Business Commentary: The fluffy money meltdown—Part II

Editor’s Note: This is the second of a two-part series. Part I appeared in the Wednesday edition of the Green Valley News and Sun.

As the real estate market boomed and millions of mortgages were set up, big banks and other financial institutions began bundling mortgages without due concern for whether they were mixing suspect instruments with those with legitimate value.

Moreover, small bundles were combined into ever-larger bundles.

A record of exactly what each bundle contained was separated from the actual bundles and, ultimately, from bundles of bundles.

It wasn’t just mortgage mixing and bundling that was the problem: every type of instrument of value was mixed into a veritable witch’s brew of investments, again without proper tracking of components, the basic value of components or the fair market value for the bundles themselves.

Once the subprime problem became common knowledge, the housing market slowed.

Banks and financial institutions had paid, willy-nilly, huge sums for mortgage bundles and other bundled assets.

They then came to realize that there was no way to determine what was actually owned.

Fair market value could not be assessed. Doubt led to panic. Panic led to dumping.

Dumping increased the trading volume of DASH (Derivatives, Arbitrage, Securitization, Hedging) instruments and reduced perceived value.

That panic trading, because DASH activities had come to represent such a significant part of total market activity, led to huge declines in stock prices around the world.

The banks and financial companies most integrally involved in DASH activities saw the presumed values of their stocks melt away; in some cases, their bonds became junk.

Investors and speculators began to make withdrawals and demand money from their investment vehicles (e.g., money market instruments, mutual funds, index funds and individual stocks).

The meltdown rapidly shifted to full-speed-ahead.

To give the benefit of the doubt, most of those working within a DASH environment probably did not realize the extent to which DASH transactions violated common sense processes such as worth-evaluation, adequate record keeping and standardized accounting.

As the trading frenzy developed, mania set in.

No matter what one institution had paid for bundles, it was assumed that they could be marketed at a profit to another bank, financial institution or investors and speculators, the greater fool theory carried to the ultimate.

Globalization of the banking and financial services industries made large-scale DASH operations possible.

But once the meltdown started, globalization meant that the meltdown hurricaned into a worldwide problem of unprecedented proportions, one unprecedented in terms of the breadth of the problem and the speed with which the catastrophe spread through world banks, financial institutions and markets.

Because globalization created the problem, the scope of the problem could not be addressed through existing policies, procedures and institutions.

First institutions, then governments and finally loose-knit cooperative efforts by governments were hastily formed.

In spite of these efforts - and some would say because of them - the world’s financial markets went into further free-fall.

Chaos became the order of the day.

Some major markets closed or restricted certain kinds of trading.

Banks and huge financial institutions failed or teetered on the edge of bankruptcy.

Governments stepped in - individually, at first, and later collectively- to provide liquidity on a heretofore unknown scale.

Rigid capitalism was set aside as governments assumed control over (or became partial owners of) failing banks and other financial institutions.

In the United States, Congress passed (and the President quickly signed) a bailout package amounting to some $700 billion.

Other governments took similar measures. Congress is considering additional measures as I write this.

And yet nothing that any government has done so far has managed to address the most salient and fundamental causes of the problems.

The real estate industry must return to tried-and-true methods of determining whether potential buyers can, in fact, afford the houses they would like to buy and make the payments for the life of the loan.

Fixed rate mortgages must again become the norm, since a critical part of the real estate problem came from variable rate mortgages.

DASH activities must be fully and effectively controlled.

The unrestricted use of these instruments as speculative devices rather than investment strategies must be studied and carefully evaluated.

Stringent rules and regulations may be needed.

Failing that, other bubbles will develop, other meltdowns occur and other government bailouts will be required.

We’ve learned the hard way that Fluffy Money is not a solid basis for a rational, long-term economy.

Eventually, debts must be paid.

When value melts, and markets collapse, gluttony is replaced by fear and panic.

Hopefully there will be enough fear and panic to cause the seeds of sanity to flourish within our worldwide economy.

If not now, when?

Author Note: Harold Mansfield was born in Fort Collins, Colo. After serving in the U.S. Army, he graduated from Colorado State University in 1958. He received his Ph.D. from the University of Denver in 1974. In 1993 he retired from Fort Lewis College, where he taught psychology, statistics and writing for 18 years.

In addition to fiction writing, part of his retirement regimen includes researching, thinking through and writing about critical contemporary social issues.

After a “lifetime” in Colorado, including 31 years in Durango, he moved to Green Valley in 2005.

Some of his writings have appeared in The Durango Herald, Solar Age Magazine, crimemagazine,com and Crossroads: A Journal of the Southwest.

Fluffy Money is not real money.

Its value is based solely on whether all involved believe that it has value.

Once confidence in value sinks, the entire structure follows.

