Bill McCord's Blog

The Fed and the Crisis

For anyone wishing to understand what the Federal Reserve actually did, and will continue to do in dealing with our current financial problems, here is a link to a San Francisco Fed web site where you will find a goldmine of facts and commentary. http://www.frbsf.org/econanswers/

It’s a great resource dealing with the process of digging out of the hole and getting back on track.

Maybe one day they will do an equally good job on their failure to prevent all this from happening. As far as I can see they did not have the courage to take away the cookie jar when this Bubble was so obviously getting seriously inflated.

Turns out that Mr. Greenspan really let us down by failing to spell out what was happening, and take the risk of being unpopular with his Political Masters. Like many before him he seemed to buy into the “New Paradigm” myth. Remember that phrase during the run up to the Dot Com bust.

In the world of smoke and mirrors called “The Finance System” the word PRIME has two very different meanings.

One is PRIME RATE (the interest rate banks charge their best clients. Normally 3% above Fed Funds Rate.

The other is SUB-PRIME to describe a mortgage (SUB-PRIME MORTGAGE) that should never have made. Hence the “The Sub-Prime Mortgage Crisis“.

In the real world occupied by most of us “Ordinary Folk” the term Sub-Prime should not be linked to a Mortgage; It actually refers to the Borrower of the Mortgage i.e. The person whose Credit, Income, and/or Cash for down payment is not good enough to get a ”Prime” Mortgage. Hereafter referred to as The Sub-Prime Borrower.

This person has always been with us. Until the unbridled greed and avarice of Banks and Wall St intervened with their “No Possible Homebuyer Left behind” programs these folks rented until such time as their financial situation allowed them to qualify for a sensible mortgage.

Let’s be clear on this. The Sub-Prime Mortgages were and are High Risk loans made to High Risk people. These loans could only be made if the Bank knew it could sell them on to a 3rd party before the inevitable late payments started. This way the Banks got their profit with effectively no responsibility for the future performance of the flakey loan.

It was effectively a game of “Pass the Parcel in a Bagdad Pub”.

By the time these loans started going bad they had spread throughout the Worlds Financial systems leading to the current situation so often referred to as the Sub-Prime Mortgage Crisis.

At the end of the day we have a large number of Banks and other Wall Street hot shots who  made enormous profits by selling what they all knew to be an unstable product to an undereducated public.

This is a recurring story in our history.

If you don’t want to become a victim of the next wave then you need to get educated in how the system really works before you meet the next Bernie Madoff.

For some thoughts on how you might do this check out my posts from 04/25/2008 “Kick Start the Kids”.

Major profits are going to be made by the big investors (including Governments) who buy the “Toxic” mortgage Bonds currently available at deep discounts from their original prices. Think of it this way:

These Bonds are each made up of hundreds, even thousands of individual mortgages such as yours and mine.

Currently only 7% of all mortgages in the U.S. are in default. Even assuming they all go to foreclosure the Lender still only loses a small percentage of the total mortgage value once the property has been resold. Let’s allow for a loss of 25% of the original value on 7% of all the mortgages in a given $20 million bond. That equates to a $350,000 loss.

For our purposes let’s say the interest rate on the Bond was 6%. That’s $100,000 per month income.

Now let’s see how buying this Bond in todays market will work out for the cash rich bottom fisher (or Government).

Purchase price of the $20 million Bond at 50% of book value = $10 million.

Note: This is way above the prices paid on the 1st Lehman Bro’s sales of similar assets.

Interest income is unchanged at $100,000 per month. The interest rate though is now 12% based on the $10 million invested.

Finally, let’s suppose our government is the the buyer, and they have promised to do everthing possible to help the 7% of homeowners who are struggling. Given a 12% effective rate on each mortgage they have plenty of scope to re-negotiate the loan into a much lower rate at which many troubled borrowers will be able to save their house.

Remember, Uncle Sam can borrow easily at rates less than half of that which will be earned. If the Treasury borrows $10 million at 5% and is able to earn 12% on it, and therefore help prevent large numbers of foreclosure, then I’m all for it..

This is a pretty simplistic example but hopefully the big big picture is clear.

As always comment are welcome.