12/14/08   Just in case you have been on an extended vacation to outer space lately, I have a news flash for you:  The economy is a MESS. In fact, Disaster would be a better word.

 At this point there is no question or debate regarding whether or not the broader US economy is going into a recession. We are in a deep recession right now.  The question is whether or not this extremely weak economy will worsen into a full-blown depression of the kind not seen since the early 1930s. Please make no mistake, that is a very real possibility and in fact may be the most likely end to the path we are currently following.

 The current economic weakness has seen the stock markets plunge, housing values fall off a cliff, bond yields on anything not explicitly guaranteed by the US Federal Govt. rocket into the stratosphere, every single Investment Bank in the US implode, the banking system in general face insolvency straight in the eye and bank lending all but vanish. I watch the news and see reporters talking about how bad the economy could possibly get and I am struck by the obvious vast lack of comprehension on what is taking place. The entire fiscal and monetary systems that form the foundation of the US economy are in disarray and facing possible collapse. Our fundamental economic system may be insolvent. It IS that bad.

 Why is this happening?  It is actually quite simple.  DEBT.  The levels of debt being carried by the US population soared to such absurd highs relative to incomes that there is simply no way for the average Joe to pay his bills. Yes, the situation and its causes are far more complex than this but when you boil the entire mess down to its core what you are left with is debt burdens that cannot be met.

 This economic mess has roots that stretch back over 40 years. Beginning in the 1970s the US Federal Govt. began mandating to Fannie Mae and Freddie Mac  (the two Government Sponsored Entities [GSE’s] chartered by the Federal Govt. to establish and maintain secondary bond markets for the sale of mortgage backed securities in order to raise capital to fund mortgages on a broad basis nationwide) to loosen lending standards in order to promote homeownership amongst lower income people. Over the years these efforts aimed at increasing minority and low-income homeownership were dramatically expanded. As these efforts took root, the GSE’s along with FHA began focusing more on underwriting guidelines aimed at achieving social engineering goals rather than the origination of sound loan portfolios that would have low default ratios. Good business practices took a back seat to political agendas.

 Then came the recession of 2001 and the sharp economic decline that followed the 9/11 terrorists attacks. The economy, already rocked by the bursting of the .com bubble in 1999-2000, faced a serious crisis of confidence. The Federal Reserve and the US Govt. responded to this economic crisis with the loosest monetary policy this nation has seen since the Great Depression. The Federal Govt. cut taxes, passed out stimulus checks and dictated further easing in credit standards from the GSE’s and FHA while at the same time vastly increasing Govt. spending. The Fed flooded the banking system with cash and cut the Fed Funds rate and Discount Rate to 1%. Together, these actions swamped the banking system with cash while at the same time loosening lending standards.

 The results should have been no surprise. We got the largest economic expansion since WWII. Banks, flushed with cash and greedy to lend it out were extending loans to anyone and everyone… And anyone/everyone was eager to borrow and spend!

 The boom in cheap money manifested itself most dramatically in housing prices. Banks and Mortgage Lenders who were flush with cash, instructed by their regulators to increase lending to higher risk borrowers and facing stiff competition amongst each other became VERY creative.  “Subprime” lending exploded, “Alt-A” lending became mainstream and even Fannie and Freddie conforming loan programs no longer required such petty things as documentation of a borrowers income.

 Want to buy a house but you cannot prove your income?  No problem!   Want to buy an $800K house but you only earn $50K a year?  No problem!  Feel like you deserve a $1 Million home even though you cannot prove you have a job?  No problem!  You have run up $75K in credit card debt and you are struggling to make the payments?  No problem….  Just take out a 100% loan to value Home Equity Line of Credit….  No proof of income required!

 It got CRAZY.  I know first hand how crazy it got because American Republic Mortgage was busy in the trenches while this entire fiasco was playing itself out. We had account representatives from wholesale lenders based all over the country beating down our doors to push the latest crazy loan program they had devised. The competition between competing wholesale lenders was fierce, the loan programs absurdly easy to qualify for and the interest rates were rock bottom.

 Let me provide a brief bit of background here…    American Republic Mortgage is a mortgage brokerage. We do not fund our own loans. We do not sell bonds or mortgage backed securities, we do not directly fund the loans we close, we do not write our own loan underwriting standards and we are not limited to offering only those loan programs backed by our own bank.

