Anatomy of a Meltdown
What caused the game-changing crashes of 2008?

How the events of the sub-prime mortgage crisis created the perfect storm for a market meltdown

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 1 1 3 4 7 10 14 16


1. Introduction Although some factors influencing the modern financial crisis have tendrils that reach way back into history, to the Carter administration and beyond, this article focuses on the immediate events which precipitated the current situation, particularly those that have transpired over the last dozen years. 2. Irrational Exuberance As we entered the late nineties, the Internet bubble was inflating full force and Internet-based companies experienced unprecedented growth. It seemed like you could not swing a cat without hitting an Internet millionaire. At the close of the 20th century the stock market was the

contemporary equivalent of the 1849 gold rush. Entire industries had sprung up in only a few short years (one of which was the stock “day trader”). In contrast to the burgeoning market, veterans of the market cycles were starting to get nervous. On December 5, 1996, Federal Reserve Chairman Alan Greenspan (Figure 1) gave a speech at the annual dinner and lecture of the American Enterprise Institute for Public Policy Research, in which he said, “… how do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions…”1 The quote was obscure. The market acknowledged Greenspan’s doubts with only a small slip,2 a hiccough amidst the surge. But, the point was made to those who were listening. Greenspan and others were intimating that they believed the market was overvalued. For the next two and a half years, the bubble continued its reckless expansion. People were talking about a new economy where assets were passé and the historical measures for valuing companies like price/earnings ratio, price to revenue ratio, etc., were being replaced by Internet valuations

Figure 1


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based on web site traffic, number of “hits,” or how “sticky” a web site was. On March 6, 2000, Alan Greenspan gave a speech at the Boston College Conference on the New Economy where he indicated that the markets were “groping for the appropriate valuations of these companies.”3 Greenspan cautioned that “speculating” was not necessarily the same as “investing” referring to the masses of people buying into the stock market with the same zeal seen around the roulette wheel. Unlike ordinary citizens, mere spectators of the market, Chairman Greenspan had the power to do something about this “exuberance” and in 1999 he began raising interest rates. The Federal Funds Rate jumped one quarter of a percent in June, followed by accompanying increases in the Discount Rate in August.4 Rate hikes continued in late 1999 and early 2000.5 The Discount Rate had risen from 4.25% to 6% between August 1999 and May 2000. Through the 1970s and 80s, the Federal Reserve had exerted its influence primarily with the goal of fighting inflation. Clearly, as the 1990s drew to a close with inflation growing at a slower rate than it had in 1996 and productivity increasing, the Federal Reserve had adopted a new proactive

role and was involved in doing what it felt was required to aid the economy.6 Greenspan confirmed this when he claimed that “market forces assisted by a vigilant Federal Reserve…” were the answer to protecting the economy from economic instability.7 Historically, there has always been a “lead and lag” to the impact of interest rate shifts on the pace of the economy. Usually the lag is about six to nine months and interest rates started rising in August of 1999. Right on schedule, the market peaked early in the year 2000. On January 14, 2000, the Dow Jones Industrials hit its highest valuation at 11,723.8 The NASDAQ and the S&P 500 both hit their highest points in March at 5,049 on the 10th and 1,528 on the 24th respectively.9 As the interest rate increases caught up with the market, valuations started to fall… and they fell fast. The Dow Jones Industrials would recover their bubble value again, but not for almost seven years, until October of 2006. The S&P 500, not until a year later in September of 2007. The worst story, however, was the NASDAQ. In just over a year, it dropped from 5,049 to 1,639, a drop of nearly 70% from which it has never recovered. (In contrast, the DJIA lost 57% of its value between the crash of


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1929 and the end of 1930.) Before Greenspan began to lower rates again, the market had lost over $5 trillion in value.10 Greenspan had taught the day traders a lesson: when he said there was “irrational exuberance” in the market, they had better watch out. The Federal Reserve may have underestimated the impact of the bursting of the bubble, and historically the Federal Reserve has not been prone to knee-jerk reactions. Unfortunately, its measured and gradual approach to adjusting interest rates was simply not responsive enough to help the economy recover. In a delayed reaction, the Federal Reserve finally began to lower rates in January of 2001 and continued reducing rates into the summer of 2001. By summer, rates were down around 3.5%, the bubble had utterly burst and the survivors were regrouping. It felt like things were improving, but then the market received its coup de grâce…the terrorist attacks of September 11, 2001. Instead of the United States economy gaining strength, it collapsed. The Federal Reserve tried to effect a recovery and dropped rates to 1.25% by December of 2001, but the economy was not reacting. By the end of November 2002, rates were

below 1% (a 45-year low) but the stock market still did not recover. Investors were still reeling from the losses they had suffered in the stock market collapse. With the market too weak to rally, money fled the equity markets like rats from a sinking ship. This capital went into cash and cash equivalents until investors could find a safer place to invest.

