Mortgage Backed Securities Put Our Financial System at Risk

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At least one person had something smart to say this week. Would you believe it, George W. Bush must have picked up the wrong speech on his way out of the door to the Capital. When he spoke on the debt crisis, his speechwriter actually seemed to know what he was talking about:

“First, how did our economy reach this point?

“Well, most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions – along with low interest rates – made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition – some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.

“Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit – combined with the faulty assumption that home values would continue to rise – led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

“Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected – along with mortgage payments they could not afford. As a result, many mortgage holders began to default.

“These widespread defaults had effects far beyond the housing market. See, in today’s mortgage industry, home loans are often packaged together, and converted into financial products called “mortgage backed securities.” These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

“The decline in the housing market set off a domino effect across our economy…”

Our president was on solid ground. He sounded as though he had been reading The Daily Reckoning, commented colleague Dan Denning. But then he stepped into the mush, claiming – along with everyone else – that a bailout is needed to put the economy back on its feet.

“Our entire economy is in danger,” said the chief executive.

And for once, the leader of the free world is correct. The U.S. economy is in serious danger.

*** New house sales plummeted to a 17-year low in August. But what was really shocking was the prices. We quote so we won’t be accused of making this up:

“The average price of a new home sold in August dropped by a record amount of 11.8% to $263,900 compared to the July average of $299,100.” In other words, if they keep falling for that rate for a year, they’ll be nearly worthless by next summer.

*** And a Dear Reader offers sound advice:

“In your Reckoning of 24th Sept 08 you wrote that in your dream you couldn’t exchange your gold coins. William Davies (one time editor of Punch ) wrote that when the chips are really down nobody wants gold, and as a native German living through the aftermath of the Second World War he knew this from personal experience. [Instead of gold] what constituted a viable currency…whisky and cigarettes. That chateau of yours, start filling the cellars now.”

There you have it, dear reader. When the chips are down…you need whiskey and cigarettes.

Bill Bonner
for The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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If not for the high leverage, many structured investment vehicles (SIVs) would indeed be secure. A legal problem for the banks is that they “forgot” to tell any of the investors about the leverage. As a consequence they will be sued for deceipt.

As Dan says, better transparency (rather than other forms of regulation) is what the market needs.

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