Sunday, November 30, 2008

_The_ bubble has burst.

Do you think the "Internet bubble" pop was bad? Assuming so, you haven't seen anything yet. The recent investment banking collapse will change our lives for decades to come. I've been trying to coax out a blog post on this topic for a few months now, and Condé Nast's Portfolio magazine, which recently ran "The End" by Michael Lewis, finally inspired me.

The 1990's were so fun!
The net bubble was a function of greedy analysts & company insiders pairing up with investment bankers to jack up IPO prices for newly minted securities in newly fashioned industries (online advertising, various Internet driven technologies, the PC business, etc). The result plowed large sums of money into the hands of many, and consumer spending took its queue, resulting in big ticket items flying off the shelves (jets, 2nd mansions, $100k watches, fast cars, etc). Many became "millionaires," and if you weren't one of them, you at least knew a few first hand.

2nd Verse; the bubble bursts
When the reality of the situation set in, and folks realized the Emperor had no clothes (you can only support massive P/E ratios for so long before you have to illustrate at least some value), the tech sector cratered, taking it's periphery with it. How quaint this mere $5 Trillion wipe out turns out to have been. Not one to go down with out a fight, the Fed dropped federal fund rates, to keep credit markets cranking and consumers spending. The masses, not wanting the memory of free wheeling spending to fade, saddled on more debt in order to keep spending. Money was cheap and this time 2nd mortgages flew off the shelves, along with home equity "secured" lines of credit. The mortgage industry was on a tear, and "regular" 1st morgtages weren't going to be enough to keep things raging; there are only so many homes you can build and buy. American minds were made up, and we were going to continue spending come hell or high water. If our bloated salaries and cash from equity stakes in "successful" investments during the Internet Boom, couldn't float our spending consciousness, mortgage backed debt would!

3rd Verse; popular leverage

Wall Street has always led our financial, and cultural "success" measure, thinking. Big spending bankers, traders, and brokers have had their place in pop-culture for decades. The masses watched in drooling amazement as finance industry employees were bonused beyond recognition, and spent lots of money on toys. We eat the stories of $10m dollar birthday parties up like turkey on Thanksgiving. For a time only the big kids on Wall Street had access to the real money; the kind that few could actually understand how it was created. Then, overnight, the perfect storm of greed (hungry Wall Street execs), derivative innovation (CDO creating quants), and deregulation entered the room; she was beautiful, single, and everyone wanted a piece. Derivatives have always been a neat trick on Wall Street. Leveraging one equity to create another, in a "side bet" manner, is a model that has been around forever. They've always been hard to explain, but until the mid-1990's, the common man could get their head around them with enough explanation and description. Too many abstractions away from the original asset however yields mysterious confusion, and wool can easily be pulled over another's eyes. It was the employee's turn now though; step aside CEO! Relative peons were creating new mortgage derived securities by the dozens, and selling them like hot-cakes to buyers with massive bank accounts (e.g. investment banks, state pensions, school districts, etc). The equity markets couldn't satiate the post Internet bubble appetite that bankers had worked up. They needed a bigger market with tighter focus. Mortgages and associated bonds were the new game in town.

Before anyone knew it, hundreds of billions of dollars in securities were being repackaged (as new derivatives (e.g. CDOs)) and re-rated at ratings higher than the underlying securities' ratings. That was the real trick! Bankers, and corrupt/lame rating's agencies, were turning shit into gold, and selling it back to every industry you could imagine. One thing to note here, Moody's (the bond rating firm) is 20% owned by Warren Buffet. I've forever admired Mr. Buffet but this new awareness has caused me to take a second look at him on my "most admired" list.

Unlike the Internet Boom's relatively scoped collapse around the technology industry, Wall Street had infected one of the largest finance vehicles known to man; mortgages ($15 Trillion worth in 2008). Mortgages, particularly during a housing/interest rate boom, comprise the underpinnings of the private financial industry. They are hugely leveraged debt vehicles. Think about it, you pony up say 20% of a speculative value in a down payment, then pay the rest off over a few decades; crazy! Undermine mortgages, and bad things happen. Enter present day; here we stand, wondering what's next. The money the commoner has invested over the years has shrunk by a full third on average. Nest eggs have cracked. Banks aren't able to lend money for the foreseeable future, and Americans can't buy houses like they used to. Our personal wells of vast amounts of money for consumer spending have dried up.

Now What!?

Obviously no-one knows, but I predict a rather harsh reality in the coming years. Jobs will be lost. Homes will continue to be foreclosed upon. Housing inventory will shoot through the roof, and their prices will fall. Stratification will find its way back into society; as the "haves" and the "have nots" will become more apparent, now that "having" will be more of a function of one's ability to raise capital/earn money, rather than one's ability to plow a hole into the ground with personal debt. The great normalizer, consumer debt, will be reeled in, and things will get weird.

Our banking heroes have fallen, and I wonder who will take their place. One thing is for sure, free-market capitalism always finds a way.

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