Money fled the equity markets like rats from a sinking ship …
3. Follow the Money… Who were these investors sitting on the sidelines and looking for a place to invest? They were Pension Plans, Mutual Funds, Insurance Companies, Private Investment companies and the like. For the most part, these are bulk investors whose investments are managed by fund managers. Often they do not have a single decision-maker, but an investment committee with a core mandate around preservation of capital. In other words, don’t lose the money.


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Consider what was facing investors at the beginning of this decade. Interest rates were hovering around 1% and inflation was at 2-3%.11 Investors were desperately looking for something that offered predictable returns with the primary requirement that the investments be safe. In other words, they were looking for protection of their principal. Beyond this basic mandate, these managers were looking to earn returns great enough to stay ahead of taxes and inflation. The painful truth was that the return of “risk-free” investments (U.S. Treasury notes) would not yield enough to offset inflation for the pension holders. The search for a new place to invest was fueled by the anxiety that many investors had been burned in the dot. com crash and that they needed to find someplace to put their cash that would generate a return, even a modest one. The Federal Reserve was likewise running low on options. With little interest rate left to cut in order to stimulate the economy, in the fall of 2001 Alan Greenspan encouraged the financial community to develop financial products that would make it easier for people to buy homes. He reiterated this position in a speech to the Credit Union National Association

on February 23, 2004, saying that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”12 The financial industry took this as a challenge and set to work developing more creative financial products around mortgage financing. Historically, real estate had been a low-risk investment. Real estate in the U.S. had typically appreciated at about 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 perceived as lower in volatility and safe. The institutions (Pension Plans, Insurance Companies, etc.) thought if only they could find a way to sink money they had waiting on the sidelines into real estate, maybe they could still earn adequate returns to beat taxes and inflation, but do it within an industry which had historically been steady, calm and safe. What was the political motive behind Greenspan’s recommendation? President Bush and the Congress were in shock over the state of the economy after the crash, the terrorist attacks of 9/11 and the corporate scandals of Enron, WorldCom, and the like. The country was starting to wage war overseas and a budget surplus


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was turned into a raging deficit almost overnight. Washington knew that low interest rates and easy access to money would increase supply in the form of increased gross domestic product (GDP), which would depress the value of the dollar. Deficits would be paid back at the low rates, foreign countries would be encouraged to buy/import U.S. goods, and money would flow through the economy. The money people would find in their second mortgages and home equity loans would pour into circulation. They hoped this would revitalize a post 9/11 economy that was practically comatose. Under these unprecedented conditions, the Wall Street Investment Bankers took Greenspan’s counsel and turned their attention to the real estate market, which precipitated a fundamental transformation in the world of real estate. 4. The Mortgage Broker Industry Before 1990, banks and Savings and Loan Associations would make mortgage loans and keep the debt themselves, “servicing” it over the entire life of the loan. In other words, banks would lend their own money and the borrower made payments directly back to the bank that loaned

