Financial Crisis FAQs

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How the hell did we get here?
Step 1 – Hot housing market: Since 1998, the hottest assets around were high-yielding sub-prime mortgages because of the hot housing market. Every financial institution bought them up because if they didn’t their competitors would and make a killing and leave them behind. It was the smart thing to do. Step 2 – Slick packaging fooled everyone: Investment banks started to bundle multiple risky mortgages together and sell them as a single security… this was done to make the risk murky and hard to quantify, thus making them easier to sell. So not only were the financial institutions buying too many risky mortgage assets, now they weren’t able to quantify the risks. But the assets were still hot so they bought them anyway. Step 3 – The unregulated bond insurance casino and the birth of credit default swaps (CDS): Because it was hard to quantify the risk in these bundled packages, an unregulated form of bond insurance was invented in case the mortgages defaulted, called ‘credit default swaps.’ CDS was completely unregulated and almost anyone could write a swap contract and sell it for cash but had to promise to pay up big if the underlying mortgage asset went sour. Since the housing market kept rising, the likelihood of that happening seemed slim at the time. This is a form of leverage and in essence they were borrowing money they hoped they would never have to pay back. Soon everyone started to write and trade CDS… it was free money just as long as the housing market was strong and it was totally unregulated so anyone could hold thousands of contracts with very little capacity to pay the ‘claims’ in case of disaster. There were leverage limits but those numbers were easy to fudge. Step 4 – Everyone needs cash bad but nobody will lend any: Ultimately if you write insurance policies, you have to be able to pay claims when they come in. The real insurance industry is highly regulated so that claims can be paid. The CDS market is not regulated so everyone ended up writing too many CDS policies. When the housing market turned, the claims started to pour in. A stampede ensued to get as much cash as possible to pay all the claims… this was fine just as long as someone else would lend the CDS players more cash… but since EVERYONE was writing CDS, nobody would lend anyone else any money because they needed to cover their own CDS losses. Credit markets began to freeze and for the past two weeks, they have been completely stalled. Turns out almost every financial institution owes about 5X-50X more in CDS claims than the entire value of their company.

I heard trading Credit Default Swaps (CDS) is essentially like gambling; is that true?
Unfortunately yes. I used to think CDS was so slick, but it was a bad idea to block the proposed regulation and it was even a worse idea to let firms like Fannie/Freddie, AIG and commercial banks gamble with CDS. It should’ve been kept in the realm of Investment bank trading departments and hedge funds. CDS is still a great idea and should continue to exist… but the gabling aspect should be eliminated… CDS is a hedging instrument… and should be used as such.

What can happen as a result of this crisis?
Almost every major financial institution in the US (except about ten of them) is about to fail. They all need to raise tons of cash fast to pay the CDS claims and to reduce their own debts they but only have portfolios full of mortgage assets that nobody wants to buy. If they fail, businesses, cities and people won’t be able to borrow any money to live and do business. Every business borrows short term money to buy inventory, pay bills and to fund payrolls. If a businessman only spent money when he had it in cash, he would be considered a horrible businessman, so it’s not just the irresponsible businesses at risk. If the credit markets totally freeze for a year, theoretically 90-99% of all businesses in the US could go into default within that year. Majority of them will start firing people within three months. For regular people, they will lose their homes and will stop buying durable goods like cars, appliances and homes. Consumer credit will also freeze and credit card limits will be reduced. Unemployment skyrockets and we essentially have another depression.

What’s the probability of a depression if we do nothing?
Based on all my research, without intervention of some kind… I would rate the chances of a depression at about 70% and the chances of a deep recession at 90%. However, if China and the Saudis were to divest their dollar denominated assets in a panic, the chances of a catastrophic disaster would be 100% (but that’s not likely). I’m not trying to scare everyone here… if 90% of all your banks were to go bankrupt at the same time, it’s going to cause a depression…plain and simple… and the banks that are left will no longer behave like banks anymore… they won’t lend money to business anymore.

Isn’t the bailout plan simply saving the asses of greedy bankers so we can save our own?
Essentially yes, but you shouldn’t hate them. The saying, “don’t hate the player, hate the game” applies here. These banks were certainly greedy but they weren’t stupid. You need to understand that banking is essentially a commodity service with zero switching costs… there isn’t much difference between one bank over the other and therefore if one of them finds a loophole and profits from it, the other banks need to quickly follow otherwise they can lose their competitiveness very quickly. This is why commodity industries everywhere are heavily regulated (including banking) and most of them form cartels (e.g. OPEC). An unregulated commodity industry with zero product differentiation will eventually squeeze the honest and reward the cheaters. Ironically most of the banks that are now in the most trouble are the ones that were the best at the CDS and mortgage trading business (Bear, Lehman). The banks with the least talented CDS traders are the ones that will now survive because they couldn’t cheat as effectively as the smart guys. Bottom line, all of them believed they HAD to take advantage of the CDS/Mortgage business or they would’ve eventually lost to the ones that did.

