theyhad applied their nancial creativityand developed new products thatturned real estate paper into a security.One that allowed investors burned

by the volatility of the stock marketat large, to now tap into the stableand safe real estate market on termsthey were used to. In fact, Greenspan

himself noted ironically that althoughthese instruments cannot reduce therisk inherent in real assets, they canredistribute it in a way that inducesmore investment in real assets 25

The Investment Bankers hadalso created a condition where theycould tap into a new revenue stream.The CMO offerings would followthe same criteria all the CharteredFinancial Analysts (CFAs) managinginstitutional funds had learned inschool. Investment Banks stood to

make 2-3% on some very hefty tradesin what became the equivalent of IPOsfor the new bond offerings.

With the bond offerings in place, the market for CMOs waswide openno longer did sellersneed to nd an investor capable of taking down an entire CMO; smaller investors could buy a portion of one.Even more attractive, they could

buy portions of several CMOs with

different credit ratings and differentrates of return in order to diversifytheir investments. These CMOsclaimed to yield 6-7% and institutionswere looking to increase their

portfolio returns, which the higher risk bonds backed by sub-prime CMOswould accomplish.

The money that had ed themarket with the crash of the dot.coms


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now ooded back in an insatiable tidalwave.

The effect was massive pull-through demand on the market,which caused a twofold reaction.

First, there was a greater ability for mortgage brokers to generate loans.And second, subprime borrowerswere now just as good as creditworthy

borrowers because the additional risk could simply be re ected in the score. In fact, the creative approachthat was fueling the real estatemarket was based mostly on the non-conforming loans.

It made sense that home buyers

with poor credit or low income wouldhave a higher score. If the investor

bought bonds backed by the CMO,then the risk of defaults would bediversi ed across many mortgagesand a greater return could be hadfor the pension fund. Essentially, agreater return would be expectedfrom a riskier investment (as would

be expected in the stock market) andthe risk could be mitigated through

diversi cation. As a result, CMOswere glutted with subprime loans.Subprime was actually preferred inmany cases.

For the mortgage industry, therewere a lot of origination fees justwaiting to be collectedthere isnever a shortage of people with eyes

bigger than their wallets; peoplewanting homes who cannot affordthem. Mortgage brokers and lenderswere teaming up to give loans to

people with bad credit, never asking

themselves why these people had badcredit in the rst place and not caringabout the risks as long as there was adollar to be made.

For a little while, money waseverywhere if someone wanted to buyreal estate. The borrower had to pay alittle more, but a home that was totallyunaffordable under realistic marketconditions was now within reach.Whether borrowers could afford these

homes or not was not the problem of the mortgage industry as long as theycould nd someone in the secondarymarket willing to buy the loans (andthanks to the CMOs, there was anearly unlimited supply of secondarysources waiting to purchase them).Being in the business of originatingloans instead of servicing them meantthat mortgage companies in general

money that had ed ooded back in aninsatiable tidal wa e.


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were a lot more interested in quantitythan they were in quality.

Not only did the InvestmentBankers like these CMOs for their institutional clients, they liked themfor themselves. Essentially drinkingtheir own Kool Aid, Investment Banksalso invested heavily in subprimemortgage backed CMOs.

6. Irrational Overreaction

While the stock market mighthave been tepid in its reaction tolower interest rates, the real estatemarket was not. Fueled by low rates

plus the new nancial products,housing and real estate were startingto boom. 2004, 2005, and 2006 werethe equivalent in real estate to theirrational exuberance of the stock

market in 1998, 1999, and 2000. Now,everybody was making money in realestate.

Like Dr. Frankenstein, Greenspanlooked at his monster and wasscared and disgusted even though he

UPSIDE DOWN ON THEIR MORTGAGES

Figure 5

CHAIRMAN GREENSPAN

Figure 4


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shared responsibility for its creation.Greenspan saw another case of marketvalues being out of sync with intrinsicfundamental asset value, only on amuch more massive scale. Like hehad in the dot.com bubble, he took action and began raising rates. But,rather than the slow and ponderousapproach typical of the FederalReserve, Greenspan started a crusadeand relentlessly raised interest rates 17times. 26 He raised the Discount Rateroughly every two months for a period

of 24 months.27

The Federal Reservedid not offer a single reduction over a period of 38 months from June of 2003 to August of 2007. 28 Interestrates only started to come down againwhen the damage was beginning tosurface.