the money until the loan was paid off. As a result of a number of fraudulent loans taken out on large scale properties, the Savings and Loan industry threatened to collapse. In response, the U.S. Government established the Resolution Trust Company (RTC)14 to bail out the banks and avoid a collapse among the Savings and Loans. The U.S. has a history of growing pains when it comes to savings and loans and the Government was taking steps to ensure that the banking system in the U.S. would not fail. From that time forward, most traditional banks almost completely stopped underwriting and carrying loans themselves. Instead, they would sell the mortgages, or “paper,” to third party lenders, entities like Freddie Mac or Fanny Mae. These two, which have been called “the linchpin of the housing bubble,”15 were private companies (chartered by congress) for the funding and holding of “conforming” mortgages that met government standards. Fannie Mae16 and Freddie Mac comprise the lion’s share of what is termed the “secondary mortgage market.” Essentially if banks were mortgage “retailers,” the secondary market 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 Freddie are no longer private companies, but act as conservatorships of congress—essentially government owned. (When these giants of the secondary mortgage market were seized last month by the U.S. Treasury department,17 they reportedly held half of the entire $12 trillion U.S. mortgage debt.)18 By selling off mortgages to the secondary market, risks of default that used to rest with the banks were now passed on to those who actually underwrote the loan. That meant that writing loans was no longer the sole domain of banks with lots of capital, because there was no longer a requirement for companies writing loans to service them. A new industry of “mortgage brokers” emerged and grew rapidly. It was apparent that simply “originating” loans could be a very profitable business. The typical process was that a person looking for a mortgage would sit down and fill out an application with a local mortgage broker and the money was provided by the thirdparty lender at closing. The buyer was happy, the seller was happy. The mortgage company and the third-party lender were happy.

What about “non-conforming” loans? The application process was one of evaluating borrowers on their creditworthiness, but there were people who needed loans who could not qualify under standard terms. The banks could never afford to make these loans in the past, because they were too risky. “Sub-prime” borrowers were much more likely to default (Figure 2). Successive legislation designed to assist minorities and low-income families get home loans put a “crack in the dike” that helped sub-prime mortgages become more mainstream. In 1977, President Carter signed into law the Community Reinvestment Act (CRA).19 This legislation sponsored a program requiring banks applying for permission to merge, relocate, or obtain FDIC insurance to be examined on whether they offered equal credit to the “disenfranchised poor.” FORECLOSURES STARTED

Figure 2


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In 1992, a new act required Fannie Mae and Freddie Mac to devote a percentage of their lending to support affordable housing targeting the same demographic (in 2004 this percentage was raised from 50% to 56%).20 While this requirement did not specifically compel Fannie and Freddie buy subprime loans (in fact, a greater number of sub-prime loans were purchased by private companies), it threw the doors wide open to a secondary mortgage market that accepted sub-prime mortgages.

… it threw the doors wide open to a secondary mortgage market that accepted subprime mortgages.
In 1995, President Clinton revived the CRA fueled by studies21 quoted by the Federal Reserve which stated that lenders who made loans to the less creditworthy segments of the population could indeed be profitable, an argument against complaints that taking on more credit risk was a threat to lender profitability.22 I am sure that if they had looked into payday loan

companies they would have found them profitable as well. This does not mean that they are good for the economy. Loans were typically not sold to the secondary market one at a time, but bundled together in a pool. By pooling their loans and selling them off, the door was opened for less than 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 party lenders would accept them along with the conforming “A” loans. Borrowers qualify for loans based on ratios that compare their income with the monthly payments required. With interest rates at historic lows, many borrowers were finding that they could qualify for bigger loans. In order to get borrowers to qualify, lenders offered buy downs, balloons, “interest only” and Adjustable Rate Mortgages (ARMs) where the payments were tied to interest rates (Federal Reserve or LIBOR) that were at 45 year lows. New home buyers were everywhere; current homeowners were either upgrading into luxury homes or taking the newly found equity out in home equity loans. Qualification standards were relaxed and there was little or no


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Figure 3

scrutiny when someone wanted to qualify for a mortgage. People with bad credit were even given “teaser” loans which had adjustable rates, which ballooned in three to five years. Mortgage brokers wrote these loans knowing that the borrowers could not qualify for the regular payment. The market was rife with advertising claiming “Good credit, bad credit, no credit: no problem” (Figure 3). People could qualify for basically any size of mortgage using what is known as a “stated income” loan, where paying slightly higher interest rates waived requirements for thorough checks on employment, income and assets. Many people

lied about their income or assets, but qualifying restrictions were so lax, that mortgages were available for people who simply stated their income or assets without verification. This type of loan became known as a “liar” loan. Lenders were offering home equity loans for over 100% of the home’s value and new homes were sold with 100% financing. This meant that where mortgages used to require significant down payments, now borrowers could get into a home with little or no “skin in the game” at all. The real estate industry was transforming.


