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 Posted: Mon Sep 29, 2008 6:02 pm Post subject: |
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Everyone here who claims "we are so *****" because stock market indexes have fallen needs to step back and look at the larger picture. Let's all calm down.
First we have to ask: why are banks seeing such heavy losses? There are several reasons. Some banks made blatantly stupid decisions, such as Wachovia's purchase of Golden West Financial, one of the leaders in adjustable-rate mortages, in 2006. Other companies made similar investments and have suffered mightily because of it. However, we should all remember that mortgage defaults do NOT constitute the majority of losses on Wall Street. In order for borrowers to find more, and more efficient lenders, asset-backed securities were created in the 1970s (with the rubber stamp of approval from the Federal government) to allow anybody to buy into a pool of mortgages. This was a very difficult thing to sell at first...why would you buy a security that has an uncertain life? Prepayment risk (that is, people paying their mortgages in advance, or refinancing their loans in times of low interest rates) was far too great for people to invest. Because of this, derivative investments, were created to allow people to buy into the levels of risk that they preferred. These derivatives actually help solve one of the major problems of mortgage lending: uncertain risk.
Now the big problem is this: nobody really knows the rate at which these mortgages are being paid off. Even though estimates are that 97% of homeowners are still paying off their mortgages on time, there is simply not enough information to price these securities accurately. People didn't think much about this for a few decades until the housing bubble occurred. One can make an argument that the government helped create the foundation of the housing bubble with the Community Reinvestment Act which forced institutions to lend to "sub-prime" borrowers, and the excessively low interest rates following the internet asset bubble. With low interest rates, they encouraged people to move their money from one bubble (internet stocks and companies like Enron and WorldCom) into another bubble (property and homes). So when the bubble burst, it exposed a major flaw in the function of these securities.
People began to put a huge premium on prepayment risk in the absence of good information and yields shot up. In the bond universe, interest rates, i.e. yields, move inversely with prices. You demand a lower price because of the uncertainty about the amount and timing of the final payout. Now because the Generally Accepted Accounting Principles (GAAP) in the US require firms to "mark to market" securities that have gone down in value (marking up is illegal), these theoretical losses became very, very real. Now, in order to maintain capital ratios and to limit losses, companies who held these securities were forced to sell them at any price, further driving down mortgage-backed securities' prices.
So this was the government's plan: buy these securities with taxpayer money and hope that A) people won't default on their mortgages and B) the market will ultimately price these securities "accurately." The troubles are these: How much are these things ACTUALLY worth? How does the government plan to price them accurately? Is the problem of mispricing going to be solved better by the government or the free market? Does the government have any other incentives here that will cause them to seize more power than they initially seem to want? How high are they willing to let our federal budget deficit get before they realize the destruction of the US Dollar must ensue?
These questions are for you to answer, but the economy doesn't work like this: Dow down = bad. Dow up = good. The market will find a solution...it always does.
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