This rampage by the FederalReserve created a snowball effectwhich is shocking the current marketand from which the economy will

likely be recovering for most of thenext decade, if not longer.

The problem was that securitiesand real property bear signi cantinherent differences. The foundationon which this house of cards was builtrested on two awed assumptionsregarding non-conforming loanstwofatal errors that analysts counted onin calculating their risk assessment.As long as either one of these tenuous

propositions held true, the house of cards would stand.

First, they banked on appreciationof the real estate assets. Real estateappreciation in the United Stateshad been a safe bet over the long-term. Over the past century, housingappreciation had averaged 3-4%, andit had averaged over 5% since 1950.

Second, borrowers typicallyincrease their incomes over time.So risk assessments were made that

banked on a better economy in which

borrowers would be able to affordhigher payments through better jobs, pay raises, etc.

This assessment surmised that asthe promotional terms expired, buyerswould be earning more money andshould be able to afford the increased

payments. If they could not make the payments, the borrower could alwayssell or re nance out of their teaser and balloon loans to a less volatile

mortgage. Appreciation of the assetshould be enough to cover retirementof the debt.

The problem is, investing is asmuch art as it is science; and thatstretches beyond the abilities of most

nancial analysts.The analysts did not anticipate

that the enormous demand for realestate would lead to in ated pricesand negative appreciation. It goes


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back to basic supply and demand.When demand goes up faster thansupply, prices also rise. So, the marketforces driving appreciation had beenmanipulated. Demand both in ated

prices and instigated a surfeit of new construction. Residential andcommercial inventories were yearsahead of the rate of absorption and

prices were years ahead of their time.

By driving the volume so high,the market had effectively sold therequired housing inventory for thenext three or four years. Homes thatcould have been legitimately soldto creditworthy buyers were nowoverbuilt inventory for a market

that was in too big a hurry to cashits post-dated check. As the market

began to correct itself, sellers foundthat they were competing with aglut of new construction inventoryand prices plummeted. Since themortgage industry had been pushing

people into higher and higher pricedhomes relative to their income, many

borrowers found themselves withmortgages larger than the value of

their homes. This shut off two avenuesof escape for borrowers caught inclimbing ARMs; they had no ability tosell or to re nance.

Second, the safeguard of increased borrower capacity should have beenobviously tenuous with the glutof subprime borrowers. Earnings

potential for subprime borrowers iserratic and volatile. It is monumentalhubris to think that this could bedistilled to nothing more than a score. Problems that might have

been limited if the sales volumehad held steady were exacerbated by the infusion of huge numbers of sub-prime buyers. Add to that thenumber of ARMs given to borrowersof all types. Even borrowers with thecapacity to absorb some increasescould not withstand a rampantsustained increase in interest rates.

For example, lets say a sub- prime borrower is offered a 30-year

mortgage for 100% of the value of a$300,000 home. He is given a teaser rate of 1% for the rst year, with astep to 4% at year 2 and then his rateadjusts monthly at 3% over the primerate (typically 1-2% over the FederalDiscount Rate). The rst year, his

principal and interest payment is $964each month. We will add $200 for

property taxes and home insurance, bringing his total monthly out-of-

investing is as muchart as it is science


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pocket expense to $1,164. Sincequali cation standards are typicallyone-third of the borrowers grossincome, we will say that this borrower

is earning $3,500 a month, or about$42,000 a year.

By contrast, a creditworthy borrower obtains a 5% xed rate loan.With taxes and insurance, his paymenton the same $300,000 is $1,810 per month.

In the second year, the sub-prime borrower sees his interest rate jumpto 4%. His payments are now $1,632.A jump of over 70% and now equal

to 47% of his gross income and heis paying only a little less than thecreditworthy borrower.