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5. Wall Street Enters Real Estate The era brought its own changes to Wall Street. In the old days, traders and Investment Banks made money from commissions as their customers bought and sold stock. The Internet changed all that by ushering in an era of ease and convenience via electronic trading. Investment Banks could not compete with the likes of E-trade or Ameritrade which were charging around $10 apiece for electronic trades. There were limited placed for Investment Banks to make money. They focused on insurance products, money management, advisory services and the most profitable avenue, underwriting Initial Public Offerings (IPOs). They were adapting to a new revenue model, and were looking for additional places to earn profits to make up for the lost revenue from commissions that they previously had when customers bought and sold stock. As the Investment Bankers got involved, they started applying the methods of the stock market to the mortgage market. They needed a way of inviting that cash sitting on the sidelines to come back into the market. Against a historical background of real estate investments as safe territory, they said, “Why don’t

we bundle the loans that the thirdparty lenders are buying and put them into a pool of mortgages and create a new financial instrument.” They created the idea of Collateralized Mortgage Obligations (CMOs). The investment committees at these Pension Plans, Insurance Companies, Mutual Funds, etc. are typically made up of people with an education and background in finance. These are people who have attended the same top-notch universities for their graduate finance degrees or MBAs. At almost every school, the same historical growth models and risk evaluation tools like the Capital Asset Pricing Model (CAPM) are taught. For these graduates, investing is a number-crunching science and evaluating risk is no more than simply factoring a Beta (β) score. β now represented the risk associated with the (potentially hundreds or thousands of) mortgages in a CMO. It purported to assign a risk value that accounted for all the variables, credit scores, loan to value ratios (LTV), term, rate fluctuations, etc. in its constituent mortgages. In order to make these CMOs more attractive to investors, the Investment Bankers set out to create a bond offering. Their thought process was, “Let’s sell these CMOs


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to Pension Plans, Mutual Funds and other entities that are looking for long-term secured payments with predictable long-term payment schedules and both protection of and return on their principal.” Investors would be able to purchase a bond in a CMO.23 Armed with β scores, the Investment Bankers took the new instruments and got credit rating agencies like Moody’s or Standard & Poors to give a credit rating to each CMO. With a credit rating, the only remaining requirement was insurance. They obtained monoline insurance24 through companies who consulted their actuarial tables for the probability that a few mortgages would default. They had no way to estimate the probability of systemic widespread defaults. This meant that although the insurance satisfied the investment requirement, it was essentially worthless because it had no capacity to cover multiple defaults. But the Investment Bankers had done as Greenspan requested, they had applied their financial creativity and developed new products that turned real estate paper into a security. One that allowed investors burned by the volatility of the stock market at large, to now tap into the stable and safe real estate market on terms they were used to. In fact, Greenspan

himself noted ironically that “although these instruments cannot reduce the risk inherent in real assets, they can redistribute it in a way that induces more investment in real assets…”25 The Investment Bankers had also created a condition where they could tap into a new revenue stream. The CMO offerings would follow the same criteria all the Chartered Financial Analysts (CFAs) managing institutional funds had learned in school. Investment Banks stood to make 2-3% on some very hefty trades in what became the equivalent of IPOs for the new bond offerings. With the bond offerings in place, the market for CMOs was wide open—no longer did sellers need to find 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 different rates of return in order to diversify their investments. These CMOs claimed to yield 6-7% and institutions were looking to increase their portfolio returns, which the higher risk bonds backed by sub-prime CMOs would accomplish. The money that had fled the market with the crash of the dot.coms


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now flooded back in an insatiable tidal wave.

… money that had fled … flooded back in an insatiable tidal wave.
The effect was massive “pullthrough” demand on the market, which caused a twofold reaction. First, there was a greater ability for mortgage brokers to generate loans. And second, subprime borrowers were now just as good as creditworthy borrowers because the additional risk could simply be reflected in the β score. In fact, the creative approach that was fueling the real estate market was based mostly on the nonconforming loans. It made sense that home buyers with poor credit or low income would have a higher β score. If the investor bought bonds backed by the CMO, then the risk of defaults would be diversified across many mortgages and a greater return could be had for the pension fund. Essentially, a greater return would be expected from a riskier investment (as would be expected in the stock market) and the risk could be mitigated through

