San Antonio student JerryHerrera makes the case for reading the  August 13, 2007 issue of Business Week, cover stories, Bonfire of the Builders.  This is of course by the way a play on words mimicing the title of what famous book about Wall Street?  Anyone know?  Hint it was fiction based on fact.  Anyway, get your hands on a copy of this issue and read  Builders.

I hope that all students are soaking in the actual financial meltdown of the markets that we are experiencing.  This is not what the economists on tv are saying, how can they be in such denial?  Because they have all bought into the idea that one invests for the long term. Well, if you go bankrupt tomorrow the long term lasts exactly 24 hours….just ask the folks at American Home Mortgage or New Century Mortgage, or holders of TRMP, not bankrupt yet, just down 75%.

Regrettably there is not course on financial history of markets.  I try to make up for that with this blog.  so here goes.

This of course is not the first financial crisis the US has undergone, nor will it be the last.  Capitalism is maarked by these upheavals. AFter the Crash  of 1929, one of the recommendations of a Blue Ribbon committee gathered to investigate the cause and prevention of another crash, made this suggesiton.

Do not allow stock trades to be made by telephone!  the thinking was that folks got too invovled in short term knee jerk panic reactions. If they actually had to physicallly stroll into the broker office it would require more effort and probably not as many would show up and therefore selling would not be as severe.  Well gee, what would that committee think of on line brokerage accounts where all one has to do is tap a key to trade?  That acceleration of trading has taken us to new heights DOW 14,000 and now is taking us back down even faster.

Another more profound suggestion that was made law was the Glass Stegall Act. This forbid commercial banks from participating in the stock brokerage or investment banking business. It turned out that many comercial banks had made 10% equity loans against stock.  Back then one could borrow 90% of the value of the stock.  So it only took a 10% decline to wipe out all the equity and then we were both broke.  This is essentially what the new hedge funds have done but more on that in the next post.

Notably your great political hero Phil Gramm removed Glass Stegall in 1998 as he left office so greedy were the commercial banks to play the stock game,  The end of course came a scant two years later with the dot.com crash, anyone heard from Phil lately. Oh Phil was of course an economist who taught at A & M…..

Now some definitions to help you understand all this.

Commercial bank – designed to handle checking and savings accounts, makes personal and commercial loans to indificuals and business,example, Regions, Guaranty, Sterling are all independent banks,
CITI, Wells Fargo, J P Morgan Chase are multi national money center banks who have spread into other quarters, to say the least thanks to our departing Senator Phil

Investmet bank An invesment bank underwites new issues of stocks and bonds, ie, it takes companies public and raises money for them.   They act as an intermediary between the investing public  (otherwise known as pigeons, lambs led to the slaughter, easy  marks, etc.) They will organize and underwriting syndicate (notice the similarity to the mob term syndicate?) to sell the securities to the pigeons, er public.  This also consists of determining the perfect price at which to offer the stock.  And so the money is raised from the public or buyers and passed on to the issuer less of course a generous underwriting fee and  selling commissions.  This also involves registering the securities and getting approval from the SEC.  The three largest investment banks are Merril Lynch, Goldman Sachs, and Morgan Stanley.  Smaller examples include folks like  A G Edwards. Edward Jones or Stifel Nicolaus, all of St. Louis.  Lehman Brothers and Bear Stearns are in this group, at least as long as they manage to stay in businesjs. 

Merchant Banks Not content with merely underwriitng these guys want to make even more money. This idea originated long ago in Europe with folks like  the Rothschilds.   The idea here is that the firm will act as both a commercial and investment bank, originating financing adn loaning the money on an interim basis. This is what Bear Stearns has been doing in its hedge funds. BS loans the money to builders having raised it in the hedge fund. It then collects interest with the idea of rolling all the loans into a saleable package to sell to the public as in income investment.  Ivan Boesky in his heyday, see
Den  of Theives. claimed to be a Merchant  Banker in this fine old tradition. He was of course a complete fraud trading on insider information.

Now  the trick of course is rather like the old joke about handling the hot horseshoe out of the fire, you don’t want to hold it long.  Ever more greedy, hedge funds borrowed as much as ten times their loans to brokers to make the loan.  That enabled them to make ever larger loans, remember we are working on a percentage commission here.  This is fine as long as you can re package theses things and sell the to an often unsuspecting public.  The name of one of the funds says it all- High Grade Structured Credit Strategies Fund.  Well it was structured all right…..But once fear sets in and one cannot sell this to someone else, a vicious downward sprial ensues. The homeowners first and then the builders cannot make the higher payments required by the variable rate loans. Then the value of the loan or collateral goes down.  And if one is leveraged ten to one, remember our bankers in the 1929 crash, we only have to exeperience a 10% decrese in value to have a 10 x 10% = 100% loss of value.

