Black Monday's Lessons for Us Non-Wall Street Borrowers
George Boelcke CCP
September 16, 2008
In the months to come, this past Monday should really be called Black Monday on Wall Street. A 500 point drop in the Dow and huge turmoil in the financial markets again, or still? It continues to be a story about greed and over-borrowing. A story that doesn´t just apply to a few big (now gone) investment firms or banks, but to millions of families.
From 2002 to 2007 Wall Street made over $27 billion in fees by slicing, dicing, packaging and selling mortgage packages, called Collateralized Debt Obligations (CDOs) to everyone from small investors to banks and everyone in between.
The problem is - these aren´t full mortgage loans. They are all minute and tiny pieces of thousands of mortgages, good stuff, bad loans, subprime and kinky ones, all put through a blender and packed nice and neat, then sold as investment grade and totally safe. Everybody wanted them and nobody could get enough on their books for years.
Investment firms were making billions in fees gathering them, packaging them and re-selling these CDOs. It turns out that they started to fall in love with the product they were selling. First, they put a ton into their own accounts because it was a great return. When things slowly started going sour, something they didn´t really want the markets to see, they kept buying more and more to make it appear the market was still buying these CDOs.
Now back to Monday: First was the huge and well established investment firm Lehman Brothers filing for bankruptcy. They were done in, or finally dragged under, by over $60 billion of bad, or questionable, mortgage loans on their portfolio.
Then came the announced sale of Merrill Lynch to Bank of America. Same story in a way, since Bank of America is buying the firm in an all-stock deal. That´s kind of like me buying your house for no cash, but only paying off your credit card bills using my Visa card.
Lastly was the insurance giant AIG filing for re-organization. It´s not that the insurance business is bad. It´s just that AIG invested their clients´ premiums in mortgage loan portfolios, instead of safe CDs, because they were getting a better return. Lesson number 780 for all of us: If you want a higher return you have to take a higher risk!
Added to the Monday list was the government takeover of Fannie Mae and Freddie Mac last week and Bear Sterns´ bailout last month. Yet, we were told that the worst was behind us? Nope. Banks and investment firms are the oxygen of the economy and this isn´t helping. The next wave? Likely a large number of smaller banks that are currently on the government watch list – which is kind of the equivalent of being in the emergency room on life-support systems.
It´s not that all mortgages are bad, it´s just that nobody can find a value for these pieces of packages of little slivers. If you don´t know what you´ve got, you can´t figure out what it´s worth. And it turns out the idea that tiny little pieces of millions of homes didn´t make it safer – it made these CDOs more of a risk! A few weeks ago, the equity firm Lone Star purchased over $30 billion of CDOs from Merrill for $6.7 billion. That´s barely 20% of the value, and there are other examples around those same percentages.
These firms got into trouble using leverage, borrowed money, to buy and hold these investments. They did it on a huge scale and bet their entire firm. When things go well, the payday is great. When things start to go bad, they go bad way faster and the end comes a lot quicker.
For us, the lesson is the same. Borrowing money is always a risk. The mortgage on our home, the extra HELOC, car loan and credit card debt for stuff we can´t remember, and bought years ago. As long as the car runs, our income doesn´t drop or we get sick, as long as our home keeps it´s value and we keep having near-perfect circumstances, we can manage. However, when circumstances change, we´re in deep trouble.
Borrowing is not your friend. It´s buying something we cannot afford and always comes with risk factors. Right now, the Lehman Brothers of the world, along with millions of families, are learning the hard lessons. Will we remember them down the road? Time will tell. But until then, things are going to get worse before they get worse.
From 2002 to 2007 Wall Street made over $27 billion in fees by slicing, dicing, packaging and selling mortgage packages, called Collateralized Debt Obligations (CDOs) to everyone from small investors to banks and everyone in between.
The problem is - these aren´t full mortgage loans. They are all minute and tiny pieces of thousands of mortgages, good stuff, bad loans, subprime and kinky ones, all put through a blender and packed nice and neat, then sold as investment grade and totally safe. Everybody wanted them and nobody could get enough on their books for years.
Investment firms were making billions in fees gathering them, packaging them and re-selling these CDOs. It turns out that they started to fall in love with the product they were selling. First, they put a ton into their own accounts because it was a great return. When things slowly started going sour, something they didn´t really want the markets to see, they kept buying more and more to make it appear the market was still buying these CDOs.
Now back to Monday: First was the huge and well established investment firm Lehman Brothers filing for bankruptcy. They were done in, or finally dragged under, by over $60 billion of bad, or questionable, mortgage loans on their portfolio.
Then came the announced sale of Merrill Lynch to Bank of America. Same story in a way, since Bank of America is buying the firm in an all-stock deal. That´s kind of like me buying your house for no cash, but only paying off your credit card bills using my Visa card.
Lastly was the insurance giant AIG filing for re-organization. It´s not that the insurance business is bad. It´s just that AIG invested their clients´ premiums in mortgage loan portfolios, instead of safe CDs, because they were getting a better return. Lesson number 780 for all of us: If you want a higher return you have to take a higher risk!
Added to the Monday list was the government takeover of Fannie Mae and Freddie Mac last week and Bear Sterns´ bailout last month. Yet, we were told that the worst was behind us? Nope. Banks and investment firms are the oxygen of the economy and this isn´t helping. The next wave? Likely a large number of smaller banks that are currently on the government watch list – which is kind of the equivalent of being in the emergency room on life-support systems.
It´s not that all mortgages are bad, it´s just that nobody can find a value for these pieces of packages of little slivers. If you don´t know what you´ve got, you can´t figure out what it´s worth. And it turns out the idea that tiny little pieces of millions of homes didn´t make it safer – it made these CDOs more of a risk! A few weeks ago, the equity firm Lone Star purchased over $30 billion of CDOs from Merrill for $6.7 billion. That´s barely 20% of the value, and there are other examples around those same percentages.
These firms got into trouble using leverage, borrowed money, to buy and hold these investments. They did it on a huge scale and bet their entire firm. When things go well, the payday is great. When things start to go bad, they go bad way faster and the end comes a lot quicker.
For us, the lesson is the same. Borrowing money is always a risk. The mortgage on our home, the extra HELOC, car loan and credit card debt for stuff we can´t remember, and bought years ago. As long as the car runs, our income doesn´t drop or we get sick, as long as our home keeps it´s value and we keep having near-perfect circumstances, we can manage. However, when circumstances change, we´re in deep trouble.
Borrowing is not your friend. It´s buying something we cannot afford and always comes with risk factors. Right now, the Lehman Brothers of the world, along with millions of families, are learning the hard lessons. Will we remember them down the road? Time will tell. But until then, things are going to get worse before they get worse.