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Why should you bother to read this…

October 1st, 2009 Leave a comment Go to comments

Dear Readers: this was a speech given to the
Womens’ Business Connection of Lamorinda last year and is my thoughts on the Credit Crunch…
What happened?
The Players:
Mortgage Brokers/ Underwriters
Securities Firms
Bond Rating Agencies
Insurance Companies
Investors: Hedge Funds, Banks, Foreign Investors, Pension Funds

The Milieu:

Real Estate market in a boom- properties overvalued, all parties assuming the market would continue to increase and I will be able to sell anything at a higher price than I
bought it for.

Interest Rates at historic lows. The assumption that Real Estate would continue to increase in value made Real Estate in any form, of any type attractive since interest
paid on bonds were historically low, and therefore unattractive.

Sequence of Events:
Mortgage Brokers/ Underwriters arranged loans to people who could not afford them, with terms ( ↑ interest rates / adjustable rates) that could not be met. Sold increasingly complex financial instruments to uneducated buyers without the financial means to meet the terms of the contract. Compensation of mortgage brokers structured to incentivize sales people to sell loans to anyone, regardless of creditworthiness.

Lack of financial sophistication of buyer
Ignoring credit guidelines in mortgage industry
Pernicious, predatory loans not disclosed
Securities Firms
Packaged loans that would not have performed (paid to term by buyers) if adequate due diligence had been performed – ignored riskiness of loans. Packaged these in large dollar denominations ( Collateralized Mortgage Obligations) and sold to buyers, while not telling buyers of the high risk.

Violation of Securities Act of 1933 to disclose risks to investors
Bond Rating Agencies
Gave good to excellent ratings on poor quality loans in order to sell to buyers. Conflict of interest in that the fees for rating the packaged loans were paid by the Securities Firms
the sellers), as part of a package deal. Did not exert due diligence in addressing the inherit risks of the loans ( poor quality credit of home buyers, expectation that RE values were unsupportable, liquidity of packages poor due to over abundance of Collateralized Mortgage Obligations). Buyers of CMOs duped as to low risk of investment.

Breech of fiduciary duty to exert due diligence in insuring integrity
of financial ratings
Failure to disclose conflicts of interest in compensation
Insurance Companies

AIG, the largest insurance company in the United States, sold Credit Default Swap insurance to insure to the buyers of Collateralized Mortgage Obligations that if the loans (CMO) were not paid, AIG would pay them. AIG’s mistakes were:
a. to not charge adequately for the inherent risk in the poor quality loans
b. to sell many more on the “short” ( there would be a default, versus there would not be a default) side than the “long” side. Ration 1.4 Trillion vs. 435 Million.
AIG did not charge enough to cover the possibility that the CMO they wrote would “go bad.” This is poor underwriting, and is typical of a soft insurance market. The fact they did not balance the risk in their own financial portfolio by either transferring this risk elsewhere ( sell it to someone else), or take a position in the Markets to make money if the Real Estate market collapsed and/or the loans did not perform was poor Risk Management. Not underwriting the risk of default by charging adequate $ to cover the possibility of failure
Portfolio unbalanced on macroeconomic assumptions and in extent of dollar risks.

Investors: Hedge Funds, Banks, Foreign Investors, Pension Funds

Purchased products CMO assuming they were risk-free, and that the Real Estate Market would continue to escalate. When mortgages went bad (failed to perform) the CMO which were large aggregations of loans that were packaged, they could not renegotiate the terms easily to “workout” a mortgage that would continue to perform AND PAY THEM. Buyers of homes could not meet the escalating interest rates, ands when the people who owned the loans (in many cases impossible to locate) could not be found to make the loan work at a more supportable rate THE BORROWER WALKED away from the Properties. This put pressure on prices (↓) causing Real Estate prices to fall further.
The Investors watching their computer screens across the World and all feeling that the sky was falling, sold their CMOs driving the prices down further. The Investors & Financial Institutions who purchased CDS to address the risk that the Real Estate Market might go down called AIG and tried to collect on their Policies. AIG had not collected enough money, nor balanced the risk. When everyone came to get paid AIG’s cash drawer ( Current Assets) was empty, bankruptcy was next. They (AIG) received $213,000,000,000.($213 Billion) from the Federal Reserve.

Lack of underwriting standards in investments
Result:

No one trusts anyone. Banks and financial institutions are not allowing individuals to use home equity/ credit cards, are increasing interest rates or cutting credit limits, not writing new loans or allowing anything to threaten THEIR financial security. The downturn in the Real Estate market has made consumers ( contractors, developers, suppliers, mortgage brokers) unable to buy the things they were buying when they felt secure and happy (cars & consumer goods). There is a lack of trust in the Financial Institutions, and a level of risk aversion on those who DO HAVE MONEY not to trust or lend to strangers.The Troubled Asset Relief Program (10/3) was passed to distribute $700,000,000,000.($700 Billion) to address the credit crisis.

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