 A mortgage brokerage offers loan programs from as many different lenders as is possible. Our objective is to have every kind of mortgage loan program that exists in the marketplace available so we can assist our clients in making the smartest possible choices for their individual situation. We make the loan programs available, we explain them to our clients and we try to assist the client in making the best possible decision.

What we cannot do is limit a client’s choice. I have read a good bit in the mass media trying to blame the current economic mess on mortgage brokers for selling all of the crazy loan programs that have driven the current collapse. What these reporters fail to understand is that mortgage brokers do not make loan-underwriting decisions. Mortgage brokers do not devise the loan programs nor do they make determinations on whether or not a given borrower is approved or declined after having applied for a given loan program. It is illegal for a mortgage broker to refuse a borrowers application for a given mortgage loan program based on anything other than the wholesale lenders underwriting guidelines. This means that if a client wanted to apply for a “No Income Verification” loan program on an Interest Only Adjustable Rate amortization…. we would be violating our license if we refused.

 So we explained the loan programs to our clients, made the risks clear and did our best to lead our clients to smart decisions. In the overwhelming majority of instances, our clients made good choices and American Republic Mortgage has not seen delinquency and default ratios on the loans originated since 2001 cause any wholesale lender to issue any complaints or terminations of brokerage contracts.

 Still, the lending environment during 2004 – 2007 was nothing short of absurd. I could go on and on with stories regarding this but two examples stand out. I specifically remember a conversation with my account representative(AE) from SunTrust Mortgage. They were offering what they called their “Easy Options” loan program. This was a combination 80% Loan to Value (LTV) 1^st mortgage and a 100% LTV 2^nd mortgage loan, no income documentation of any kind was required and credit scores down to a minimum of 620 were acceptable. So you did not have to have good credit, you did not have to prove any income and you did not have to have a single dollar in down payment. I told my AE that this was crazy and there was no way these loan programs would service over time. He assured me that the underwriting actuaries and investment bankers selling the related bonds along with the bond ratings agencies had evaluated the loan programs and assured everyone that they were safe and rated AAA. We all know now who was right!

The second loan program that stands out as absurd amongst the detritus of mortgage garbage are the “Pay-Option ARM” programs championed by Wachovia Mortgage (and others). These loan programs were not just Interest Only…  but they offered a minimum payment option that did not even cover the minimum interest due and instead the difference between the interest only payment and the minimum payment was tacked onto the loan balance each month. These were “Negative Amortization” loan programs. If you made only the minimum payment (which is exactly what the overwhelming majority of borrowers do) then the balance on your loan increases each month. This negative amortization will go on until the loan balance is 120% of the original loan amount at which point the loan converts to being fully amortized over the remaining term.

 To illustrate exactly how toxic this sort of loan program can be, lets look at a simplified example. If you took out a $600K Pay-Option ARM loan in 2006 your minimum monthly payment would be only $1,930.  But with an interest rate of 7.5% the interest only payment would be $3,750. The difference of $1,820 would be tacked onto the loan balance each month. In less than 5 years the loan balance would balloon to the 120% level of $720,000. At that point, it would convert to a fully amortized payment with 25 years remaining. In this example, the borrowers payment would adjust from $1,930 per month to $5,320 per month.   OUCH!

 Now consider this loan program in a broader context. In places like California  (or Florida… Nevada… Arizona…Washington DC….) the availability of cheap and easy money for real estate fueled an unprecedented boom in building and home prices. Speculators were driving the market, home prices were rocketing up at 40% - 50% per year and buyers were literally fighting over whose full price contract was submitted first. Prices across the board were increasing at absurd rates. A situation rapidly evolved where even the lowest end of the housing spectrum had seen prices boom to the point of abandoning all historical relationships with things such as incomes and rents. The guy using the crazy Pay-Option ARM program to buy a house in a suburb of LA was not buying a McMansion… he was paying $600K for a 3 bedroom / 1 bathroom 1200 square foot ranch house on a postage stamp lot built in the mid 1960s!

 Now, this individual is getting a notice that his loan is about to reset. His Pay-Option ARM has reached the 120% maximum negative amortization amount and his payment is going to jump from $1,930 per month (which he could afford…  but barely) to a whopping $5,320 per month which is more than his entire take home pay. He also learns that the home he paid $650K for in 2005 is now worth only $350K but his mortgage balance is $720K!