What does the current bailout plan do?
The basic plan is to initially issue new dollars to buy up about $250 billion in sub-prime mortgage assets for about $0.45$0.85 on the dollar… the other $450 billion will be used later to buy more. In a few months, another bailout fund of $700 billion will probably be authorized by congress. In total, there’s about $7-$9 trillion in mortgage backed securities out there… but not all of it is distressed and with a $2.5 trillion dollar capital infusion much of that $7-$9 trillion will become ‘trade-able’ again. (With the Fed’s help, we will most likely be infusing about $2.5 trillion into the markets this year). A special Gov fund will be created and professional managers will be hired to manage and eventually sell the assets… it looks like right now Bill Gross at PIMCO and Black Rock will be the head managers. Bill Gross is the best fix income manager in the world and Black Rock has some of the best fix-income traders in the world. I personally think Gross is a god walking among monkeys and was thrilled to hear that he will most likely be getting control of this fund. The managers will try to first re-sell off as much of the non-complex assets as possible at cost ($0.45-$0.85 on the dollar) or higher. What will be left is a fund of extremely complex mortgage bundles that cannot be easily valued. Over the next five years, the fund managers will begin to break up the bundles and then re-package them into more simple assets and begin to sell them off at a profit.

Is it true that we can make a profit from this bailout?
The government’s track record of buying distressed assets and turning a profit is basically perfect but that’s not saying much because even an idiot can turn a profit when you’re buying assets at fire-sale prices, have unlimited time and your cost of capital is the lowest in the business. Really… give me unlimited funds, unlimited time, the lowest cost of capital and political connections with other governments and even I can turn profit… easily. In addition, with Bill Gross at the helm, I’d say that there is almost a 95% probability that we’ll profit from this bailout just as long as our currency doesn’t collapse and we avoid another world war.

I heard we’re not really spending the $700 billion, is that true?
From an accounting perspective, the taxpayers will only be hit with the losses on these investments, if any. If Bill Gross can just break even, then the bailout would technically cost us nothing, minus interest and opportunity costs. From a “use-of-cash” perspective, yes we will be using $700 billion in new cash to buy assets.

How is the bailout plan supposed to work… actually?
In general, this is an indirect, trickle-down plan. We’re setting the spark then asking the market to correct itself. Step 1: First, the goal is to get the banks to sell their toxic assets at a loss to the government. Participation is the key because many of them will want to sit on the toxic assets and ride out the storm on their own so they won’t have to absorb the losses and admit defeat. Step 2: Then we launch the “Bill Gross Restoration Shop”… essentially having him play the role of the classic car restorer. Once these assets are consumed by the government fund… the less complex assets will be unwound, reconstituted then re-marketed immediately. With Bill Gross at the helm of the fund, it’s pretty certain these assets will be correctly stripped of the toxic elements, re-capitalized and then priced to move. The icing on the cake is that these securities will now be federally insured. When the traders, hedge funds and private equity players see this they will want to get in on the action again (greed and trust in Bill Gross’ judgment would compel them to act)… that’s when the fixed income markets will begin trade again. Bill Gross will also have the ability to buy more discounted toxic assets from these traders and do the same thing over and over again… buy, strip, recapitalize, insure and price to move…. rinse and repeat. Step 3: Once the markets start to price these assets correctly again (rather than at illogical fire-sale prices), the higher quality pools of mortgage assets will begin to emerge and will be sold by the banks that need to raise capital and be purchased by investors that have capital. Once that happens, the banks will be unshackled and they will be able to do business again, a.k.a, lend money and charge interest. Step 4: Once that happens, businesses and corporations everywhere will have access to short term funding again and be able to buy inventory, pay their workers… and so on. Step 5: Many years down the line, Bill Gross would have sold all these assets and report to congress on his results. He would have written down the totally toxic parts but would have made money on the parts that were salvageable. If there’s a profit, then it will then be used in future government programs or to reduce the national debt.

