Skin in the game

I have been following the financial crisis , I call it a panic, and I am frustrated with the hyperbole and demagoguery of the media and the politicians. The whole situation reminds of the old cliche that " I've made up mind, so don't confuse me with the facts".

The following is an examples of "conventional wisdom" that never made sense to me.

If the Banks made all those bad loans just to sell them to an unsuspecting public through securitization and therefore "had no skin in the game", why did the Banks suffers all of those billions of dollars of losses?

I know the answer to the question, but it's not that those Banks didn't have skin in the game . In fact it was the reverse. The real Banks for the most part didn't make subprime loans ( not really their thing). The "banks" who made most of the subprime loans where unregulated finance companies, or loosely regulated thrifts, that usually had words like "golden" in their names and acted more like Amway salesmen than banks. Wall St thought that, through the "magic" of securitization, risk would be reduced by spreading it widely, so no one suffered too badly if things went wrong. In fact rather than spreading and thus reducing risk, it actually spread the contagion once the panic began. In current youtube parlance , it went viral. Logic and reason went out the window and panic and stupidity walked in the door. No one wanted to buy those "toxic" assets, no matter how few "toxic" loans were in the pool of loans which were collateral for the securities, which were now almost worthless, notwithstanding the actual relatively low number of mortgage defaults at the time.

There were many perpetrators of this debacle, none of whom had malicious intentions. The spark that set things in motion ( there would probably have been another spark since the US economy was clearly way overleveraged and something had to precipitate a correction) was "subprime" lending. The problem began with complaints that banks were not lending enough to people who had less than stellar credit. This lead unfortunately to the the advent of subprime lending, meaning lending to people with substandard credit at higher rates to cover the higher risk. The Government didn't discourage this and later actually encouraged it. Subprime lenders weren't your usual banks, at least not the big Wall St investment banks or even the major commercial banks. Eventually these companies were making loans to anyone with a pulse, as long as they could sell them to Wall St. In turn, Wall St. was buying them as long as they could get the rating they needed from the Rating Agencies so they could sell them to investors. Investors were buying as long as they had the desired rating. I get dizzy just explaining all that.

Why? Of course, Wall St was encouraging this because they were making lots of money selling the securities ,and the faux banks, who were making the loans, were making lots of money selling the loans to Wall St for sale to public investors, who were buying the securities without doing their own due diligence, but rather relying on the ratings of the Rating Agencies, who were getting paid by the issuers of the securities( read Wall St again). What a country!

However another big culprit ( politically correct people don't like to talk about this) were the local communities who didn't have access to traditional credit ( as it turns out for good reason). They wanted more loans to fulfill the American dream of home ownership.

The Government, the only one who could and should have put a stop to it--Didn't-- for a variety of reasons. As Barney Frank famously said "Let's roll the dice" or was that Julius Caesar? Let's just say the Government lacked courage--what a shock.

But let's now answer the question of why the Banks lost so much money thus creating the collapse of the real economy. Guess what the Banks did? They bought lots of those securities that turned out to be so toxic and therefore dramatically less valuable than what they paid for them. Why you ask? They were highly rated and therefore safe. If it looks like a dog chasing his tail , I see the analogy.

So you see it's not that the Banks ( read real the Banks we love to hate on the news every day) didn't have enough "skin in the game", it turned out that they had too much.

More examples and other thoughts will follow with future posts.

Eric

12/27/09