Blindsided by the Economy?

In a wide sweeping interview, here is how Dick Cheney characterized the downturn in the economy.

Vice President Dick Cheney says that his boss, President George W. Bush, has no need to apologize to the American people for not doing more to head off the financial calamity, saying no one saw the crisis coming.

Now, Cheney is not the first government official to be "blindsided" by the negative turn in the economy. Whenever I hear someone say this, I am reminded of Casablanca in which people were "shocked to find gambling at Rick's".

If the government was blindsided by the downturn of the economy, maybe one should ask which particular warning sign they missed.

At the beginning of 2007, the entire niche of sub prime collapsed. Over the next several months dozens of banks like New Century, First Franklin, and Argent all failed. Several of these institutions were owned by larger financial institutions like First Franklin which was owned by Merrill Lynch. In August, Alt A began to collapse and with it the entire housing market. Now, companies like Greenpoint, First Magnus, and Indymac all collapsed as well. Many of these were also owned by larger financial institutions like Greenpoint which was owned by Capital One.

By September of 2007, Ben Bernanke began a series of rate cuts that continue today. Since the beginning of last year, our economy has consistently lost jobs. In March of 2008, Bear Stearns nearly collapsed and it was only saved through an unprecedented incursion into the market by the Fed. By July, both Fannie Mae and Freddie Mac also collapsed and needed to be bailed out.

Now, Dick Cheney can look a reporter in the eye and proclaim that he was blindsided by the downturn in the economy. Blindsided by what I might ask. If he didn't see the signs, exactly what was he paying attention to. The grim economic news was right in front of Cheney et al, and he simply didn't recognize it.

Free Markets and Lehman Brothers

What if I told you that there is a segment of real estate that is booming right now? I bet you would tell me I was crazy. You would be wrong. If you buy, sell, or market foreclosed properties, business is very good for you. Furthermore, since it is difficult to qualify for a loan, there are more renters. As such, if you are a landlord business is also better for you. Furthermore, the shock to the market has sent interest rates way down. As such, if you are an excellent borrower and you've made your payments on time, this financial crisis may very well reward you with better loan terms. That is the nature of these so called crises. For every loser, there is someone on the other side that is the big winner. Lot's of people lost big on October 29th, 1929, however a few smart folks won big when they invested on October 30th, 1929. In many ways markets can be a zero sum game, not always but it can. For every boneheaded move that is punished there is an equally astute move that is rewarded.

In the same manner, much the same is happening in the aftermath of the collapse of Lehman Brothers, Merrill Lynch, and AIG. All three made foolish gambles and they are paying for it. Bank of America, on the other hand, has swooped in a shrewd and heartless manner and picked up the pieces of Merrill Lynch at a significantly reduced rate. That's what happens in any capitalistic market. Stupidity is punished and shrewdness rewarded. That's why I am troubled that the politicians on both sides are proclaiming the system broken. Far from it, the system is performing exactly as it was designed to perform.

The silly calls from both sides of the aisle today are cynical at best and downright naive at worst. Both sides are calling for reform, transparency, and accountability. Last I checked having to file for bankruptcy is being held accountable. Those politicians that complain that we don't have enough transparency are themselves being totally misleading. It wasn't that these transactions weren't transparent. Rather that these financial vehicles are the financial world's equivalent of rocket science. It doesn't much matter how transparent the transaction is if no one outside the investment bankers that put it together have any idea what any of it means. Yet, the familiar call of reform is uttered each and everytime the markets are shaken, as though capitalism and markets have ever guaranteed that there will never be financial stress.

I, myself, can save all the politicians months of analysis and I will tell them exactly why Merrill Lynch, AIG, and Lehman are in such trouble. It is because of greed, recklessness, stupidity and carelessness. Unfortunately, there is no government regulation that can guard against those human failings. You can't unfortunately regulate stupidity. As the GEICO commercial goes, I do have good news. There is in fact a force that can regulate and punish all those human failings and that force is the market itself. That's exactly what the market did with its swift hammer when it forced Lehman into bankruptcy and Merrill Lynch into accepting a very unfavorable buy out offer. Just as quickly as it punished their irresponsible behavior it rewarded the shrewd behavior of Bank of America as they bought out Merrill Lynch at a favorable rate.