 It does not take a Nobel Laureate in Economics to figure out what this borrower is going to do. When you consider that median home values in all of the red hot markets from 2004 – 2007 increased to levels that were totally out of whack with median incomes you can begin to understand how broad the use of these kinds of toxic loan programs became. The ONLY way buyers were able to afford homes at these crazy price levels was to resort to one of these loan programs. In many markets, these kinds of loan programs made up the vast majority of mortgages funded during the boom years and just like the example above the overwhelming majority of these loans are heading for the same bad ending:  Foreclosure.  (Despite the absurdity of this entire scenario…  Wachovia was still funding these asinine loan programs in July of this year!)

 The cheap and easy money flood did not just promote a housing boom. It drove the entire economy. Lending standards for credit cards and unsecured loans or lines of credit also dropped as did standards for car loans and other consumer lending. Everything from plasma televisions to blackberries to video games and new cars boomed as consumers and corporations were flush with all the cheap cash the banks could convince them to take… and it took little to no convincing at all!  Does 0% financing for 18 months with no payments due sound familiar?

 Literally tens of millions of people accessed rapidly increasing home equity during the boom years, often several times. Between 2003 – 2007 over $7 Trillion in home equity was taken out through first mortgage cash-out refinances and 2^nd mortgage programs. The effect of this cannot be over-stated. Consumers went on extravagant vacations, ran up tens of thousands of dollars in credit card debt, took out multiple car loans and then paid it all off with an easy to get, interest only minimum payment, Home Equity Line of Credit (HELOC). When the latest round of debt consolidation was complete, the consumer went right back out and ran up the debt again confident in the belief that his home would double yet again in value over the coming year or so allowing yet another cheap debt consolidation refinance! Rinse and repeat…

 The result of this easy money bonanza and hyper-boom in housing was massive, unprecedented levels of debt. Wall Street Investment bankers packaged all of this debt paper into various AAA rated Mortgage Backed Securities (MBSs) and Collateralized Debt Obligations (CDOs) and insured it all with massive issuances of Credit Default Swaps (CDSs) and sold it all over the world. Who purchased this stuff?  In all likelihood YOU did. It was bought by Foreign Central Banks, Pension Funds, College Endowments, Mutual Funds, 401K’s, IRA accounts, Sovereign Wealth Funds, Hedge Funds…basically, the worldwide demand for these seemingly safe and high yielding investments was endless. The greater the demand on Wall Street for these products to sell, the easier lending standards got and the more easy credit consumers gained access too. The cycle fed upon itself and everyone from the local garbage man to the Wall Street banker was flush with cash and happy as pigs in mud.

 BUT IT WAS NOT REAL.  The entire economic boom was driven by this easy money and debt. Such a boom cannot continue forever because savings or income does not fuel it. The economic expansion experienced between 2003 and 2007 was a “False Economy”. Low rates and loose monetary policy fueled absurd lending practices resulting in unrealistic asset value inflation. This was a bubble economy and like all bubbles it was destined to burst.

 But in this case… the bursting is not so simple. As I have demonstrated, the bubble was not just housing prices. It was the entire global economy.

 Asset valuations on the broadest of terms across the planet were all falsely inflated to unsustainable levels. This includes home values; stock prices, bond prices, MBSs, CDOs, CDSs and the list could go on. The fact that broad classes of assets had become inflated to impossible levels is clear to everyone at this point. The DOW is down over 5600 points or 51% from its highs and all major global stock indexes have seen similar or worse declines. Credit markets are frozen and bond prices have plummeted driving yields to historical highs for most Non-Govt. guaranteed bonds. Nationwide housing prices are off 23% and in some of the previously hottest markets prices are down over 50%.

 Banks and giant multinational corporations leveraged themselves to unprecedented levels during the boom years. Credit was easy, cash was rolling in and the boom appeared to be endless so everyone sought to fuel further growth by taking on yet more debt. Investment banks were leveraged over 40 to 1! Can you imagine owing $40 for every $1 in hard assets you have?

 All of the debt based investment paper that was sold across the globe spread the risks to everyone. These debt based investment “assets” such as Credit Default Swaps had their values ultimately based upon the expected returns to be generated from payments made on all the debt extended to consumers. But because lending standards had become detached from such petty nuisances as the borrowers income or ability to repay the debt the expected delinquency and default rates on the loans were utterly unrealistic. This began to be starkly demonstrated as delinquencies and defaults on actual loan portfolios soared.