Business Commentary: The fluffy money meltdown—Part I

By Harold Mansfield

Originally published November, 26, 2008

Editor’s Note: This is the first of a two-part series. Part II will appear in the Sunday edition of the Green Valley News and Sun.

The subprime fiasco and the resulting financial meltdown, currently at play, are likely to go down in history as two the most vital issues in the early part of this century.

While it is too early to tell how deep and how long the economic effects will last, they have already caused worldwide financial chaos.

Only widespread government actions and assurances have so far averted total catastrophe.

There seems to be no shortage of blame, but that does not relieve the suffering of those who have lost their jobs, homes, health insurance coverage, all or some of their retirement nest eggs or material possessions.

Rather than pointing fingers, it makes more sense to talk about fundamental causes.

When the housing and financial markets turned gluttonous, rational business policies and procedures were set aside.

To meet rising expectations and demand, an anything goes mentality set in.

Real estate brokers sold homes to those who could not—by any rational measure—afford them and arranged short-term mortgages with escalating interest rates that set the mortgagees up for failure.

While the frenzy of the real estate bubble provides a partial rationale, there were many complex components.

Greed was an important factor.

Over a period of years, the financial services industry initiated several practices that came to dominate the industry: Derivatives, Arbitrage, Securitization and Hedging (DASH).

Volumes have been written to explain these complex and over-reaching practices, but simplified descriptions follow for the purposes of this essay.

Derivatives are financial instruments that derive their value from underlying assets with definable (theoretically assessable) value.

Examples include stocks, bonds, home mortgages and investment contracts.

As originally introduced into the financial world, the object of derivatives was to provide an additional layer of investments for professional traders, investors and speculators.

Arbitrage is the financial technique of trading in financial instruments or on financial market segments for which—depending on the market—the same investment carries different values.

Arbitrageurs trade on these differences to make money.

Currency exchange differences are an example.

In theory, such investing and/or speculation was risk free because the trading was done on an electronic basis and prices were set at the time of trade.

Securitization is the process of mixing different kinds of financial instruments (e.g., stocks, bonds or mortgages) into bundles and building markets for those bundles.

This is effective when trading individual pieces making up the bundle would be cumbersome, time-consuming or non-rewarding in terms of time or cost.

In theory, securitization and bundling simplified trading, allowed for more trades of greater value and added to market volume without undue, added risk.

Hedging has a long history.

It was initially used in modern times to provide financial insurance against losses in the commodities markets, where volatility is the norm.

In essence, traditional hedging acted as insurance against severe losses due to seasonal or market-demand price swings.

For example, gold typically goes up in price as the stock market goes into freefall, so an investor could hedge against a probable stock market decline by buying gold futures.

This isn’t a guarantee, of course, but it is a hedged bet that may substantially reduce risk.

One problem with DASH practices, individually and collectively, is that they came to dominate modern financial activities.

Instead of fulfilling special, limited functions, they rapidly and excessively grew to a disproportionate percent of global financial activity.

Finally, they overshadowed more traditional and —some would say—legitimate financial activities, such as direct stock and bond trading.

A second problem with DASH activities is that they became dependent upon and driven by leveraging, which is a fancy word for debt.

Many institutions whose trades dealt in DASH activities did so with debt instruments carrying many times the presumed (often optimistic) value of the underlying cash, stocks, bonds, mortgages or other instruments of value.

In some cases, the leverage factor was ten, twenty or forty times the underlying value as assessed with acceptable practices.

The enormous role that leveraging played in DASH activities was no different than the role of debt in the real estate market, where loans far in excess of rationally derived value became commonplace.

At an individual level, families were incurring massive debts for ever-larger, more expensive vehicles and mountainous credit card debt with little thought to consequences, much less saving or investing.

Debt incurred as DASH and inflated real estate and expensive consumer credit is Fluffy Money.

Little real equity (sometimes just 1/40th of the presumed value of DASH instruments) and highly leveraged and unrealistic debt across the board were the building blocks for a worldwide financial house of cards.

It took the collapse of just one sector—the housing bubble—to begin the collapse of the entire Fluffy Money pyramid.

Author Note: Harold Mansfield was born in Fort Collins, Colo. After serving in the U.S. Army, he graduated from Colorado State University in 1958. He received his Ph.D. from the University of Denver in 1974. In 1993 he retired from Fort Lewis College, where he taught psychology, statistics and writing for 18 years.

In addition to fiction writing, part of his retirement regimen includes researching, thinking through and writing about critical contemporary social issues.

After a “lifetime” in Colorado, including 31 years in Durango, he moved to Green Valley in 2005.

Some of his writings have appeared in The Durango Herald, Solar Age Magazine, crimemagazine,com and Crossroads: A Journal of the Southwest.