This has also happened to the hedge fund Cerebrus that bought Chrysler though they are not guilty of this kind of pyramiding.  Cerebrus intended on selling shares or bonds to the public to finance the purchase, now no one wants to lend them the money, at least not at these interest rates. Why not? 

Because there are three emotions that govern markets, Hope Fear Greed. Guess which one just reared its ugly head?

Okay, class dismissed for now, more later.

I talk a lot about design and its importantce. This is a great interview about innovation versus six sigma.
Please read it, we will be discussing six sigma this semester in the cost class.  Six sigma is all about maintaining quality of a known quantity, how we build a car, how we do eye surgery, how we register students. But  the person inteviewed makes the point that change never comes from the center, it comes from the periphery. Thing about the spacecraft that won the prize for achieving the edge of space.

It has portholes for a windshield because they don’t require as stong a piece as one windshield
No one wore a spacesuit, the pilot was my age and wore a t shirt and and a ball cap
They did it all for $20 M, a remarkable accomplishment.

Look back on my blog where I discuss simple cars like the Renault Logan.

Innovation is coming in India, France, China, not in Detroit. Think outside the box as they say.

A stated purpose of this blog is to relate what we study in class to real world events. Well it gets no more real world than what is happening to Bear Stearns. We have chronicled and predicted the fallout in the mortgage market for some time here. Now after only two or three months of real fall out, there is already talk that this firm may be taken over by someone else. 

Read about Bad News Bear here.  Can you identify all the terms used in the article, that is also part of the reason for the blog.  For example, what is a bridge loan? 

A bridge loan is a form of intermediate financing until a more permanent long term loan can be secured. Here Bear Stearns made the loans themselves thinking they would earn the interest and then roll the loan to someone else. Wrong, now that the debt markets are essentially closed, which is to say lenders are wary of taking on any new debt, BS ( now is that a great abbreviation for these guys or what) is stuck with the loan. 

The article mentions that BS (gee I love that, this is fun) has $73 billion of debt and equity to hedge against losses. What does that mean?  It means that BS could write off loan losses or any other loss as long as it has capital to write them off against.  BS has $15 B in cash but how long will that last?  What does it mean when the article suggests that investors may want some of the 30% collapse in the stock price back?  It means that unless BS can show they are actually doing something to restore confidence, there is not likely to be any.

And among the possible suitors, I found myself wondering hey, these guys all have the same potential problems, who wants more of the same and tomorrow any of them, like Lehman, could be in the same shape, Egads!

You can read in BS own words about how they really are experts in this sort of thing  Odd their web site does not mention any of the things we have discussed here……

Meanwhile last Friday  Central Banks dumped money into the system.   Does this ease investor fears or sound the alarm that indeed something could be very very wrong in deed.  An old saying in financial circles is that when firms or governments are attempting things too little too late it is a bit like re arranging the deck chairs on the Titanic in the honest belief that will cause the ship to miss the iceberg. I am already spotting this reference in some of these articles.

A Bush adviser has actually suggested  re instituting the military draft.    For some history on this click  Kathy Gill’s column.   The minimum age has always been about 18. The maximum age has varied  with demand. During WW II it got as high as 45!  My recollection is that the last time during Viet Nam it went up to about 32-34.  There are numerous problems with a draft as the military learned during  Viet Nam.

The military normally needs about 200,000 folks a year  to join various branches.  But millions of folks turn 18. who to pick, and that is where the discrimination comes in , clearly most won’t be picked.  As for suggestions that everyone have to do something, well, this would require a gigantic  Depression Era type work program. And about the time folks got trained to do whatever they would probably finish their two to three year requirement.  This is a particular problem with a military draft. One reason so many died as soldiers and sailors in WW II, they simply did not know what they were doing, inadequate training. 

Oh I am sure you ladies will want to thank feminists and particularly now retired Patsy Schreoder D Colorado who insisted that women be admitted to all branches of the service and in fighting capacities.   I mean if women were not included in a new draft, would that be discriminatory?

