The Current Financial Mess - Simplified!

The whirlwind of news surrounding the current financial mess we’re in has my head spinning.

First it’s foreclosures, then it’s Fannie and Freddie and then it’s Merril Lynch and AIG - when will it stop?

But more importantly than that, this rapid destruction of the American financial system has many people wondering how it got started to begin with?

That’s why I decided to write this week’s article in response to this question on TickerHound:

How did this financial mess get started in the first place?

So let’s go through it step-by-step, from the beginning until this weekend when the Government announced a $700 billion bailout of the financial services industry. It’s our tax dollars that will be financing this bailout so I think it’s important that we all understand how and why it happened.I. It all started in the housing and mortgage market:

Basically, lenders were loaning money to whoever wanted to buy a home. Credit score, income and assets became irrelevant terms as brokers and local lenders rushed to issue new mortgages.

It seemed like a relatively “low risk” strategy at the time to many banks. Reason being, they figured that even if people stopped paying their mortgages, the housing market was doing so well that folks could just sell the house for a profit and pay back the remainder of the mortgage.

And that’s really where the trouble started.

II. Then the Investment Banks Got Involved:

Mortgage Backed Securities (MBS) are nothing new on Wall Street. They’re sort of like bonds, meaning there’s a “principle amount” (the amount being loaned) and interest coupons (or payments) that would be paid monthly on the loan. However, MBS’s aren’t single loans.

Instead, these loans were really thousands of individual mortgages all pooled together to create a single, tradable security.

This is another reason why many lenders were happy to keep giving out mortgages to folks (even if they didn’t qualify). Local lenders knew that they’d be able to package up all those mortgages and just sell them right to the big investment banks and not have to worry.

The banks then turned around and would trade these Mortgage Backed Securities like they would a stock or a bond - trying to pocket profits in between each trade.

III. Bubbles

The basic assumption in this whole mess was that housing prices would continue to rise each year.

In fact, that assumption turned out to be pretty accurate. According to the S&P Case-Schiller Index, home prices nearly doubled across the country from 2001 - 2006.

That’s because it was so easy to get a mortgage, everybody wanted to buy a home. Thus spurring demand and in turn driving up prices further. It sort of became a self fulfilling prophecy, which in turn became a full-fledged housing bubble.

And just like any good bubble, it eventually had to pop!

IV. The “After-Pop”

So after the housing market finally started to tumble, the financial services industry went into a year-long death spiral. Here’s the basic sequence of events:

1. People couldn’t afford their mortgages anymore.
2. They couldn’t sell their homes for more than they paid due to falling prices
3. So they defaulted on their loans - this happened to millions of people!
4. The big investment banks which now owned all the mortgages suddenly realized that these “assets” were virtually becoming worthless in a very short period of time.
5. So the banks had to take massive write-downs on these loans. The way this works is the banks were considering these baskets of mortgages as assets on their balance sheets. Once the assets went from being worth $100 to $1, the banks basically lost 99% of their value.
6. When that happened it made it very difficult for the banks to get loans themselves (imagine applying for a loan when all you have is a pack of bubble gum and the clothes on your back - it’s not likely to happen).
7. When the banks couldn’t get their own loans they were either going to be forced into bankruptcy (Lehman Brothers) or had to be swallowed up by healthier firms (Bear Stearns, Merrill Lynch, etc.)

V. How the Government Got Involved

Ever since Bear Stearns went under the government has played a fairly prominent role in this whole mess.

But it wasn’t until we almost saw the implosion of Fannie Mae and Freddie Mac that the government really made its presence felt.

Fannie Mae and Freddie Mac are sort of like “buyers of last resort” in the mortgage market. They were established to maintain liquidity in these markets in the event of the large banks being unable to trade their Mortgage Backed Securities.

So in the end, Freddie and Fannie were sitting on trillions of dollars in bad home loans.

And while these companies were private organizations they were however government sponsored organizations. So if the government had let either one of these companies fail then it might’ve made it very difficult for the United States to keep selling debt to big foreign buyers, like China. Remember, it’s our ability to sell our debt to other countries that has been funding our country’s operations (e.g. wars, etc.) for the last several years.

