Financial Crisis...What's Next?

Today we saw a 678 point drop in the DOW. The DOW has now lost 25% of its value over the past thirty days, 39% in the past year.

Why? The Global Economy has been on a credit binge for the past 40 years and this is the day of reckoning. The Sub-Prime Mortgage Crises brought our banking and investment markets into the binging thus geometrically multiplying the effects of the overall misuse of credit.

Banks lent money to unqualified borrowers to buy homes. Both buyer and lender knew that the borrower would not be able to make the payments when the favorable mortgage terms reset; but both also knew that the price of real estate was going to continue to go up and thus this would not be a problem. Waiting outside the bank were a hoard of investment bankers; CDs were paying 2.5% and this new mortgage was paying 7%, they snatched them up as fast as the bank could write them. These Investment Banks were not held to the same rules as Consumer banks; they could use borrowed money (leverage) to buy these mortgages. They could borrow short term money at 2.5% and turn it into an investment that was paying 7%. Granted there was a risk in these Sub Prime Mortgages, so the Investment Banks packaged maybe a 1000 of them together all with different degrees of risk thus diversifying the investment a CDO. Smart investors recognized this risk and asked for some assurance that if these mortgages should default they would still get their money. In rides AIG on a white horse and offers a Credit Swap, (Insurance to pay the investor if the mortgage should default) but not being called insurance it was not held to the rules of insurance (You must keep deposits on hand to pay any claims).

Over the past 60 days we have seen banks fail. Auditors came in and found that their assets on hand were out of line with their debt obligations and they were unable to raise enough capital to bring their debt to equity ratio back into line. The consumer was OK, the FDIC stepped in and made their deposits up to $100,000 good. But that other bank that lent the failed bank some short term money the week before lost its funds. This is why the global banking system has frozen-up. Banks are afraid to lend other banks any money, banks are afraid that the assets they have on their books will be devalued (The mark to market rule: and asset is worth whatever the market will pay for it today). If such a devaluation should accure they could be forced to close their doors.

Over the past 60 days we have seen Commercial Banks fail or be bought out. As the mortgages started to default investors stopped getting their 7% interest payments, they panicked and demanded their money from their broker. First the brokerage frim started liquidating their holdings to cover the demands for cash, thus putting selling pressure on the stock market and starting the slide down. Bear Sterns, Merrill Lynch and AIG were not able to keep up with the outflow of money and sought a governmental life preserver, Lehman Brother filed for bankrupsy.

That brings us to two weeks ago when AIGs Credit Swap business came out from under the rock it had been hiding under. This is when the banks, hedge funds, pension funds, insurance companies, and institutional investors learned that their Credit Swap (Insurance) had no capital to pay claims. Remember if you have a package of mortgages with a face value of $10 million on your books with insurance, its worth $10 million even with the defaults, but if there is no money to pay off the insurance…What are your mortgages worth? Last week it was announced that there would be an auction to auction off Lehman Brothers CDOs and Credit Swaps on Friday October 10, 2009…tomorrow. Remember the Mark to Market Rule. Tomorrow everyone will know what the assets they hold on their books and in their portfolios are worth. That is why the market has been in a freefall for the past eight days of trading. If hedge funds had anything of value it was being sold in fear that Monday October 13 could be too late. That $10 million package of mortgages could be worth $120,000.

Over the next 90 days our banking system and our investment markets will take a new form, as they should. It is my opinion that if you own banking and investment firm stocks you could be in for some real hurt. On the other hand if you own stock in well managed companies you will have more in your account next year at this time then you do today. When it’s all over the greedy bankers, hedge funds, brokerage firms, and speculators will be the big losers, as they should.