The third year, his rate begins to

oat based on the Federal DiscountRate. In the latter part of 2003, theDiscount Rate was 2%. Add 2% toreach the Prime Rate and another 3% for his loan terms and this year his effective rate is 7%. That equatesto a monthly payment of $2,196. Asecond jump of 74% and now hes

paying 63% of his gross incometoward his mortgage. In two years thisloan has eaten up an extra thousand

Figure 6


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dollars each month in income and hisexpenses have exceeded those of thecreditworthy xed-rate borrowerall

before interest rates start to climb.Over the next two and a half

years, the Discount Rate will climbto 6.25%. This equates to an effectiveinterest rate of 11.25%, or a monthly

payment of $3,114. This represents89% of his gross income. This

borrower cannot physically make this payment with what is left over after his payroll taxes are deducted. He is

making payments that are reasonablefor someone earning $113,000 a year on a $42,000 annual income. Hecannot afford to stay in this home,so to avoid foreclosure, his optionswould have been to either sell it or re nance with new terms, but themarket was not adequate to allowhim to take either of these options,so, with no money of his own at risk (due to the 100% nancing), and with

little regard for his credit score (heentered this mortgage as a sub-prime

borrower) he walks away. Whoever holds his loan is left to foreclose on it.

In excess of the increased rate of foreclosures that might be expectedwith sub-prime borrowers due tothe characteristics of their personal

nances, the requirement of no moneydown and a manipulated market wasa recipe for disaster. Borrowers like

the one in my example had homes thatthey could not sell, payments theycould not make and nothing in their homes to lose. It was one of the most

painless times in history for borrowersto let their mortgages default.

As all of this was unfolding,the Federal Reserve continued toraise interest rates. Alan Greenspandid not just blunt the exuberanceor slow the economy with his ratehikes; he single-handedly smotethe underpinnings of the barely

resurrected market with a deluge of foreclosures.

With the lead and lag nature of interest rate shifts on the economy,it took until the latter part of 2007to see the tip of the iceberg in termsof what a nancial disaster had beencreated. August of 2007 saw therates beginning to lower again, butthe true magnitude of the problemswere only beginning to surface. Theanalysts, who predicted that only a

Greenspan single-handedly smote the market with a delugeo oreclosures.


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small percentage of those who heldadjustable rate mortgages woulddefault and Alan Greenspans opinionthat the odds are favorable thatcurrent imbalances will be defusedwith little disruption, 29 were just deadwrong.

7. Leverage and the Credit Crunch

A critical factor that also served tocompound the crisis is leverage . Most

people do not know that a traditionalnancial institution can lend ve

dollars for every dollar of depositsor equity it has. That also means thatfor every dollar that is lost in default,

ve are kept back from the market.In other words, if 20,000 homes at$100,000 apiece (total value of $2

billion) default, the actual impact onthe market is ve times greater. It isas if 100,000 homes defaulted or $10

billion in cash was pulled from themarket.

Investment Banks are notleveraged at the same rate astraditional banks, however. Theyare leveraged much more. LehmanBrothers was leveraged at a ratio of 35 to 1. In the above example, thesame 20,000 foreclosures would pull$70 billion from the market. In other words, $2 billion in foreclosures feels like $70 billion! The ripple effects of each default are magni ed. This is the

root of the liquidity crisis. Nobodyhad been checking under the hoodto see who would make the nal

payment.I have already mentioned that

Investment Banks were heavilyinvested in their own CMOs. Byhaving a heavily leveraged positionand a market primed for massivedefaults by spiking interest ratesand a mortgage industry that wasforce-feeding people with bad credithomes that they could not afford, the

economy was pushed to the brink of disaster. The good faith that washolding the system together by athread was dependent on nobodylosing yet. After all, if the practiceswere so bad, wouldnt we have seensome signs, maybe some casualties bynow?

In order to understand the overallmarket, the macro level picture, it isessential to understand the market

at a micro levelthe level of theindividual.