Why is everyone saying the bailout plan is flawed?
In general, the plan is flawed because it’s a conundrum. The plan doesn’t actually force any of the banks to do specifically what we want them to do (start lending money)… we set the machine in motion and then sit back and hope they do what we want. However, if we put in too many provisions and force them to do X, Y and Z, they might not participate and try to ride out the storm on their own thereby making the bailout plan moot. Then again, do we want to write a blank check to the idiots that got us into this mess with no guarantees that it would work in the first place? I can see the merits of both arguments.

Why do the Republicans and Paulson want to get rid of the oversight, golden parachute and equity upside provisions?
I know it seems like they’re corrupt and want to save their Wall St. buddies. That’s not true. The key to the bailout plan working is PARTICIPATION. We need as many institutions as possible to participate in the sale and prevent them from just sitting on the toxic assets to try to ride out the storm. Don’t get me wrong, oversight, compensation and equity provisions are good things… but if these provisions dis-incentivize the banks from participating, then the whole purpose of the bailout would be moot. The Democrats are arguing that these banks will participate even with these provisions because they’re desperate. Frankly I can empathize with both positions and I don’t know which one is right. However, if all you want to do is increase the likelihood of the bailout working with full participation… then fewer provisions is better than more. But I can understand how distasteful it seems to write blank checks to the culprits of this mess.

What about those Democrats suggesting using direct capital infusions into the regional banks and the other direct investment plans versus the current trickle down bailout plan?
The various direct infusion plans have the greatest likelihood of working immediately… NOBODY will deny this. But it would mean directly recapitalizing thousands of regional and commercial banks and taking minority stakes in them and providing tax breaks to directly incentivize lending. The great part of these plans is that they would virtually guarantee full participation, which is what we need for any bailout to work. Despite its logic, it would NEVER pass in congress because it means the growth of government and the government taking partial minority ownership in large parts of the banking system. Although there are provisions so that these banks would be privatized again over time (like Fannie and Freddie)… this is the type of thing conservatives would rather die than pass. In addition, we’re not certain what this would do to the competitiveness of the credit markets 10 years and it would certainly mean many badly managed banks would survive this crisis instead of just letting the strong ones survive. Foreign banks will also be made less competitive and would close shop and go home. However, there is no doubt the direct plans benefit the general population the most and would work the quickest. Even the conservatives would agree the direct plans would actually create the effect we’re looking for to save the markets in the short term… but they’ll also tell you this is ideologically pseudo-socialism. Personally, I view it like declaring martial law. The president can suspend our constitution temporarily in emergency situations… in that same way we could suspend private ownership in certain pockets of the system until the crisis passes. Bottom line, the projected success rates for the direct plans far exceed those of the indirect plans… but I do admit it opens up various moral hazards.

If the Republicans could make an ideal bailout plan, what would it look like?
First off, they wouldn’t want any kind of bailout. If they really had their way they would just let it play out and fix itself regardless of how long it takes. This isn’t necessarily evil or irresponsible… in fact is probably the fairest of the actions and the most responsible… but the question is who would suffer the most… should we let the common citizen who didn’t have anything to do with this suffer for the mistakes of the free market? Some Republicans, including the SEC chairman, Treasury secretary and the President think something should be done. The sticking point for the Republicans is full participation. If we put in too many provisions, banks will hold onto these toxic assets and just hunker down and try to ride out the storm…. thus keeping the credit markets frozen. The initial three page Paulson plan is exactly what the Republicans really want. As far as promoting full participation, I have to admit that they do have a good point here. Plus Paulson will have to make some moves that seem illogical at first in order to fix this thing… that’s why he had a no-oversight provision… he wasn’t just trying to cover his ass. He needed the flexibility to make some hard decisions without being bogged down by congressional oversight. The secondary plan floated by House Republicans would allow $700 billion of these toxic assets to become federally insurable (rather than purchasing them), thus making them ‘safer’ and more easily tradable. Almost all of these toxic assets were already insured but some of the counterparties couldn’t pay the claims… therefore this program would provide, ‘government guaranteed’ insurance. That’s it… they would then sit back and hope that these assets would begin to trade again.

Who is to blame for all this, the SEC, Greenspan, Democrats or the Republicans?
If this is all you’re concerned about you’re destined to remain uneducated about this issue. The real question is what were specific causes of the problem and how did we get here? Leave the blame game to the FBI who has been given authority under the senate bill to go after the worst of the offenders.