VI. How AIG and Insurance Fit In

AIG came into the picture when it began selling “insurance” to the big banks.

This technically wasn’t insurance, but that was mainly due to clever wording on the part of AIG management. Because for all intents and purposes, they were basically insuring the mortgages held by the banks - this type of insurance was called a “Credit Default Swap”, or a CDS.

Basically, the banks would pay AIG a monthly fee and in turn AIG would promise to make the bank whole on any mortgages that defaulted (sure sounds like insurance to me).

At the time I’m sure this sounded like a good idea because everybody assumed housing prices would continue to rise.

Well we all know how that turned out and that’s why in the end AIG was left holding the bag for billions of dollars in bad loans.

VII. The Bailout

So that brings us to where we are today: On the eve of the largest government bailout of the private sector in the history of this country.

The implications for these actions are vast and complex.

On the one hand, the government has to do this; the alternatives are too disastrous to even comprehend. On the other hand, what type of message does this send to the banks going forward? That it’s ok to engage in risky, reckless behavior and they’ll always get bailed out in the end?

I think I’ll save the rest of my commentary for another post.

I hope this gives you a clear picture of why and how we got into our current predicament.

If you have any other questions on this topic feel free to go to TickerHound for the answers!

Beware the Banks and Brokers!

After reading a post by Fred Wilson yesterday, I started to get a little concerned about an impending economic downturn. While it's always been in the back of my head - considering we've been in a bull market for the last 4 years - I haven't paid it much mind in a while.

Now Fred was talking about a downturn specific to the web - I mean, that's where he makes his bread and butter so it's something that is near and dear to his heart - but my concern is more broad based. I think we can see a major downturn hit the stock market and that will have a reverberating effect throughout the economy, and especially in the fragile tech space.

Here's my take:

After working on Wall Street for a few years you learn a couple of tricks. One of which is, if you want to know which way the market is headed six months in advance, keep an eye on the banks and brokerages.

Once you see the banks and brokerages start to take a dive, you know that the rest of Wall Street isn't too far off - we'll call them a "leading indicator". Every major bear market was preceded by sub-par results in the banks and brokerages.

Now, much of this is going to have to do with the recent mortgage crisis the country has plunged into. A lot of these banks are going to take a monster hit on all of these defaults we're seeing.

In fact, the Wall Street Journal just reported that Morgan Stanley (NYSE: MS) took a 17% hit to Net Income this quarter. Lehman Brothers (NYSE: LEH) showed an increase in profits but took a hit in fixed income due to the mortgage issues.

I also think that many of the banks and brokerages have been reaping the benefits of an unsustainable bull market - the market has been up almost 20% a year for the last 4 years - that means that when this market heads south (or stops rocketing higher) these companies can no longer use their trading and investment banking fees to compensate for losses in other divisions. And that my friends means the brokerages will be headed south for the winter.

When that happens many of the IPO dreams and lofty valuations for many of today's web startups will go into hibernation for the winter as well. But in all fairness this "dot-com renaissance" we've been seeing isn't solely predicated on the public equity markets. But at the very least I think we'll see VC's and other private equity firms tighten the purse strings a bit.

Like I said in my comment to Fred's post, I don't think we're headed for an all out crash in the Internet space, but with the market looking like it might take a bath, investors and entrepreneurs alike need to be cautious now and prepare for a potentially tough winter.

Some steps to take:

1. Batten down the hatches and lower your burn rate: If you're currently supporting high fixed costs figure out ways that you can right-size your Income statement if revenue suddenly takes a hit (i.e. if revenue drops 25%, how can you cut costs by 25%?).

2. Stockpile your supplies: For investors and entrepreneurs this means you need to get capitalized! If you've got enough cash on hand and this downturn isn't "too" bad, you'll be just fine. But for those operating on a shoe string budget already, you might be in for even tougher times if this downturn hits.

3. Focus on the Fundamentals: At the end of the day most of this stuff is beyond any of our control, so there's not much we can do by worrying. So focus on your business - continue to execute on all fronts and proceed with your plan. Don't take your eye off the ball for a single second.

I think James Dean said it best - "Dream as if you'll live forever; live as if you'll die tomorrow."

I prefer, "Act like your company will be around forever; but plan like it could be gone tomorrow."