How We Got Here - Part 1

Art Cashin is a governor of the NY Stock Exchange and has amazing insight into the way the financial engines of the world work. It is my privilege to read his comments every morning.

Here is his explanation of the financial mess we are working our way through.

With all the finger pointing and acrimonious "us and them" about, we thought it would be helpful to look back and find out how we got swept into the worst financial crisis since the Great Depression. The following is an amalgam of observations by several members of the FoF [Friends of Fermentation] over several evenings of marinating.

As many believe, a driving force in this process was greed. Somewhat perversely, however, the greed was on both sides of the transaction.

Let's set the background. Overall, interest rates had remained low from the mid-nineties on. There were a variety of reasons for this phenomenon. First, was a nearly back to back series of financial shocks. There was the collapse of the Thai Baht followed by the Russian Ruble followed by Long Term Capital Management. At each one, the Fed and other central banks responded by flooding the system with liquidity. And, the crises came so hard upon each other that the banks could not drain the liquidity before having to add more for the next crisis. Then came Y2K. Central banks worried that the public might hoard cash fearing a Y2K collapse of ATMs, bank records, etc. To prepare for the drain that this hoarding might cause, they added yet more liquidity.

Shortly before Y2K actually began, the Fed, realizing there was no hoarding, began hiking rates to sop up all that liquidity. The hikes were a strain on the Dot.com Bubble and it began to collapse. In response, the Fed began to cut again and then, along came 9/11. The concern was that a fear of terrorism could kill the economy. That fear permeated Washington. Recall that when President Bush was asked – "What can the people do for the country in this crisis?" He simply replied "Go shopping." The message was not lost on Fed. They kept lowering rates. Americans would not be fooled twice, however. They would not rush back to the stock market. They'd put the new liquidity in something "safe" – something like "real estate."

Central banks didn't feel much pressure to raise rates since inflation was basically dormant. They wondered why such huge liquidity had not sparked rounds of inflation. Mr. Greenspan attributed it to an amazing and unusual growth in "productivity." It was productivity alright – but it was Chinese productivity. At very low wages, they produced low cost goods which they sold to U.S. consumers, holding down prices and thus inflation. Further, the Chinese recycled the money by buying a swelling pile of U.S. Treasuries – further holding down yields. So, with no sign of inflation, the Fed kept rates very low, very long.

Now, if you are a pension fund manager these low yields on bonds were causing you problems. Without a better yield, you might be under-funded which might cause you to be unemployed. Seeking better yielding alternatives to Treasuries and corporate bonds, they began to look at those recently new instruments – mortgage backed securities.

This was the picture the pension managers (and other bond buyers found). The packages were made up of different mortgages, which gave an image of safety through diversification. There was a small bit of subprime in the package to "juice up the yield." The ratings agencies (who got paid by the packagers) pronounced the packages to be AAA.

So, the bond buyers began to buy and, early on, it worked just as planned. Everyone from pension managers to bond arbitrageurs loved them. They loved them so much they asked for more – and more – and more. That led the packagers (banks and brokerages) to ask the mortgage writers to get more and more mortgages. That's when things began to fall apart.

In the early years of growing demand for packages, mortgage writers cut rates and cut down payments to sell mortgages. They quickly used up nearly all qualified home buyers while they created a huge housing boom. Yet the demand for the packages grew and grew. (Get me more. I love the yield.) At the same time, Congress was pressing Fannie and Freddie to make mortgages "more available."

The packagers, or syndicators pressed hard for more mortgages to package to meet the demand. The conventional mortgage lenders began to lower standards to expand the target audience (and comply with Congress). The nonconventional lenders threw out almost all standards. Some even began to pay people to apply for mortgages. Some had no income, no job or assets. (The so called Ninja mortgage).

So the greed of the buyers and of packagers fed on each other. A once very viable product became tainted like meat rushed out to meet holiday demand without being fully checked for bacteria. Soon it would bring a fear that would poison the whole system. And, to help grease the skids, FASB 157, the accounting rule to enforce "mark to market" was put in effect November 15, 2007, less than a month after the Dow made its all time high. Talk about ringing a bell at the top.

So let's review how we got here. The Fed held rates artificially low for a very long time. That created an almost insatiable demand for yield which crowded into mortgage CDO's. The demand caused packagers to sharply lower standards to levels well below those used in the computer models that the validity of the packages was based upon. The rating agencies seemed to just rubber stamp the paper.

The fatal flaw in syndication was exposed. Without recourse or look back, the original mortgage lender had no liability. With no "skin in the game", there was no motivation to properly vet the mortgages. The motivation was just the opposite. Move as much paper as you can, book the profits and do it again. Add to all of the above, the imposition of a poorly thought out mark to market rule that would turn a few problems into a massive chain reaction. That's how we got here.