The same dynamic would have taken place if the politicians had stayed away from trying to fix things when the mortgage crisis hit. For every borrower that would have been foreclosed on there would have been a shrewd shark on the other side buying that very property at a reduced price. Once again, the market would have punished irresponsible behavior and rewarded shrewd behavior. Of course, there is no political capital in supporting the behavior of the vultures that swoop in to buy foreclosed properties and so the politicians couldn't simply stand by and let the market dynamics punish those that deserved punishment reward those that deserved reward. Instead, they stepped in and offered a lifeline to borrowers that deserved no such thing. Instead, borrowers who became late on their mortgages will now be rewarded with mortgages they would never get in the open market. Meantime, borrowers that are on time are stuck with the same mortgages they had. Furthermore, banks stuck with mortgages they couldn't sell themselves in the open market will be able to sell them to the federal government at inflated values.

This is the sort of "reform" we can look forward to if either side actually follows through on some of these same campaign promises. For instance, both sides have already taken to attacking an easy target, CEO's of failed banks. Both sides are promising to end the practice of fat CEO bonuses for CEO's that preside over failure. Now, I am no less appalled at the likes of Angelo Mozillo getting tens of millions while Countrywide failed than anyone else. That said, exactly how will the federal government insure that CEO's don't walk away with millions while the company fails? Will the Congress create a committee to examine all CEO packages? Will the Congress create a committee to approve all CEO bonuses? While I agree that it is obscene to allow CEO's to make millions while companies fail, isn't that ultimately the discretion of the board not the government?

All reforms come with unintended consequences. For instance, to manage future risk the feds could once again limit the finanical activities that banks can engage in. That would mean that banks that hold your checking account wouldn't also be allowed to hold your mortgage or your investments. Of course, if you feel comfortable handling all your financial transactions at one place, the government would make sure that is no longer an option. Frankly, what sort of "accountability" can the federal government provide that a bankruptcy and a defensive merger didn't provide? Wasn't it the market itself that held bad borrowers, irresponsible banks, and irresponsible financial services companies accountable for their actions? Will the Federal Government now sit in on merger and acquisitions meetings and approve all financial mergers?

That's the nature of the market. Industries evolve and adapt. Companies need to evolve and adapt with them. Companies that fail go away, and companies that perform shrewdly thrive. We no longer have the likes of RCA, Texas Instruments, Commodore, or the blacksmith, however I don't remember anyone demanding accoutability, transparency and reform when those institutions failed. Just because some financial services companies have failed doesn't mean the industry will. The industry will not only survive this but live to see the day when it will thrive through this, unless that is if the government follows through on their insistence for accountability, transparency, and reform. Then, it is just very possible that the government will insure that financial services will be impossible to conduct.

Lehman Brothers and the Free Market

What if I told you that there is a segment of real estate that is booming right now? I bet you would tell me I was crazy. You would be wrong. If you buy, sell, or market foreclosed properties, business is very good for you. Furthermore, since it is difficult to qualify for a loan, there are more renters. As such, if you are a landlord business is also better for you. Furthermore, the shock to the market has sent interest rates way down. As such, if you are an excellent borrower and you've made your payments on time, this financial crisis may very well reward you with better loan terms. That is the nature of these so called crises. For every loser, there is someone on the other side that is the big winner. Lot's of people lost big on October 29th, 1929, however a few smart folks won big when they invested on October 30th, 1929. In many ways markets can be a zero sum game, not always but it can. For every boneheaded move that is punished there is an equally astute move that is rewarded.

In the same manner, much the same is happening in the aftermath of the collapse of Lehman Brothers, Merrill Lynch, and AIG. All three made foolish gambles and they are paying for it. Bank of America, on the other hand, has swooped in a shrewd and heartless manner and picked up the pieces of Merrill Lynch at a significantly reduced rate. That's what happens in any capitalistic market. Stupidity is punished and shrewdness rewarded. That's why I am troubled that the politicians on both sides are proclaiming the system broken. Far from it, the system is performing exactly as it was designed to perform.

The silly calls from both sides of the aisle today are cynical at best and downright naive at worst. Both sides are calling for reform, transparency, and accountability. Last I checked having to file for bankruptcy is being held accountable. Those politicians that complain that we don't have enough transparency are themselves being totally misleading. It wasn't that these transactions weren't transparent. Rather that these financial vehicles are the financial world's equivalent of rocket science. It doesn't much matter how transparent the transaction is if no one outside the investment bankers that put it together have any idea what any of it means. Yet, the familiar call of reform is uttered each and everytime the markets are shaken, as though capitalism and markets have ever guaranteed that there will never be financial stress.

I, myself, can save all the politicians months of analysis and I will tell them exactly why Merrill Lynch, AIG, and Lehman are in such trouble. It is because of greed, recklessness, stupidity and carelessness. Unfortunately, there is no government regulation that can guard against those human failings. You can't unfortunately regulate stupidity. As the GEICO commercial goes, I do have good news. There is in fact a force that can regulate and punish all those human failings and that force is the market itself. That's exactly what the market did with its swift hammer when it forced Lehman into bankruptcy and Merrill Lynch into accepting a very unfavorable buy out offer. Just as quickly as it punished their irresponsible behavior it rewarded the shrewd behavior of Bank of America as they bought out Merrill Lynch at a favorable rate.