Markets run on the emotionsof greed and fear. Without fear, themarkets are fueled by greed, whichthe nancial news often talks aboutas faith or con dence. Whenmortgage defaults started to rise, the

rst market sign that faith in the bloated and corrupted system was


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beginning to falter came in March of 2008 with the fall of Bear Stearns.

In 1998, a hedge fund called Long

Term Capital Management (LCTM)failed. It had been established in1994 by an impressive pedigree of individuals including economic Nobellaureates Myron Scholes (of Black Scholes fame) and Robert Merton,and had generated annualized returnsof over 40% in its early years usingcomplex mathematical models for convergence trades. 30 Exhaustingthe opportunities for such trades,LTCM branched out into other areasand subsequently lost hundreds of millions of dollars. The InvestmentBanking community felt pangs of fear and rallied to rescue the company.By September of 1998, the FederalReserve Bank of New York hadorchestrated a bailout involvingBarclays, Chase, Credit Suisse,Deutsche Bank, Godlman Sachs,

Merrill Lynch, J.P. Morgan, Morgan

Stanley, Salomon Smith Barney, andLehman Brothers among others. One

rm conspicuously, however, did notsupport the bailout.

That rm was Bear Stearns, thecountrys fth largest investment

bank. 31 When Bear Stearns gotinto trouble in early 2008twoof its hedge funds which had biginvestments in sub-prime mortgages,folded in July of 2007and asinvestors became increasingly waryof heavy investment in the mortgage

industry, the Investment Bankingcommunity remembered that Bear Stearns had not participated in the

bailout of LCTM. The rumor on WallStreet was that, as retaliation thesupporters of the LCTM management

bailout led a rash of short selling of Bear Stearnss stock. Bear endedup agreeing to a Federal Reserve-supported sale to J.P. Morgan Chasefor $2 per share on Monday March

17, a 93% drop from its trading priceon Friday March 14. The aftershocksof Bear Stearns would send moreof the market into fear modeand over the remaining months toSeptember and October, the ChickenLittles of the market would slowly beacknowledged as prophets and sub-

prime mortgage backed securitiesstarted being referred to as toxic.

Figure 7


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The faith that existed in themarket crumbled to the point that intodays market banks do not evenhave enough con dence to loan eachother money. The inter-bank loan

process is freezing for lack of trust.With banks and Wall Street losing

faith and succumbing to the fear thatdrove the market to successive record

breaking losses, is it any wonder that individuals are also losing faith?At the same time that they get thenews that the people who invest their

pensions or retirement funds havenot only breached their mandateto generate returns, but have failedat the critical mission to not losethe money, they are told that thegovernment has decided to co-optthem as a huge collective co-signer ondebts that have already gone bad.

The markets run on the emotionsof greed and fear and now we areexperiencing fear.

8. Conclusion: Safety in the LongTerm View

The country is in the midst of adownturn as it repeats its dot.comexperience of banking on blue skyinstead of real value. In fact, AlanGreenspan admitted that his intentwas to replace the Dot.com Internetstock bubble with a real estate homeinvestment and lending bubble

as the only way to prevent a deeprecession. 32 Inheritors of that decisionare left to contemplate whether theformer recession or the current one isworse.

I suggest that the current correctionis certainly larger and deeper. A criticaldifference in the nancial scope is that thevolume of sales in the real estate marketis not driven by what people can pay;it is driven by what people can borrow .So, a problem that was bad in the stock market has became catastrophic in thereal estate market with the only brightlight being that real estate is a tangibleasset with some level of underlying valueas opposed to the vapor assets of the dot.com era.

The sense of upheaval in the marketduring this reset reveals a lot aboutthe players. There is plenty of nger-

pointing going on. Even Greenspanshrugs off his responsibility saying,The core of the subprime problem lieswith the misjudgments of the investmentcommunity. 33

And then there are those who are

taking steps to shore up the system.

The markets run onthe emotions o greed and ear and now weare experiencing ear.


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Congress and the Federal Reserve haveenacted a scal policy in an effort tofacilitate inter-bank loan processing.

They are making investments directlyinto banks and the banking system.The big government bailout representsan effort of the Federal Reserve, theTreasury Department and Congress to

buy commercial paper that facilitatesmoney to start owing into the marketand there is a global coordinated effort tocut interest rates.