What are the primary factors that caused the financial crisis?
Imagine dominos toppling… if one of the dominos in the line were absent, the toppling would stop. The financial crisis is quite similar. The strange part about this crisis is that it would’ve never happened unless all or most of the contributing factors did their part to cause it. Individually none of these factors would have done the trick. Below I will try to assign weightings based on each factor’s contribution to the crisis, but like I said, individually none of these factors are necessarily bad. (Below: Duplicate factors have weightings split between categories) (40%) OVER-LEVERAGE: The great depressions of ’28, the crash of 1987, the Asian financial crisis, LTCM…just to name a few were specifically caused by financial institutions exploiting exotic instruments to use more leverage. That’s exactly what happened to us… yet again. Leverage in moderation is great; it allows you to trade $10 worth of securities with only $5 in your bank account and maximize your returns. However, over-leverage can be deadly when markets go sour. Without leverage, when you lose your $10, you lose $10. With leverage, you can not only lose your original $10 but could end up owing $500 on top. • (+15%) Credit Default Swaps – CDS is a derivative asset that is essentially tradable bond insurance. However, it is completely unregulated and very few rules exist that cannot be bent or avoided. When you write a CDS contract you are promising to pay cash claims if the underlying bond product defaults. If the bond doesn’t default, it’s basically free money. For excessive CDS writers it can also be a form of leverage because they’re taking on huge potential liabilities against small cash reserves… and they’re just praying the bonds don’t default. Some firms would write hundreds of CDS contracts to raise cash to pay employees or to use the cash as collateral for additional debt. Writing CDS is a drug and almost all the banks got addicted to… because in a hot real estate market it appeared to be free money. (+15%) In 2004 the SEC waived its leverage rules for the top US Investment Banks – The SEC has capital rules that limit banks to a debt/capital ratio of 12 to 1. After Bush’s re-election, five firms -- Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley were granted an exemption; they promptly levered up 20, 30 and even 40 to 1…and a semi-bull run ensued. Four years later, 3 of these original 5 have gone bust. Why were they granted this exemption? We don’t know really… most of us on Wall St. assumed it was done at the request of the just re-elected president to keep the economy strong during his second term… but none of us really knew. Personally, I can tell you that we all didn’t really mind at the time and praised him for it… I did too. (+10%) Wealth effect from home ownership – When the value of everyone’s homes keep going up, they built up a lot of equity. Even though this value is only on paper, the wealth effect is real and people realize they can max out their credit cards and take out more home-equity loans against the collateral of that building equity. It now appears the US consumer was just as over-levered as the banking system.

(30%) EXCESSIVE DEREGULATION: When you de-regulate any kind of market, it attracts investment, improves price discovery, increases efficiency, increases liquidity and promotes growth; it’s a great thing. Unfortunately abuse of the system almost always follows. Striking a good balance is the key… but no balance at all is disastrous. • (+15%) The 2000 Commodities Futures Modernization Act – This act was passed by a Republican congress with the help of the Democrats and a Democratic president. It made commodities such as "interest rates, currency, and stock indexes" as "excluded commodities." They could trade off the futures exchanges, with minimal oversight by the CFTC. Neither the SEC, nor the Fed, nor any state insurance regulators had the ability to supervise or regulate the writing of credit-default swaps (CDS) by hedge funds, investment banks or insurance companies. At first it was great because it made markets liquid and very efficient… the intentions were good… but abuse quickly followed and even our most prudent institutions got caught up in its excesses. (+10%) Financial Services Modernization Act of 1999 – This act was passed by a Republican congress, was spear-headed by Phil Graham and was resisted vigorously by the Democrats and Clinton. It repealed the Glass-Steagall regulation law that separated the financial institutions that the public needed to function (commercial banks and insurance) with the more risky world of Wall Street. With its passage anyone’s small-town corner bank or insurance company could now dabble in the risky securities and derivatives that

normally would be exclusive to the realm of hedge funds, investment banking traders and private equity firms. This single law brought down AIG, our country’s strongest most solvent insurance underwriter. This law helped to bring down WAMU, Wachovia and IndyMac. • (+5%) 2004 SEC waiver of leverage rules for 5 investment banks– there were many good reasons why the 12/1 leverage ratio rule was in place… but mostly because going beyond this ratio almost always lead to a bubble that would eventually burst. Nobody knows why the SEC decided to waive this rule for the five largest US investment banks… but we all know the result… 3 of these 5 have gone bankrupt and the remaining 2 had to be rescued. That’s a 100% failure rate. The market run between 2004 and 2007 was great but the cost we had to pay was too great.