Your thoughts?

Let’s back up and let me give you some basics to better understand what happened in the real estate market.  Traditionally a home was sold as follows.  The buyer would be required to put up a down payment toward the purchase, once upon a time this was about 20%. That cash payment did at least two things.  First it gave the home buyer a stake in the transaction. That amount of money was probably his or her largest financical commitment, something they would not likely walk away from. It was an amount such that they would probably do almost anything to preserve the investment and keep the house and not lose that down payment.  Second, it gave the lender some wiggle room.  For example, the buyer puts down $20,000 on a $100,000 home.  Now stop and think.  Suppose for whatever reason the region in which the home is built suffers economic setback, say  the Permian Basin which is a single idustry economy, oil, and the price of oil drops drastically. People lose jobs, many put homes up for sale, there are few to no buyers, home prices plummet.  Now suppose the home is worth $80,000 or even $70,000.  Is our buyer likely to sell the house and lose his down payment of $20,000, ie, the sale price would equal or barely equal the debt against it.  Not likely, more likely the kids get paper routes, the parents take second jobs, whatever, to keep from losing the house and their $20,000.

Now fast forward to 9/00.  After the attack the stock market plunges and America is uncertain about whether to even board an airplane. Clearly this would accomplish the attackers’ goals and really slow the economy.  The only blunt edged weapon available to the Fed Govt is to lower interest rates which it does.  While this does nothing to encourage one to board an airplane, it causes the home builders to go beserk.  Now here is something else about traditional home buying.  Basically your home payment should not be more than say 30% of your net take home cash paycheck. The reason is that the lender wants  the buyer to be able to make the payment and maintain a living standard, put food on the table for example. 

And so, if the mortgage rates are say 7%, and your take home pay is fixed at $2,000 per month, you qualify for a payment of say 2000 x .3 = $600.  Now  if the mortgage rate drops, that 600 bucks will qualify you for a more expensive home as the payment of $600 will make a payment on a  larger home if the rates drop. 

Example

$80,000 x 7% = $560

$160,000 x 3.5% = $560

So the magic of lowering interest rates means that the same payment buys twice the house. 
Wow, are the home builders and lenders thrilled.  Why, because the more house they build and sell the more they all make!  Whoppeeeee!  And so appraisers continue to appraise property higher and higher so the value of the homes goes up and up and wow are the property tax people at the cities thrilled, as property taxes based on appraised value are going up.

Everyone is clearly getting financially drunk so to speak at this party until, you guessed it, rates go the other way.  If our buyer got a variable rate mortgage, his rate could conceivably go back to 7% from 3.5%, ouch, now the payment has doubled.  And if the buyers cannot make the payments, everyone is under water.

But it was much much worse.  Giddy from the excitement of all this, lenders cast aside traditional conservative lending practices.  They talked old folks into re financing their homes on variable rates.  They talke apartment dwellers with no savings into zero down mortgages, that’s right no equity, te entire amount is financed. What is wrong with that concept?  Easy, the buyer has zip nada to lose. And so the buyer just leaves the keys on the lenders desk, suddenly there are entire neighborhoods with no equity and no one to buy.

But it was worse than that!  How you say?  Lenders went beyone that and made zero down interest only loans. Yep, the buyer is paying nothing on the principal, just interest.  These are nothing more than casino bets that housing prices will always go up or at least stay the same. 

Now, are you still with me, how do I cleverly tie all this up and relate it to accouting.  Glad you asked.

How then do we value the mortgage on the blanace sheet  of lenders with zero down no principal mortgages.  The mortgage value is there all right but the collateral is not, it is dropping as soon as the person moves out of t he house.  If there is no collateral is the mortgage worth what we say it is?  No it is not and that is when the mortgage company becomes the equivalent of Wiley Coyote who has run off the cliff to find nothing under him but air.  Wiley like the mortgage companies, drops to his doom. In the catoon of course, Wiley magically returns in the next segment, American Home Lenders and others of course do nt, they are history.

Now, the debts however are still arounnd. What to do, all debts must be paied, whether thru banktruptcy  or whatever. In bankruptcy, the mortgage company goes banktupt. The trustee takes the collateral the homes and puts them up for auction. Now we will find out what they are really worth.  But wait, do you really want to try to sell a house into a non existent market, ie, the air under Wiley?  No and this is why the Federal Govt FED bought $38 B  of worthless mortgages on Friday, to try to bolster the markets.