It is my belief that these are the stepsthat needed to be done. In 1929 therewas no scal policy, and yet eventuallycompanies recovered. Everything was

Laissez-faire . It is my opinion that manyof these steps will prove to be necessaryand wise. I think that the government will

probably end up making a lot of money, but it is essential that steps are taken to provide the perception that the bankingsystem is safe.

Contrary to what seems to be theoverriding public opinion, I do not laythe entire blame for the current crisis at

the feet of the investment community, butthey do bear partial responsibility. I think these Investment Bankers were trying todo a good jobthe job they were trainedfor, but this crash has now proven that

nance is not merely a science. Multipleways of analyzing must be evaluated andimplemented when making these typesof investments. I think that they in factabdicated their responsibility to assess therisk of these investments to the analysts

who rated the credit of the CMOs. And,for that abdication they have paid dearly.

But, in the face of the market

meltdown, experienced investors arecalm and looking at the economicsituation with an eye to the long-term.These investors put their money wherefundamentals have been thoroughlyvetted. They watch for population growth,which follows regional job growth. For those who are prepared, these cycles

provide abundant opportunity.I am extremely positive and

optimistic on the market when investorsare holding a long-term view and canoverlook the interim volatility. This tooshall pass.


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Kirby Cochran is an educator, speaker and thought leader in the eld of management andnance and is a leading expert on capital structure and shareholder value. He has been teaching

new venture nancing and entrepreneurship to graduate students for over a decade. Kirbycurrently serves as an adjunct professor in the Finance department of the David Eccles Schoolof Business at the University of Utah. A veteran of the venture capital industry and a pioneer of emerging approaches to raising capital, Mr. Cochran has been at the forefront of the growthcompany nancing and management trends for over twenty- ve years.

In his new series of articles entitled Leadership Insight , Mr. Cochran reveals secrets used byentrepreneurs and CEOs to drive growth in their companies. This information has always beendif cult and painful for Senior Managers to acquire, found only in the ruthless university of experience and obtained through costly tuition at the school of hard knocks.

North Point Advisors, the rm founded by Mr. Cochran, advises growth companies on theimplementation of the best practices discussed in Leadership Insight for increasing shareholder value.

ABOUT THE AUTHOR

ACKNOWLEDGEMENTS

Chad Jardine, our close associate and friend, was responsible for much of the leg work and physical writing of this article. His contribution allowed the principles and practices of our consulting process to come to life in book form and bring our insights, personal experiences andunique voice to a new audience via the printed page.


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1. Gr eenspan, Alan. 1996. Remarks made at the Annual Dinner and Francis Boyer Lecture of the American

Enterprise Institute for Public Policy Research, Dec 5, Washington D.C. http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm Note: this statement became the title of a book byRobert Shiller published by Princeton University Press in 2000. More information is available athttp://www.irrationalexuberance.com

2. Wi kipedia. Irrational Exuberance. 2008. http://en.wikipedia.org/wiki/Irrational_exuberance (accessedOctober 16, 2008).

3. Gr eenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston CollegeConference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/BoardDocs/Speeches/2000/20000306.htm

4. Th e Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and DiscountRates. 2008. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html

5. Ibid.6. En gdahl, William F. Aotearoa: a Wider Perspective. http://aotearoaawiderperspective.wordpress.com/

the- nancial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/the-

nancial-tsunami-part-iii-greenspans-grand-design/7. Gr eenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston CollegeConference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/BoardDocs/Speeches/2000/20000306.htm

8. Ya hoo! Finance. Dow Jones Industrial Average (^DJI): Historical Prices. 2008. http:// nance.yahoo.com/q/hp?s=^DJI&a=09&b=1&c=1928&d=09&e=16&f=2008&g=d