(25%) REAL ESTATE MARKET FRENZY AND SUBSEQENT FALL: A strong real estate market is ALWAYS a good thing. However, like any asset class it should go through periods of ups and downs… it’s healthy. Between 1998 and 2006 it was going at warp speed with no letup… everyone was also making money in the stock market, rates and inflation were kept low and two wars made everyone uneasy about stopping the fun. Everyone including the least worthy were getting bad loans and buying homes that were extremely over-appraised. These junky loans were then being repackaged as securities and sold to the markets. Because the real estate market was still hot, these junk securities appeared to be high-yielding, yet safe bets. These junky bond bundles soon became the hottest investments around and everyone was getting in. Ancillary products such as unregulated Credit Default Swaps (CDS) were created to insure these junky bonds but were greatly abused as cash raising tools rather than insurance. Then the real estate market finally turned. The junky bonds started to behave like junk and the holders were all rushing for the exits at the same time. The CDS writers were stuck paying out their entire asset bases as claims and were going bankrupt. Since everyone was already over-extended they stop lending to each other and the credit markets froze…and now here we are. * Was the hot real estate market the cause of this crisis? Of course not… but it provided the backdrop for all the over-extension, abuse and hubris.* • (+10%) Alan Greenspan, Bernanke and the Fed – In 1997 Greenspan and the Fed missed the opportunity to change margin requirements. Had the Fed acted, the tech bubble would not have inflated as much, and the subsequent crash would not have been as severe. Between 2001 and 2003 Greenspan dropped the federalfund rates to 1% to prevent the terrorists from crashing our economy. Lulled into a false belief that inflation was not a problem, the Fed then kept rates at 1% for more than a year. This set off an inflationary spiral in housing, and a desperate hunt for yield by fixed-income managers. Between 2003 and 2007 interest rates were still historically low even despite massive deficit spending on a war, a sky rocketing money supply and an obvious housing bubble. (+10%) Fannie and Freddie Mac (underwriting) and complexity – How were these small mortgage brokers and thrifts able to offer such low interest rates and good terms? Because Fannie and Freddie (F/F) would keep taking the loans off their hands in the secondary market (50% of all of them to be exact). Even though F/F were not big loan originators (dealing with customers) they enabled the smaller brokers to do business by underwriting their loans. How was F/F able to afford dealing with so many middle-men? Because as long as they kept buying up the all the subprime they didn’t have to pay state taxes and because of their size they had the economics to repackage loans and make them profitable. F/F certainly didn’t invent the repackaging of loans (which hid risk and increased complexity)… the investment banks did, but because of F/F’s size they made the problem of complexity more wide spread. (+5%) Awful lending practices (originations) – Of the subprime or near-subprime mortgages currently outstanding, 50% of all them were originated by mortgage service companies not subject comprehensive federal supervision; another 30% were made by banks or thrifts which are not subject to routine supervision or examinations and the remaining 10%-20% were originated by Freddie/Freddie and others. With interest rates so low, these institutions were desperately trying to get people to buy homes in any way they could. They could borrow from the Fed at 3%-5% and lend at 5%-10%... so trying to push through as much volume

as possible as quickly as possible was the goal. What followed were “no money down” mortgages, predatory ARMs and a shift in loan to value from 80% to 120%. Banks began to develop automated underwriting (AU) systems that emphasized speed rather than accuracy in order to process the greatest number of mortgage apps as quickly as possible. How many commercials have you seen asking you to take out loans against your home equity? Then came the real crazy stuff like “piggy back,” “interest only,” “negative amort,” loans and reverse mortgages. I literally can go on and on but we all know what happened here: interest rates were unnaturally low and every mortgage broker or bank in the country was desperate to recruit anyone off the street to lock them into a 5%-10% loan when they themselves were borrowing at 3%-5%. (5%) REGULATION AND RULES THAT DIDN’T WORK: • (+3%) Mark to market rules – Enron has taught us that we cannot let financial institutions make their own assumptions about the value of extremely complex assets because they will most certainly lie about the value of those assets. Thus “mark-to-market” were created so that the market will determine the price of those assets. However, what happens when the market is behaving in a panic, won’t those assets then be grossly UNDER-valued? Because many of these banks are forced to book some of these mortgage assets at irrationally low values, their balance sheets look terrible and it won’t allow them to borrow money and do business. In the future, the non-governmental FASB must find a middle ground between “mark-to-market” and “mark-to-model.” • (+1%) Credit Ratings Agencies – Moody's, S&Ps and Fitch tried their best to rate complex bundles of thousands of mortgages with mix credit ratings. But in the end there was no way a few ratings analysts could take the workload of evaluating each and every loan in a loan bundle. Sometimes the SEC needs to step in and categorize certain extremely complex assets as ‘un-ratable.’ (+0.5%) Federal Reserve’s regulatory authority failed – 2003-'07: The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-tovalue ratio and debt-servicing ability. The borrower's ability to repay these mortgages was replaced with the lender's ability to securitize and repackage them. (+0.5%) Appraiser / lender collusion – Any homeowner can tell buyers that their home is worth much more than it really is so it’s the Appraiser’s job to be the reality check and tell the bank and the buyer what the home is really worth. However numerous cases of Appraiser/lender collusion have been uncovered by the FBI and will be prosecuted.