But in reality there is never enough money for a Hillary style bailout which she has already proposed.  The market will have to go where it needs to go to find equilibrium.

Did that help?

IT is of course common for the accused in this country to gather the best lawyers (read most creative and imaginative)  to mount a defense.  Now comes this story from China about Corporate Hari Kari.   Cosidering it was the fault of the paint supplier, this is a rather amazing choice of actions.  In short the head of the Chinese company that made toys for Mattle ex[eroemced a reca;; pf  hundreds of thousands  toys due to defective paint.  The paints was supplied by friend of his. 

Now contrast that story with this one, a genuine tragedy, about a teen that killed four friends whle joyriding.   Attempting to ‘catch some air’ the teen smashed the stolen car in which they were riding into a parked train.  All four of his companions were killed.  Now the good part, his attorney, Richard Racehorse Haynes, blames the accident on a the fact that the train was parked at an unlit crossing for thirty four minutes, oh, yes, at 4 AM in the morning when the teens were joyriding in the stolen car. It was the second car the driver had stolen that evening. 

A considerably different choice of actions eh?

Well here is a site I will have to add to Helpful Websites, brainy quotes.  It is handily categorized by authors and subject.  Click and give it a whirl, here are a few classics by John Ruskin.

Eudcation is the leading of human souls to what is best, and making what is best out of them. 
I would add, to what is best for them.

Modern Travelling is not travelling at all; it is merely being sent to a place and very littel different from becoming a parcel.
Ruskin lived from the early 1800s to 1900 by the way. What would he think of air travel?

There is hardly anything in the world that some man cannot make a little worse and sell a little cheaper, and the people who consider price only are this man’s lawful prey.

When  a man is wrapped up in himself, he makes a pretty small package.

This Sunday DMN reports that one person  has been sentenced to one year for charging some $450,000 on her credit card.  A second person will be tried in Sept.  Nine to eighteen people have been disciplined.

Notably these two are lower level secretary types.  Accountability, no one in charge, who approved these payments,  hundreds are apparently stil on the payroll that did the same things  but to a lesser degree? 

Anyone care to sound off on what this says about the tone of the organization?

I had some Ford bonds but sold them afer reading so many articles that suggested in reality the Ford balance sheet has no value.  As of this monring reading this article by the new CEO of Ford , I am really worred about  the company, but glad I sold anyway.

Alan  Mulally says that we the US shold consider a European gasoline tax. Now understand that gasoline is now $7-8 in Europe. Over half the price is tax to the government.   Would that price  affect your drive to school?

What is he thinking?  The two vehicles that Ford still sells well are the gas guzzling Ford Piclups and the Mustang, never heralded as an economy car, let’s face it.  When asked if he endorsed a gas tax, he said er ah well ahm.

And to think this guy was Number Two at Boeing.

In a bull or up stock market, all news is eventually bullish.  This means that whether it sounds good or not, the spin is such that it eventually translates into higher prices. Conversely, in a bear market, all news is eventually translated in to lower prices. The reason for this is not so much fundamental, as psychological.  All companies do not stop making money in the same moment. Indeed many will continue making good money throughout the bear market But the negative crowd psychology will lower expectations which lowers the P/E or price earnings ratio. Accounting and finance students will recall that the P/E measures how many dollars investors are willing to pay for one dollar of earnings.  At a bull market peak, such as the dot.com frenzy of 2000, investors will pay lots of money for stocks that have no earnings, the dot.coms.  At a bear market valley, say December 1974, investors pay very few dollars for even the earnings of the most substantial companies.

Now I told yo all that to set the stage for this article.  Yesterday the DOW industrials were up about 150 points. Yet this morning the news is that a French Bank has about given up trying to calculate asset values in American hedge funds.  And so the Dow Industrials DJIA, which will not start trading here for another hour and a half by the way, fell 90 points.  Okay, how is it possible that the Dow Industrials fell before they even opened for trading in New York?  The answer is that various exchanges around the world offer futures or derivative trading in stock indices, including the DJIA.  But note that it was not just mortgage and real estate companies that fell in value, it was the entire DJIA!  This is the result of negative market psychology.  We are making the turn from a bull to bear market. Just yesterday the President (of the USA that is) announced that he was confident the markets would regain their footing.  He would not have issued the statement of course if indeed he was not worried whether they will or not, he was trying to calm the market.  This morning at least, that did not work.