The same dynamic would have taken place if the politicians had stayed away from trying to fix things when the mortgage crisis hit. For every borrower that would have been foreclosed on there would have been a shrewd shark on the other side buying that very property at a reduced price. Once again, the market would have punished irresponsible behavior and rewarded shrewd behavior. Of course, there is no political capital in supporting the behavior of the vultures that swoop in to buy foreclosed properties and so the politicians couldn't simply stand by and let the market dynamics punish those that deserved punishment reward those that deserved reward. Instead, they stepped in and offered a lifeline to borrowers that deserved no such thing. Instead, borrowers who became late on their mortgages will now be rewarded with mortgages they would never get in the open market. Meantime, borrowers that are on time are stuck with the same mortgages they had. Furthermore, banks stuck with mortgages they couldn't sell themselves in the open market will be able to sell them to the federal government at inflated values.

This is the sort of "reform" we can look forward to if either side actually follows through on some of these same campaign promises. For instance, both sides have already taken to attacking an easy target, CEO's of failed banks. Both sides are promising to end the practice of fat CEO bonuses for CEO's that preside over failure. Now, I am no less appalled at the likes of Angelo Mozillo getting tens of millions while Countrywide failed than anyone else. That said, exactly how will the federal government insure that CEO's don't walk away with millions while the company fails? Will the Congress create a committee to examine all CEO packages? Will the Congress create a committee to approve all CEO bonuses? While I agree that it is obscene to allow CEO's to make millions while companies fail, isn't that ultimately the discretion of the board not the government?

All reforms come with unintended consequences. For instance, to manage future risk the feds could once again limit the finanical activities that banks can engage in. That would mean that banks that hold your checking account wouldn't also be allowed to hold your mortgage or your investments. Of course, if you feel comfortable handling all your financial transactions at one place, the government would make sure that is no longer an option. Frankly, what sort of "accountability" can the federal government provide that a bankruptcy and a defensive merger didn't provide? Wasn't it the market itself that held bad borrowers, irresponsible banks, and irresponsible financial services companies accountable for their actions? Will the Federal Government now sit in on merger and acquisitions meetings and approve all financial mergers?

That's the nature of the market. Industries evolve and adapt. Companies need to evolve and adapt with them. Companies that fail go away, and companies that perform shrewdly thrive. We no longer have the likes of RCA, Texas Instruments, Commodore, or the blacksmith, however I don't remember anyone demanding accoutability, transparency and reform when those institutions failed. Just because some financial services companies have failed doesn't mean the industry will. The industry will not only survive this but live to see the day when it will thrive through this, unless that is if the government follows through on their insistence for accountability, transparency, and reform. Then, it is just very possible that the government will insure that financial services will be impossible to conduct.

The Tragic Fall of Merrill Lynch

When I was a stock broker in the late 1990's Merrill Lynch was one of a select few of investment firms along with Goldman Sachs, Paine Webber, Morgan Stanley, and a few others that made up the gold standard of investment firms. Today, their existence was put to a merciful end when Bank of America agreed to buy it out.

Bank of America on Monday began adding another slice to its growing financialservices empire, buying Merrill Lynch in a $50 billion deal that would create a bank offering everything from fixed-income trading to credit card lending.

It will rival Citigroup Inc., the biggest U.S. bank in terms of assets.

Bank of America Corp. said early Monday it would acquire Merrill Lynch in an all-stock transaction worth about $50 billion that should lift the uncertainty shrouding Merrill since the start of the credit crisis over a year ago.

A few weeks ago, we knew trouble was brewing when Merrill dumped billions worth of mortgages at an obscenely low price.

Merrill has agreed to sell $30.6 billion of its repackaged debt, known as collateralized debt obligations — generally suspect and subprime mortgages — for 22 cents on the dollar. Private equity fund Lone Star Funds is the buyer.

So, how did this once financial giant suffer such a monumental fall? The story of Merrill Lynch's downfall is embedded in one of the worst acquisition strategies in the history of mergers and acquisitions. In September of 2006, Merrill Lynch bought up First Franklin..

Merrill Lynch (NYSE: MER) today announced an agreement to acquire the First
Franklin mortgage origination franchise and related servicing platform from National City Corporation (NYSE: NCC). Under terms of the agreement, Merrill Lynch will pay a $1.3 billion purchase price for San Jose, Calif.-based First Franklin Financial Corporation, and affiliated business units National City Home Loan Services, Inc., and NationPoint.