Are Fannie and Freddie the cause of all this? Should we get rid of these horrible government institutions?
This was one of my first conclusions until I actually did my research. Now I’d have to say Fannie and Freddie were two of the three primary ‘enablers’ for only the first stage of this crisis: the overheated housing market. First off, Fannie and Freddie (F/F) are regular corporations. They are only called government sponsored entities (GSEs) because they get state tax exemptions for buying mortgages held by lower income families in the secondary market; they’re underwriters for the brokers that serve the poor. But this state tax exemption is no different than the billions in royalty exceptions and tax subsidies given to US oil companies for drilling in low-yield oil fields (both of which are far bigger tax breaks than anything F/F get). Technically speaking, all US weapons manufacturers, most farmers, all car companies and all US oil companies are also GSEs, it’s just that we don’t think of them that way. The fact is F/F both do not get any federal aid, nor can the government realistically dictate to F/F its lending standards or practices. The government has no federal powers over F/F whatsoever. F/F are incentivized by state governments to underwrite low quality mortgages but it’s completely optional… just like optional tax incentives that are given to corporations to not pollute, to farmers to continue to farm and to car companies to not ship jobs overseas. So if Fannie and Freddie are regular greedy corporations, so what are they really guilty of? They are guilty of keeping the real estate market unnaturally hot for too long, or what we call ‘price distortion.’ They allowed mortgage brokers, big and small, to keep writing low quality mortgages because F/F kept buying them up in the secondary market. This also kept real interest rates unnaturally low. F/F kept buying up these bad mortgages because they knew their size and economies of scale would allow them to still make a profit by bundling them as high yield income streams. F/F are essentially gigantic junk bond investment bankers. Were they guilty of the current crisis? No, but they helped create the environment where Wall St. cheaters could later make a profit from cheating. They were the ‘stage setters’ but they didn’t force anyone to abuse the system with the CDS craze or to over-lever their balance sheets… F/F were just trying to make a profit like everyone else. Frankly, I hate F/F with a passion because they put smaller and smarter lenders like my cousin out of business and keep the bad ones in business… but I can’t get myself to blame them for the current crisis. Did the government somehow compel or force F/F to sacrifice prudence for the sake of the poor? No… unfortunately our government had no say in how F/F conducted its business. In fact, we should be angry that our government didn’t have any influence over how F/F conducted their business… because their business practices and market distorting policies should have been more tightly regulated and monitored. Should we kill Fannie and Freddie now that they’re nationalized? Realistically yes, they basically started price wars with a lot of smart lenders in the market and created too much price distortion. Putting poor families into homes to build retirement security was a great PR tool they used, but in practice F/F were too powerful and did it in a way to undercut the competition. In the end, they were profit hungry corporations and behaved that way. Now that they’re nationalized again, we should be very selective when promoting lending to the poor and prevent price distortion in ultra-hot markets. And most of all we should make these programs live up to their altruistic mottos. The new government managed Fannie and Freddie should try and achieve its utopian goals but should do so only in small segments of the market where they’re most needed and they should remain as government programs or not at all. The FHA needs to be reigned in too, or change its focus to promoting home ownership OR cheap rental housing whatever the market naturally favors at the time. In addition, stopping price distortion should be written into these program’s charters… they should help the poor, but not artificially bolster a market that needs some healthy correction from time to time.

Why don’t some of these banks just hunker down and ride out the storm?
That’s exactly what we don’t want. Individual banks might start to think they’re unique and can ride out the storm… but if enough of them do this the markets will freeze and they’ll all go down at the same time. I can use game theory math to explain this, but it’s pretty simple… if a few big banks start thinking they’re special and not like the others, those few start a chain reaction that brings down the whole group including themselves.

Can we trust the FDIC? How long does it take to file a claim for my deposits.