diversification. As a result, CMOs were glutted with subprime loans. Subprime was actually preferred in many cases. For the mortgage industry, there were a lot of origination fees just waiting to be collected—there is never a shortage of people with eyes bigger than their wallets; people wanting homes who cannot afford them. Mortgage brokers and lenders were teaming up to give loans to people with bad credit, never asking themselves why these people had bad credit in the first place and not caring about the risks as long as there was a dollar to be made. For a little while, money was everywhere if someone wanted to buy real estate. The borrower had to pay a little more, but a home that was totally unaffordable under realistic market conditions was now within reach. Whether borrowers could afford these homes or not was not the problem of the mortgage industry as long as they could find someone in the secondary market willing to buy the loans (and thanks to the CMOs, there was a nearly unlimited supply of secondary sources waiting to purchase them). Being in the business of originating loans instead of servicing them meant that mortgage companies in general


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Figure 5

were a lot more interested in quantity than they were in quality. Not only did the Investment Bankers like these CMOs for their institutional clients, they liked them for themselves. Essentially drinking their own Kool Aid, Investment Banks also invested heavily in subprime mortgage backed CMOs. 6. Irrational Overreaction While the stock market might have been tepid in its reaction to lower interest rates, the real estate market was not. Fueled by low rates plus the new financial products, housing and real estate were starting to boom. 2004, 2005, and 2006 were the equivalent in real estate to the “irrational exuberance” of the stock

market in 1998, 1999, and 2000. Now, everybody was making money in real estate. Like Dr. Frankenstein, Greenspan looked at his monster and was scared and disgusted even though he CHAIRMAN GREENSPAN

Figure 4


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shared responsibility for its creation. Greenspan saw another case of market values being out of sync with intrinsic fundamental asset value, only on a much more massive scale. Like he had in the bubble, he took action and began raising rates. But, rather than the slow and ponderous approach typical of the Federal Reserve, Greenspan started a crusade and relentlessly raised interest rates 17 times.26 He raised the Discount Rate roughly every two months for a period of 24 months.27 The Federal Reserve did not offer a single reduction over a period of 38 months from June of 2003 to August of 2007.28 Interest rates only started to come down again when the damage was beginning to surface. This rampage by the Federal Reserve created a snowball effect which is shocking the current market and from which the economy will likely be recovering for most of the next decade, if not longer. The problem was that securities and real property bear significant inherent differences. The foundation on which this house of cards was built rested on two flawed assumptions regarding non-conforming loans—two fatal errors that analysts counted on in 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 appreciation of the real estate assets. Real estate appreciation in the United States had been a safe bet over the longterm. Over the past century, housing appreciation had averaged 3-4%, and it had averaged over 5% since 1950. Second, borrowers typically increase their incomes over time. So risk assessments were made that banked on a better economy in which borrowers would be able to afford higher payments through better jobs, pay raises, etc. This assessment surmised that as the promotional terms expired, buyers would be earning more money and should be able to afford the increased payments. If they could not make the payments, the borrower could always sell or refinance out of their teaser and balloon loans to a less volatile mortgage. Appreciation of the asset should be enough to cover retirement of the debt. The problem is, investing is as much art as it is science; and that stretches beyond the abilities of most financial analysts. The analysts did not anticipate that the enormous demand for real estate would lead to inflated prices and negative appreciation. It goes


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back to basic supply and demand. When demand goes up faster than supply, prices also rise. So, the market forces driving appreciation had been manipulated. Demand both inflated prices and instigated a surfeit of new construction. Residential and commercial inventories were years ahead of the rate of absorption and prices were years ahead of their time.

… investing is as much art as it is science …
By driving the volume so high, the market had effectively sold the required housing inventory for the next three or four years. Homes that could have been legitimately sold to creditworthy buyers were now overbuilt inventory for a market that was in too big a hurry to cash its post-dated check. As the market began to correct itself, sellers found that they were competing with a glut of new construction inventory and prices plummeted. Since the mortgage industry had been pushing people into higher and higher priced homes relative to their income, many borrowers found themselves with mortgages larger than the value of

their homes. This shut off two avenues of escape for borrowers caught in climbing ARMs; they had no ability to sell or to refinance. Second, the safeguard of increased borrower capacity should have been obviously tenuous with the glut of subprime borrowers. Earnings potential for subprime borrowers is erratic and volatile. It is monumental hubris to think that this could be distilled to nothing more than a β score. Problems that might have been limited if the sales volume had held steady were exacerbated by the infusion of huge numbers of sub-prime buyers. Add to that the number of ARMs given to borrowers of all types. Even borrowers with the capacity to absorb some increases could not withstand a rampant sustained increase in interest rates. For example, let’s say a subprime 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 first year, with a step to 4% at year 2 and then his rate adjusts monthly at 3% over the prime rate (typically 1-2% over the Federal Discount Rate). The first year, his principal and interest payment is $964 each month. We will add $200 for property taxes and home insurance, bringing his total monthly out-of-