9. Ya hoo! Finance. NASDAQ and S&P 500: Historical Prices. 2008. http:// nance.yahoo.com/q/hp?s=^IXIC

10. En gdahl, William F. Aotearoa: a Wider Perspective. http://aotearoaawiderperspective.wordpress.com/the- nancial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/the-

nancial-tsunami-part-iii-greenspans-grand-design/11. In ationdata.com. Historical U.S. In ation Rate1914-Present. 2008. http http://in ationdata.com/

in ation/in ation_Rate/HistoricalIn ation.aspx12. Gr eenspan, Alan. 2004. Understanding Household Debt Obligations. Remarks at the Credit Union

National Association 2004 Governmental Affairs Conference, Feb 23, Washington D.C. http://www.federalreserve.gov/boarddocs/speeches/2004/20040223/13. Fr eeby50. More on Historical Home Appreciation. http://freeby50.blogspot.com/2008/05/more-on-

historical-home-appreciation.html14. Wi kipedia. Resolution Trust Corporation. 2008. http://en.wikipedia.org/wiki/Resolution_Trust_

Corporation (accessed October 16, 2008).15. Fr eeman, Richard. Executive Intelligence Review. Fannie and Freddie Were Lenders: U.S. Real Estate

Bubble Nears Its End. http://www.larouchepub.com/other/2002/2924fannie_mae.html16. No te: In what could be seen as a predecessor to the CMOs, Fannie Mae was allowed to issue Mortgage

Backed Securities (MBS) by the Federal Government in 1968.17. Ha gerty James, R., Ruth Simon, Damian Paletta. 2008. U.S. Seizes Mortgage Giants. The Wall Street

Journal Online. September 8, 2008, http://online.wsj.com/article/SB122079276849707821.html18. Du higg, Charles. 2008. Loan-Agency Woes Swell From a Trickle To a Torrent. The New York Times.

July 11, 2008. http://www.nytimes.com/2008/07/11/business/11ripple.html?ei=5124&en=8ad220403f cfdf6e&ex=1373515200&adxnnl=1&partner=permalink&exprod=permalink&adxnnlx=1224014956-Lxg46M4tsZkyi+JNJnlybg


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19. Wi kipedia. Community Reinvestment Act. 2008. http://en.wikipedia.org/wiki/Community_ Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008).

20. Re eser, Joe. 2008. The Real Cause of the Current Financial Crisis. OpEdNews.com. September 27,2008. http://www.opednews.com/articles/2/The-Real-Cause-of-the-Curr-by-Joe-Reeser-080926-83.html

21. No te: One of which was entitled The Community Reinvestment Act and the Pro tability of Mortgage-Oriented Banks on March 3, 1997.

22. Wi kipedia. Community Reinvestment Act. 2008. http://en.wikipedia.org/wiki/Community_ Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008).

23. En gdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tipof the Iceberg. Globalresearch.ca. November 23, 2007. http://www.globalresearch.ca/index.

php?context=va&aid=741324. Wi kipedia. Monoline Insurance. 2008. http://en.wikipedia.org/wiki/Monoline_insurance (accessed

October 16, 2008.)25. Gr eenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College

Conference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/BoardDocs/Speeches/2000/20000306.htm

26. Th e Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount

Rates. 2008. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html27. Ibid.28. Ibid.29. An drews, Edmund L. 2004. Greenspan Shifts View on De cits. The New York Times. March 16, 2004.

http://www.nytimes.com/2004/03/16/business/16FED.html?ei=5007&en=840134c450c6059b&ex=1394859600&partner=USERLAND&pagewanted=print&position=

30. Wi kipedia. Long Term Capital Management. 2008. http://en.wikipedia.org/wiki/Long-Term_Capital_ Management (accessed October 16, 2008).

31. Wa ggoner, John and David J. Lynch. 2008. Red Flags in Bear Stearns Collapse. USA Today. March 19,2008. http://www.usatoday.com/money/industries/banking/2008-03-17-bear-stearns-bailout_N.htm

32. En gdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tipof the Iceberg. Globalresearch.ca. November 23, 2007. http://www.globalresearch.ca/index.

php?context=va&aid=741333. Re uters. 2008. Investors, Not Fed, To Blame For Crisis-Greenspan. Reuters.com. April 7, 2008. http://

www.reuters.com/article/marketsNews/idUSL0742422520080407

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