Withdrawing your deposits in a scare is not necessary. The process is seamless and the applications for the claims are made by the banks, not by the depositor… so the common citizen will not lose access to their money even if their bank’s CEO is fired and the bank is defunct. The FDIC takes over the deposits and runs the operations. The websites won’t go down nor will the ATMs be closed before you can find a new bank.

Is there an example in history where there was a financial crisis and it corrected itself?
Yes, Japan… they were in a recession for 10 years and it destroyed the currency. The recession was so bad their Fed lowered their interest rates to zero for a long time and still nobody wanted to invest in anything Japan. The government nationalized some of the banks eventually anyway. But their country didn’t implode so there’s the example. Xxx xxx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx

What did the Japanese do wrong in the 90s?
In short: They wanted to maintain the sanctity of their free markets and existing contracts and at first left everything alone. When it got so bad, they then started to intervene but it was too late and their massive liquidity infusions and 0% interest rates were, by then, ineffective… they had already crossed the point of no return. They wanted the free markets to correct themselves and indeed the markets did but it took 10 years and destroyed the Yen. What we learned from Japan in the late 90s is that decisive and overwhelming force is the right way to stop the flood gates from opening… the piece-meal approach is what killed the Japanese financial system. Lastly we learned that ideological purity make a few people at the top feel better about themselves, but the rest of the country suffers and don’t really give a damn about ideology. xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx

What did secretary Paulson tell the congress that scared them so much?
He told them almost every bank in the US currently holds tons of toxic mortgage assets that when valued at market rates creates negative equity for almost every single bank in the country. This sets off a chain reaction that is obvious.

What kind of regulation is the best?
Let’s face it, anything involved in leverage and derivatives MUST be regulated. xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx xxxxxx xxxxxxxx xxxx xx

Doesn’t the government suck at managing assets?
Yes, but the government won’t be managing this bailout or the fund… they can hire anyone to manage this fund. It appears that Bill Gross and Black Rock will be tapped for the job. Bill Gross and Black Rock is about as good as it gets when it comes to fixed income management and trading. Spot on…Bravo.

Shouldn’t we prevent the complexity of these securities? Should we outlaw complex instruments all together?
No, but we should put in valuation rules that lie somewhere in between “marking-to-market” and “marking-to-model” and let the private governing board, FASB, determine what those rules should be. However, there are instruments where the complexity’s intended purpose is to deceive the buyer into taking on risk that cannot be easily quantified, such as collateralized mortgage assets that are securitized and then re-packaged more than two times. These should be outlawed and the SEC should set these rules.

What about getting rid of Mark to Market rules?
Something in between “mark-to-market” and “mark-to-model” might be best. Temporary suspension for 12 months of these rules makes sense too but getting rid of them altogether is crazy. It would be condoning widespread cooking “of the books.”

For complex structured assets, valuation is not straightforward… just ask Enron. Before the “mark-to-market” rules, Enron traded energy transmission contracts far into the future where certain assumptions needed to be made in order to price the contracts for the present. It was Enron’s responsibility to model these assumptions and the tax auditor’s responsibility to make sure these model assumptions weren’t crazy. Having done this type of valuation work myself, I can tell you that I can make the model say whatever my boss wants it to say… really, I can. And that’s exactly what Enron did… they lied about the value of their contracts and their greed eventually brought down the energy markets and almost all the accounting firms. Fast forward to 2008, these mortgage bundles also rely on many future assumptions for valuation, but because of the Enron debacle, it’s mostly illegal to keep an asset on your books at “mark-to-model” numbers, but rather you have to book it at its current market value, or “mark-to-market.” But what if we were in a horrible market where everything was grossly UNDER-priced? You would have to book your assets at levels that didn’t make any sense and since your creditors will only let you do business if your books are “healthy” they’d start calling in their debts because your books look awful when you ‘mark’ these assets to the horrible market. “Mark-to-model” valuation certainly leads to abuse… but in horrible, crisis-like markets, “mark-to-market” rules don’t make sense either. If we survive this crisis, we need to find a happy medium. I would let the FASB set and continually update certain ‘global’ variables such as GDP growth, inflation and future LIBOR for certain “mark-to-model” assets and would set limits for what percent of your assets can be categorized at level-3 (a.k.a. dark assets, or assets that are so complex you cannot value them). Finally, I would require yearly re-valuation periods where you would re-mark your assets to the market and reset the value of your books according to FASB rules.