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Figure 6

pocket expense to $1,164. Since qualification standards are typically one-third of the borrower’s gross income, 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% fixed rate loan. With taxes and insurance, his payment on the same $300,000 is $1,810 per month. In the second year, the sub-prime borrower sees his interest rate jump to 4%. His payments are now $1,632. A jump of over 70% and now equal

to 47% of his gross income and he is paying only a little less than the creditworthy borrower. The third year, his rate begins to “float” based on the Federal Discount Rate. In the latter part of 2003, the Discount Rate was 2%. Add 2% to reach the Prime Rate and another 3% for his loan terms and this year his effective rate is 7%. That equates to a monthly payment of $2,196. A second jump of 74% and now he’s paying 63% of his gross income toward his mortgage. In two years this loan has eaten up an extra thousand


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dollars each month in income and his expenses have exceeded those of the creditworthy fixed-rate borrower—all before interest rates start to climb. Over the next two and a half years, the Discount Rate will climb to 6.25%. This equates to an effective interest rate of 11.25%, or a monthly payment of $3,114. This represents 89% 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 reasonable for someone earning $113,000 a year on a $42,000 annual income. He cannot afford to stay in this home, so to avoid foreclosure, his options would have been to either sell it or refinance with new terms, but the market was not adequate to allow him to take either of these options, so, with no money of his own at risk (due to the 100% financing), and with little regard for his credit score (he entered 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 expected with sub-prime borrowers due to the characteristics of their personal finances, the requirement of no money down and a manipulated market was a recipe for disaster. Borrowers like

the one in my example had homes that they could not sell, payments they could not make and nothing in their homes to lose. It was one of the most painless times in history for borrowers to let their mortgages default. As all of this was unfolding, the Federal Reserve continued to raise interest rates. Alan Greenspan did not just blunt the exuberance or slow the economy with his rate hikes; he single-handedly smote the underpinnings of the barely resurrected market with a deluge of foreclosures.

Greenspan … singlehandedly smote the … 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 2007 to see the tip of the iceberg in terms of what a financial disaster had been created. August of 2007 saw the rates beginning to lower again, but the true magnitude of the problems were only beginning to surface. The analysts, who predicted that only a


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small percentage of those who held adjustable rate mortgages would default and Alan Greenspan’s opinion that “the odds are favorable that current imbalances will be defused with little disruption,”29 were just dead wrong. 7. Leverage and the Credit Crunch A critical factor that also served to compound the crisis is leverage. Most people do not know that a traditional financial institution can lend five dollars for every dollar of deposits or equity it has. That also means that for every dollar that is lost in default, five 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 on the market is five times greater. It is as if 100,000 homes defaulted or $10 billion in cash was pulled from the market. Investment Banks are not leveraged at the same rate as traditional banks, however. They are leveraged much more. Lehman Brothers was leveraged at a ratio of 35 to 1. In the above example, the same 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 magnified. This is the

root of the “liquidity” crisis. Nobody had been “checking under the hood” to see who would make the final payment. I have already mentioned that Investment Banks were heavily invested in their own CMOs. By having a heavily leveraged position and a market primed for massive defaults by spiking interest rates and a mortgage industry that was force-feeding people with bad credit homes that they could not afford, the economy was pushed to the brink of disaster. The good faith that was holding the system together by a thread was dependent on nobody losing yet. After all, if the practices were so bad, wouldn’t we have seen some signs, maybe some casualties by now? In order to understand the overall market, the macro level picture, it is essential to understand the market at a micro level—the level of the individual. Markets run on the emotions of greed and fear. Without fear, the markets are fueled by greed, which the financial news often talks about as “faith” or “confidence.” When mortgage defaults started to rise, the first “market” sign that faith in the bloated and corrupted system was


