“Certainty? In this world nothing is certain but death and taxes.”
– Benjamin Franklin
There is one other thing that is certain in this world: When something goes wrong in the economy, the rich and powerful will pass the problem down to the middle class and poor.
Nothing illustrates this axiom more than the housing market. For those who don’t remember what happened 20 years ago, here’s a very quick refresher:
- Many people, mostly lower middle class and poor families lost their homes because of foreclosures (pdf).
- The economy tanked from 1989-92.
- Numerous Savings & Loans went under, decimating retirees’ investments.
- The U.S. government created the Resolution Trust Corporation to dispose of all those thrifts and properties at a cost of $140 billion to taxpayers, according to Bloomberg.
- The folks hired to run the Resolution Trust Corporation were the same people responsible for the collapse in the first place. They were rewarded for failing.
- Credit dried up for years, making it difficult for the rest of the middle class to buy homes.
If you think the current housing crash will be any different, I have some investment grade CDOs I would like to sell you. What? Don’t know what CDOs are?
Until a few weeks ago, neither did I, though I have been looking all over for them.
Let me explain: Over the last few months I’ve been wondering about the “other side” of the housing crash. In foreclosures, two parties suffer directly. The homeowner is one obvious party.
The other USED to be the lender, such as the Savings and Loans I mention above. And sure enough, a lot of subprime lenders have gone under because they owe money back to lenders, have no cash left to finance new mortgages and have no one left to qualify for loans under tougher lending standards.
The story should end there, but it doesn’t. Subprime lenders don’t hold onto most loans, they sell them. The mystery to me was to whom?
Well, you and me, sort of. You see, Wall Street is very adept at moving money around. Lots of it.
So here’s who holds all that debt:
- Special instruments called CDOs, which stand for Collateralized Debt Obligations, were created and then bundled together. Collateralized means “we take-a your house-a if you don’t-a pay-a.” The new instruments usually contained a mix of top-notch mortgages with shaky yet more profitable subprime ones.
- These financial instruments are then bought and sold much like bonds or stocks.
- Who buys these things? I’m still trying to get a handle on this aspect, but it seems just about everyone from individual investors to pension funds to 401ks to banks to hedge funds.
- Who is vulnerable? Anyone or any organization that holds riskier forms of these financial instruments.
- Why are they so vulnerable? Because many of these CDOs contain bad debt or debt that is about to go bad.
- Also, many CDOs were purchased by hedge funds with you guessed it, more debt!
- What is about to happen? “You’ll see massive losses from banks, insurance companies and pension managers,’’ Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York, tells Bloomberg. “The longer they wait, the worse it’s going to be.’’
- So won’t the banks and investment companies be the big losers? To some degree, yes, but it appears that much of this suffering will be passed along to you and me.
- How? Pensions losses might be passed to retirees, investments will lose value, banks might charge higher fees to recoup losses or the government may bail out some institutions. Don’t be surprised if the stock market or economy take a hit, too.
- But wait, there’s more: When one of Bear Stearns’ hedge funds nearly went under last month, the company pumped $3.2 billion into the fund to keep it afloat. That’s their choice to make of course, though I would argue that the loss should be passed onto the investors.
But why spend so much money on the rescue? Fear. If Bear Stearns allowed its high-end fund to collapse, what would other investors think?
“Crap, I’m exposed here. If Bear Stearns will allow one fund to collapse, maybe it will allow others to collapse.” So Bear Stearns rescued the fund.
While this is understandable, there is a much bigger issue at stake here, which is revealed in the Bloomberg story: If the Bear Stearns hedge fund did collapse, other CDOs and similar instruments would be worth even less.
“A concern was that a forced sale would slash prices on CDOs, providing new, lower benchmarks that investors would have to use to value their holdings, resulting in billions of dollars of losses,” writes Bloomberg.
But even more scary are all those CDOs purchased with debt, explains the Bloomberg article:
“We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions,’’ debt strategists at Barclays Capital in New York said in a June 28 report. “The worry is that this will be large enough to trigger margin calls which, in turn, will cause other liquidations and so on.’’
At the same time, rating services such as S&P and Moody’s have been slow to downgrade the value of these funds. Which allows the smart and wealthy folk to GET THEIR MONEY OUT BEFORE THE REST OF US.
Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody’s maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.
“That’s like saying these trees are just fine as there’s a forest fire on the other side of the hill,’’ said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.
Of course, even with all these warnings, plenty of wealthy folk still don’t see the writing on the wall and will take hard losses. For some, it may already be too late.
One such fund, Horizon ABS Funds prevented investors from withdrawing their money at least temporarily, reports The New York Times. Apparently one savvy investor sought to withdraw $650 million, which accounts for one-quarter of the fund’s value.
For many of us, protecting our assets is not in our hands.
We have little control over our pension funds and most of us have no idea how exposed our IRAs and 401ks are to this overall mess. But if you look at the historical record, we will soon “discover” that the biggest victims are elderly pensioners.
Do I have proof of that? Nope, other than they ALWAYS seem to be the worst hit. Perhaps it’s because they are easily persuaded by slick money men who promise safe, large returns on their investments. It’s certainly what happened when the S&Ls crashed about two decades ago.
Here’s what Jim Jubak writes in MSN Money:
If I hear one more money manager who loaded up on subprime mortgages or buyout loans say “don’t worry,” I’m going to tear the rest of my hair out. …
We – the individuals who will take the hit if a pension fund can’t meet its obligations or if a mutual fund’s returns go south – shouldn’t worry, the professionals imply, since, well, since they’re professionals and know what they’re doing. The professionals have carefully built portfolios to spread out the risk so that even if one or two loans or mortgages go bad, the portfolio as a whole won’t take a noticeable hit.
To which I say, “If only.” In truth, either these professionals don’t know what they’re talking about – which I believe is true in a number of cases – or they’re deliberately trying to sell happy endings in the hope that they can get out with their skins intact.
Just for the record, I DID try to pull my pension money out last month, but the evil Tribune Company wouldn’t let me. I was more successful moving all my 401k money into a rollover IRA account I control. It’s all T-bills for the next few months as I study which markets are healthy and diseased.
But I am now of the strong belief that billions of dollars are about to disappear from American pockets. There is no escaping this reality because SOMEONE has to absorb the losses that will be generated by declining housing values and loan defaults.
I suspect it will be you and me, even if we don’t have money specifically tied to other people’s greed and folly.
Fannie and Freddie Ride Again
- Buyers Avoid Bear Stearns' Cut-Priced Sale
- U.S. Subprime Defaults to Rise, Credit Suisse Says
Thanks to Patrick.net for several links.