First Franklin is one of the nation's leading originators of non-prime residential mortgage loans through a wholesale network. Lake Forest, Calif.-based NationPoint is engaged in online direct-to-consumer mortgage lending. First Franklin and NationPoint together originated more than $29 billion in loans in 2005. Home Loan Services, headquartered in Pittsburgh, together with Merrill Lynch's existing Beaverton, Ore.-based Wilshire Credit Corporation servicing platform, will have a total servicing portfolio of approximately $70 billion.

"These leading mortgage origination and servicing franchises will add scale to our platform and create meaningful synergies with our securitization and trading operations," said Dow Kim, president of Merrill Lynch's Global Markets & Investment Banking Group. "This transaction accelerates our vertical integration in mortgages, complementing the three other acquisitions we have made in this area and enhancing our ability to drive growth and returns. We look forward to working with the experienced teams at these companies to serve their clients and leverage our broad range of mortgage products and services."

What sounded like a good idea, and clearly from this story it did, turned out to be an unmitigated disaster. First Franklin was one of the giants of the sub prime industry. At the time, sub prime was still in period of boom. At about the same time, Merrill Lynch also took exposure in UK sub prime mortgage company Freedom Mortgage. In fact, Merrill Lynch made acquisitions in no less than four different four sub prime companies. Suddenly, sub prime, which the company had limited if any exposure to for nearly one hundred years, became their huge bet. It took no more than six months for the sub prime industry to tank. Merrill Lynch, which paid top dollar for First Franklin et al, was now suddenly stuck with billions worth of loans that weren't performing. (in other words people weren't paying them back)

Suddenly, these multi billion dollar acquisition became an albatross around the necks of Merrill Lynch. Suddenly, this multi billion dollar financial services company became at the mercy of a business that it made a full court press into not but a year earlier. In fact, the solvency of the entire company became threatened almost exclusively because it held onto billions of non performing loans. These loans were put on their books courtesy of their acquisition of First Franklin, Freedom, and others within the last couple years. It was this very pack mentality that ultimately cost Merrill Lynch. The rest of the financial services market appeared to be making money hand over fist in sub prime mortgages. The powers that be at Merrill Lynch wanted a piece. Suddenly, they were in a business in which they had no expertise, and the acquisitions that they made only a couple years earlier, ultimately lead to its downfall.

Monday Bloody Monday

That's the only way to describe the economic hurricane to hit Wall Street this morning. Lehman Brothers is filing for Chapter 11. Merrill Lynch is being bought out by Bank of America for half what it was worth a year ago. Finally, AIG is on the bring of destruction and looking for financing.

First, this latest hurricane of bad news on Wall Street should indict the current Federal Reserve policy. I was weary of the Fed's aggressive action in saving Bear Stearns from financial disaster. At the time, the Fed not only acted as the Federal Reserve and opened up its coffers to back the deal. The Fed also acted as an investment banker and a rainmaker. It brought Bear Stearns and JP Morgan together. It negotiated the deal, and it even extended a line to make sure the deal went through. Most troubling of all, the Fed forced this deal on both sides over a weekend when it would normally take many months to negotiate something like this. This was all done under the assumption that 1) Bear Stearns' failure would be too much of a shock to the markets to allow and 2) this would not become something the Fed would do regularly.

These assumptions only worked if Bear Stearns was a unique situation. Clearly that was a faulty assumption. Here is how my colleague Francis Cianfrocca at Redstate described it.

As I described here, this is the weekend that the Treasury and the Federal Reserve decided to stop bailing everyone out. Secretary Paulson has been hinting for weeks now that we have to let capitalism work the way God intended it to. Which means: if you screw up, you die.

This is what we free-market conservatives have been saying we wanted all along, folks. We'll be getting a chance to eat our own dog food. On balance, I have to say it's a good thing... I hope.We are now going to see the unwinding of the 158-year-old broker-dealer Lehman Brothers.

The regulators are going to try this another way, and they decided to let Lehman die without the benefit of an overt and specific public bailout, as had been the case with Bear Stearns and Fannie Mae/Freddie Mac.

Unfortunately, responding to financial crisis is not the sort of thing we can try through trial and error. I am not privvy to private correspondence but I'd be willing to bet the powers that be at Lehman saw what the Feds did for Bear Stearns and expected the same for them. Now then, the time for serious criticism is later. More important for now is what the immediate future holds. Francis picks that up.