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Figure 7

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 in 1994 by an impressive pedigree of individuals including economic Nobel laureates Myron Scholes (of Black Scholes fame) and Robert Merton, and had generated annualized returns of over 40% in its early years using complex mathematical models for convergence trades.30 Exhausting the opportunities for such trades, LTCM branched out into other areas and subsequently lost hundreds of millions of dollars. The Investment Banking community felt pangs of fear and rallied to rescue the company. By September of 1998, the Federal Reserve Bank of New York had orchestrated a bailout involving Barclays, Chase, Credit Suisse, Deutsche Bank, Godlman Sachs, Merrill Lynch, J.P. Morgan, Morgan

Stanley, Salomon Smith Barney, and Lehman Brothers among others. One firm conspicuously, however, did not support the bailout. That firm was Bear Stearns, the country’s fifth largest investment bank.31 When Bear Stearns got into trouble in early 2008—two of its hedge funds which had big investments in sub-prime mortgages, folded in July of 2007—and as investors became increasingly wary of heavy investment in the mortgage industry, the Investment Banking community remembered that Bear Stearns had not participated in the bailout of LCTM. The rumor on Wall Street was that, as retaliation the supporters of the LCTM management bailout led a rash of short selling of Bear Stearns’s stock. Bear ended up agreeing to a Federal Reservesupported sale to J.P. Morgan Chase for $2 per share on Monday March 17, a 93% drop from its trading price on Friday March 14. The aftershocks of Bear Stearns would send more of the market into “fear” mode and over the remaining months to September and October, the Chicken Littles of the market would slowly be acknowledged as prophets and subprime mortgage backed securities started being referred to as “toxic.”


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The “faith” that existed in the market crumbled to the point that in today’s market banks do not even have enough confidence to loan each other money. The inter-bank loan process is freezing for lack of trust. With banks and Wall Street losing faith and succumbing to the fear that drove the market to successive record breaking losses, is it any wonder that individuals are also losing faith? At the same time that they get the news that the people who invest their pensions or retirement funds have not only breached their mandate to generate returns, but have failed at the critical mission to “not lose the money,” they are told that the government has decided to co-opt them as a huge collective co-signer on debts that have already gone bad. The markets run on the emotions of greed and fear… and now we are experiencing fear. 8. Conclusion: Safety in the Long Term View The country is in the midst of a downturn as it repeats its experience of banking on “blue sky” instead of real value. In fact, Alan Greenspan admitted that his “intent was to replace the Internet stock bubble with a real estate home investment and lending bubble”

as the only way to prevent a deep recession.32 Inheritors of that decision are left to contemplate whether the former recession or the current one is worse.

The markets run on the emotions of greed and fear … and now we are experiencing fear.
I suggest that the current correction is certainly larger and deeper. A critical difference in the financial scope is that the volume of sales in the real estate market is 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 the real estate market with the only bright light being that real estate is a tangible asset with some level of underlying value as opposed to the vapor assets of the dot. com era. The sense of upheaval in the market during this reset reveals a lot about the players. There is plenty of fingerpointing going on. Even Greenspan shrugs off his responsibility saying, “The core of the subprime problem lies with the misjudgments of the investment community.”33 And then there are those who are taking steps to shore up the system.


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Congress and the Federal Reserve have enacted a fiscal policy in an effort to facilitate inter-bank loan processing. They are making investments directly into banks and the banking system. The big government bailout represents an effort of the Federal Reserve, the Treasury Department and Congress to buy commercial paper that facilitates money to start flowing into the market and there is a global coordinated effort to cut interest rates. It is my belief that these are the steps that needed to be done. In 1929 there was no fiscal policy, and yet eventually companies recovered. Everything was Laissez-faire. It is my opinion that many of these steps will prove to be necessary and 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 banking system is safe. Contrary to what seems to be the overriding public opinion, I do not lay the entire blame for the current crisis at the feet of the investment community, but they do bear partial responsibility. I think these Investment Bankers were trying to do a good job—the job they were trained for, but this crash has now proven that finance is not merely a science. Multiple ways of analyzing must be evaluated and implemented when making these types of investments. I think that they in fact abdicated their responsibility to assess the risk 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 are calm and looking at the economic situation with an eye to the long-term. These investors put their money where fundamentals have been thoroughly vetted. 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 investors are holding a long-term view and can overlook the interim volatility. This too shall pass. 