 As the reality of these defaults began to manifest itself through unprecedented numbers of foreclosures, the world was forced to wake up from its debt-fueled dream of easy and endless boom times. It turns out that consumers in fact cannot borrow unlimited amounts of money and simply make the payments with yet more borrowed money. As foreclosures and defaults rise to historical highs, investors worldwide are being forced to face a simple fact: all of those debt related investment vehicles that they had so eagerly purchased and considered safe were actually not safe and in fact might be so risky that they are literally not worth the paper they are printed on.

 How bad is this? How much of this “toxic asset” paper is out there? The most recent US Govt. estimates say there are over $33 Trillion in outstanding Credit Default Swaps on the books of banks and investment companies. This is based on valuing these assets at full face value. But the problem is nobody can tell what the actual values are because the markets for these kinds of assets have completely vanished. There are no buyers for these assets. The fact that the delinquency and default ratios on the loans ultimately linked to these assets are through the roof has made valuing the assets impossible. This is the core of the solvency issue facing our banking system.

 Regulatory rules related to banking allow banks to lend to a certain percentage of their assets. If a bank is allowed to lend $20 for every $1 dollar in assets they hold and they hold $10 Billion in assets then they can issue and service up to $200 Billion in loans. But what if they already hold $200 Billion in loans and $5 Billion of their assets are made up of Credit Default Swaps? What if those CDSs are actually only worth $5 Million instead of $5 Billion? If so, the bank is over leveraged and insolvent.

 When Lehman Brothers went bankrupt their assets were sold to the highest bidder. This included the sale of Credit Default Swaps held which sold for about $0.08 on the dollar.  Yes….  8 cents on the dollar.

 The “Mark to Market” accounting rules that were mandated by the US Govt. after all of the corporate accounting scandals of the early 2000s (remember Enron and Anderson Consulting…..) dictated that banks and corporations must value the assets on their corporate accounting books at the current market driven values. So if the market for a given security is $0.08 cents rather than $1 dollar the bank or corporation has to mark that asset to this value. If this reduction in asset value results in a leverage ratio that exceeds the banks regulatory maximum then the bank either has to reduce debt or face insolvency. If there is no market to sell the debt and if they cannot raise additional capital in order to bring the leverage ratios back in line, the bank will go into the hands of the FDIC for liquidation.

 But what happens when everyone holds huge amounts of these toxic assets, no market exists for them and if marked to market all holders face insolvency? This is the scenario we are faced with today. The entire global banking and financial system is interwoven with these toxic assets. Everyone holds them, nobody can tell what they are worth and everyone is scared that everyone else may go belly up due to their exposure at any moment. Nobody can (or is willing) place a value on these assets. Technically, the entire US banking system could be insolvent.

 This is what drove the original “TARP” or Troubled Asset Relief Program, the $700 Billion broad “Bailout” program pushed through by Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. Realizing that the massive and systemic exposure to toxic mortgage and debt related assets could result in the entire financial system being insolvent their plan was to use US Govt. funds to begin buying up these assets from banks and thus providing a market while backstopping the solvency of the banking system.

 But this plan is now dead. Paulson announced on November 12^th that the Treasury Dept. no longer planned to use TARP funds for the purchase of these assets. Instead, the first $350 Billion of these funds is being handed out to various banks through mandated Govt. equity positions. Basically, the same banks and bankers who made all the horrible decisions that lead up to this mess are now being handed out literally hundreds of billions in Govt. funds and being told to go and lend it. The bailout program is supposed to save us all from too much debt by giving us more debt. Paulson was forced to abandon his plans to buy up the toxic assets on banks balance sheets because when he came to realize the massive amount of such assets he had to face the fact that $700 Billion wouldn’t even make a dent. Had the original ill-conceived plan been followed, the only result would be $700 Billion in additional US Govt. debt with nothing to show for it.

 It is obvious that Paulson and Bernanke have dramatically underestimated the scope of this crisis all along. Bernanke is admitted exactly that. Every step of the way…. Bailout program after bailout program….  They have failed to halt the financial meltdown and their actions have had little to no impact. Why?

 Because neither the US Federal Govt. nor the Federal Reserve has been willing to face the reality that the core of this crisis is asset valuations that are unsustainable. An economy cannot function properly when prices are too high relative to consumers’ incomes. The bulk of US bailout efforts to date have focused on attempting to prop up asset values at the unsustainable levels. The Govt. has raised the maximum GSE conforming loan amount to try and prop up high housing prices and it has pumped massive amounts of money into banks holding mortgage-backed assets on homes in markets with clearly inflated values. All of the funds pumped into such bailout efforts are a complete waste.