The Federal Reserve did announce last night that its various emergency-liquidity facilities would be significantly broadened and expanded in scope. If you're so inclined (and I am), you can consider this another kind of bailout. But the Treasury and the Fed both refused to give Wall Street what the latter were looking for, which is an explicit public guarantee of Lehman's distressed assets. It's a completely new chapter in the Panic of 2007. (And 2008. And 200...)

Whether Lehman's assets and trading positions are liquidated in an orderly or disorderly fashion will determine the tone of the next few weeks in financial markets.

The only bright side here might be that Bank of America is acting like the vulture we need in order to facillitate a recovery. After sweeping in to buy out Countrywide, they are now eating up the remains of Merrill Lynch, though of course, that was a terribly corrupt deal. (the Countrywide buyout that is) While all of this is going on, some so called experts are adding fuel to the fire (H/T to Hot Air)

Christopher Whalen, managing director of Institutional Risk Analytics, a research firm, predicts that approximately 110 banks with $850 billion in assets could close by next July. That's out of 8,400 federally insured institutions, he said, which together hold $13 trillion in assets. Individual customers are starting to get nervous about the financial health of their banks for the first time in generations, he said. Whalen's firm analyzes the safety and soundness of banks for business clients, but began receiving inquiries from individuals in the past two months for the first time, he said.

"If we don't get ahead of this, we are going to face a run on the retail banks by election day," he said.

AP Business Writers Madlen Read, Tim Paradis and Stephen Bernard in New York, Martin Crutsinger in Washington, Ieva Augstums in Charlotte and Michael Liedtke in San Francisco contributed to this report.

Now, before anyone runs out and withdraws all their cash, just keep in mind most accounts are insured up to 100k. This sort of nebulous and cryptic fear mongering is the worst kind of thing at a time like this. Without offering anything concrete, this analyst says that "some customers are getting nervous" and if we don't get out "front there will be a run on banks". That is the sort of irresponsible statement that sets off a panic where there wasn't one.

I, for one, think this may wind up being a good thing in the end. Think about what is happening now as some sort of cleansing. It's like the financial equivalent of one of those teas you can buy at GNC that cleanses the body of all of its toxins. The financial market has lots of toxins in the form of bad loans. Now, all the banks and other financial institutions that hold onto these need to be removed and only leave those that didn't get too weighted in said loans. That's what is happening today. Keep in mind that these teas make you need to go to the washroom over and over when you take one, but you wind up feeling better days and weeks later. The same thing can happen now if we all let the market do what it does, and no one panics.

Merrill's Mortgages and the Corrupt Dodd/Frank Bill

Those that support the $300 billion bailout created by the Dodd/Frank have justified the bill using two faulty premises. Supporters of the bill refuse to call it a bailout for two reasons.

1) They claim that while borrowers will get new more affordable loans, these borrowers will now have to share their equity with FHA. While this is true, it is also misleading. That's because these borrowers almost always have no equity currently. Let's take an example. Let's say we have a borrower that owes $300,000 on a property worth $250,000. This bill will lower their balance to somewhere in the neighborhood of $225,000. Now, they will have $25,000 in equity but when they sell they will have to split that equity with FHA itself. Of course, this is nothing short of a boondoggle for any borrower that has been irresponsible. Sure, they now only own fifty percent of their equity, but fifty percent of something is still more than one hundred percent of nothing.

2) Banks will have to take a write down on their mortgages. That's true. In this same example, a bank would have to sell their $300,000 mortgage and only get $225,000 back. This may at first appear to be punitive. Yet, let's look what is happening to Merril Lynch's mortgage portfolio.

Yet the investment bank posted a $4.9 billion loss just two weeks ago, in a quarter in which it revealed $9 billion in writedowns.

Merrill has agreed to sell $30.6 billion of its repackaged debt, known as collateralized debt obligations — generally suspect and subprime mortgages — for 22 cents on the dollar. Private equity fund Lone Star Funds is the buyer.

Now, it should be pointed out that Merrill's case is extreme and so other banks would likely get more in the open market. That said, the difference between what they will get from FHA and what Merrill got from the market is quite significant and thus there is no doubt that FHA will offer all these banks, Countrywide and BofA included, a deal they would never get on their own.

As I have often pointed out, Bank of America received a very depressed price when they bought out Countrywide. That's because Countrywide was also holding on to a large portfolio of loans. These loans would also likely get a similar price on the open market to that of the Merrill Lynch backed mortgages. Now that Dodd/Frank has passed, the new entity will likely receive somewhere in the neighborhood of 3 times for these loans over what they would have received in the open market.

This is the sum total of this corrupt bill. Both the borrowers and the banks are receiving treatment we are NOT supposed to give to folks that act irresponsibly.