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Kirby Cochran is an educator, speaker and thought leader in the field of management and
finance and is a leading expert on capital structure and shareholder value. He has been teaching new venture financing and entrepreneurship to graduate students for over a decade. Kirby currently serves as an adjunct professor in the Finance department of the David Eccles School of 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 growth company financing and management trends for over twenty-five years. In his new series of articles entitled Leadership Insight, Mr. Cochran reveals secrets used by entrepreneurs and CEOs to drive growth in their companies. This information has always been difficult 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 firm founded by Mr. Cochran, advises growth companies on the implementation of the best practices discussed in Leadership Insight for increasing shareholder value.

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 and unique “voice” to a new audience via the printed page.



2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18.

Greenspan, 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 by Robert Shiller published by Princeton University Press in 2000. More information is available at Wikipedia. Irrational Exuberance. 2008. (accessed October 16, 2008). Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College Conference on the New Economy, Mar 6, Boston, Massachusetts. BoardDocs/Speeches/2000/20000306.htm The Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount Rates. 2008. Ibid. Engdahl, William F. Aotearoa: a Wider Perspective. the-financial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/thefinancial-tsunami-part-iii-greenspans-grand-design/ Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College Conference on the New Economy, Mar 6, Boston, Massachusetts. BoardDocs/Speeches/2000/20000306.htm Yahoo! Finance. Dow Jones Industrial Average (^DJI): Historical Prices. 2008. com/q/hp?s=^DJI&a=09&b=1&c=1928&d=09&e=16&f=2008&g=d Yahoo! Finance. NASDAQ and S&P 500: Historical Prices. 2008. hp?s=^IXIC Engdahl, William F. Aotearoa: a Wider Perspective. the-financial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/thefinancial-tsunami-part-iii-greenspans-grand-design/ Historical U.S. Inflation Rate1914-Present. 2008. http inflation/inflation_Rate/HistoricalInflation.aspx Greenspan, Alan. 2004. Understanding Household Debt Obligations. Remarks at the Credit Union National Association 2004 Governmental Affairs Conference, Feb 23, Washington D.C. http://www. Freeby50. More on Historical Home Appreciation. Wikipedia. Resolution Trust Corporation. 2008. Corporation (accessed October 16, 2008). Freeman, Richard. Executive Intelligence Review. ‘Fannie and Freddie Were Lenders’: U.S. Real Estate Bubble Nears Its End. Note: 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. Hagerty James, R., Ruth Simon, Damian Paletta. 2008. U.S. Seizes Mortgage Giants. The Wall Street Journal Online. September 8, 2008, Duhigg, Charles. 2008. Loan-Agency Woes Swell From a Trickle To a Torrent. The New York Times. July 11, 2008. cfdf6e&ex=1373515200&adxnnl=1&partner=permalink&exprod=permalink&adxnnlx=1224014956Lxg46M4tsZkyi+JNJnlybg


19. Wikipedia. Community Reinvestment Act. 2008. Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008). 20. Reeser, Joe. 2008. The Real Cause of the Current Financial Crisis. September 27, 2008. html 21. Note: One of which was entitled The Community Reinvestment Act and the Profitability of MortgageOriented Banks on March 3, 1997. 22. Wikipedia. Community Reinvestment Act. 2008. Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008). 23. Engdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tip of the Iceberg. November 23, 2007. php?context=va&aid=7413 24. Wikipedia. Monoline Insurance. 2008. (accessed October 16, 2008.) 25. Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College Conference on the New Economy, Mar 6, Boston, Massachusetts. BoardDocs/Speeches/2000/20000306.htm 26. The Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount Rates. 2008. 27. Ibid. 28. Ibid. 29. Andrews, Edmund L. 2004. Greenspan Shifts View on Deficits. The New York Times. March 16, 2004. 394859600&partner=USERLAND&pagewanted=print&position= 30. Wikipedia. Long Term Capital Management. 2008. Management (accessed October 16, 2008). 31. Waggoner, John and David J. Lynch. 2008. Red Flags in Bear Stearns’ Collapse. USA Today. March 19, 2008. 32. Engdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tip of the Iceberg. November 23, 2007. php?context=va&aid=7413 33. Reuters. 2008. Investors, Not Fed, To Blame For Crisis-Greenspan. April 7, 2008. http://