Who’s to blame for AIG?
I hate to say this because I love the guy and for people that work on Wall St., he’s our hero but … I’d peg Phil Graham for AIG. Letting insurance companies trade high risk assets like hedge funds was a bad idea and blocking any and all regulation for leveraged products was also a bad idea. There were many good reasons why this was illegal before Phil helped unregulated it. Thus, if one thing or person could be blamed for AIG, it has to be Phil. However, you can’t really hate the guy because it’s pretty clear who he is and he’s never hid who he has been fighting for. He and his wife are partially responsible for stupid things like AIG and Enron, but he’s also done some great things to unregulated Wall Street and keep the markets working efficiently. The reason I don’t blame AIG’s trading desk for taking so many risks is that they were just doing what their investment banking trader counterparts were doing… there was money to be made and it was their job to try and chase it. They would have continued to chase it until someone told them that insurance companies shouldn’t behave like hedge funds. In the end we learned that any derivative products or instruments that allow you to lever up your book must be monitored in some way.

Is this a bailout or a “rescue package?”
It’s a bailout, but without it we’re going to crash so badly that a follow-up rescue wouldn’t work. The best way to describe it is, “a distasteful yet necessary bailout.”

Is the bailout too big or too small?
The answer lies in the psychological state of bank CFOs. What number would compel them to sell their toxic assets at a huge loss, then to recapitalize and then free up lending? …My sense is $700 billion is enough for now but a follow up $700 billion will be needed in a few months.

Are the bond rating agencies to blame for this?
Partially yes, but rating bonds is an art, not a science and it’s done by a small number of people. The assumptions you must make to determine the future cash-flow productivity relative to capitalization are just that, assumptions. For these complex mortgage packages it’s just too much work to individually evaluate every mortgage in a bundle of 10,000 mortgages. Trusting these fly-by-ratings is dangerous because the ratings agencies are claiming that something is safe when they know they didn’t do enough research to really determine that.

The question is do we want to be told lies so we can do more business or told the truth and not have any business transacted at all? How about a compromise?: What we learned from the current crisis is that if something is so complex that you can’t do a good job evaluating it… then you shouldn’t put out a rating at all. It should be pegged with a rating of, “NA.” However, since there’s more than one ratings agency in the game, if one doesn’t rate something, then the others can gain an advantage by rating it thereby forcing all of them to put out a rating, no matter how flimsy. Thus we should have the SEC deem certain products to be too complex to be given a publically published rating. These complex products can still be rated privately for investors that need an evaluation before purchasing it, but no public ratings should be given… thereby limiting bad information from spreading or being trusted by everyone. The bond ratings agencies can still charge a tiny fee for an ad-hoc, private rating… this would still allow these complex assets to be bought and sold.

Do we really have free markets?
No… the phrase, “we must preserve our free markets” is a joke to those working on Wall St. That phrase is designed for public consumption.

Was it the foreign capital inflows over the past 6-8 years that overheated and over levered our economy?
xxxxxxxxxxIt makes it sound like it’s the foreigner’s fault. It was the inflows that helped prevent this crisis for this long.

Why did the Euro drop so much relative to the dollar and why is LIBOR rising?
Over the past ten years, many economists have theorized that the economies of Europe and Asia have become so strong and flexible that they are now ‘de-coupled’ from the US economy making them resilient to our ups and downs. However, in times of crisis it seems the rest of the world has not de-coupled because many of the markets in Europe and Asia are now also experiencing credit squeezes… specifically in EU inter-bank borrowing rates (LIBOR) are starting to rise in a panic. So what do these foreign economies and investors do now? Buy more dollars. First off, the worldwide rush for dollars is a ‘flight-to-flexibility.’ Since the world conducts trade and buys oil primarily in dollars and they don’t know if their domestic credit markets will soon be frozen too, they want to load up on dollars so they can at least buy oil and still conduct trade into the near future. If the US wasn’t a global reserve currency this demand would not be as sharp. Specifically for the EU, this is a ‘flight-to-bailout.’ Meaning the likelihood of a credit freeze in Europe is now rising but the likelihood of a bailout is slim. New efforts for a €300bn pan-European bailout are in the works but how quickly can it be implemented? Even though they share the same currency and central banking system, this consortium of countries each have their independent governments and leaders and getting all of them to agree to fund a bailout would be hard to achieve. At the very least it’s much easier to pass a bailout package in the US than it is in the EU. This is why the world has not yet switched to the Euro as the global reserve currency despite the EU being much more stable over the past 20 years.

How will this affect the world?
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What do I do to protect my family?
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