Understanding The Crisis, Part Five

This part should really be more straightforward for you, but many people may just not have thought of applying the same basic procedures we use at times in our own lives to the huge sums of money and the fancy titles involved with corporate financial dealings. Let's say you need some bucks and off you go to a friend or a relative (not always the same thing). You ask them for a certain amount, and you offer to let them hold your vehicle title until you repay them the amount you want to borrow. They accept. You have just "secured" the loan you wanted; that is, "secured," meaning that you have given them the ability to take your vehicle if you don't repay them. There isn't any magic to the way things are done by businesses either. If you go for a mortgage, you're going to sign a note to the lender giving them the right to the property if you don't pay. The main thing is, if you loan money to someone, you want to be able to get that money back, plain and simple.

When Wall Street investment banks bought mortgages from loan originators, they put these mortgages into "bundles" so that they could then sell them to investors.*** Okay, so YOU are an investor. What do you want to know about the securities issued and backed by these mortgages? Naturally, you want to know the chances of getting your original money back (the "principal"), plus the interest amount (your profit). What this comes down to is "risk;" that is, you want to know the risk you're taking by investing in these securities. If you buy some sort of U.S. bonds, you essentially have no risk (unless there's an upheaval that replaces the existing government, or a foreign invader takes over), because, in a worse case scenario, the government can print money to pay you the amount you are owed. With corporations, or even state or local government entities, they can't legally print money to pay you back, so there is a varying amount of risk, and the way investors decide upon that risk is by checking the rating given to whatever security they are looking to invest in.

There are a number of "ratings agencies" in the country, but probably most notable are "Moodys" and "Standard & Poors." I'm sure you've heard these names many times, but especially in the last year or two. Ratings agencies put a "grade" on various investments, with "AAA," aka "triple A," being the highest "grade," meaning that you would have very little risk of not getting paid if you invested in whatever security that was rated such. They are "supposed" to check the credit worthiness of the issuer (investment banks) and the actual products being used to "secure" the investment product. In most cases, the securities backed by American mortgages^^^ were given the highest rating, "AAA." Wall Street aggressively marketed these investments all over the world, including to foreign governments and foreign local government entities.+++

So what happened? There may well be more to come out on this story, as the country searches for answers to the economic meltdown, but there were problems with how these securities were rated. Two things seem to stand out: First, the investment banks paid the agencies to rate these securities they, the bankers, were issuing. This was not against the law, except the law of common sense. Let's say you are interested in buying a car from me. You naturally would want to know if it has any problems, and I tell you, "MY mechanic has checked it out and he says its in perfect running condition." Now, it may well be in perfect running condition, but just the fact that MY mechanic gave it his approval should be a red flag to you; after all, I paid him for his evaluation. The Wall Street investment banks and the ratings agencies had a very cozy relationship.### Secondly, how much the ratings agencies really knew about the mortgages backing these securities is highly questionable, and with Wall Streeters having bought just about any subprime mortgages they could lay their hands on, it just doesn't seem credible that the ratings agencies could have given these securities a "Triple A" rating.

Whatever comes to light in the future, the fact that these mortgage securities were rated "AAA" made investors flock to them in the belief that they were "safe," later much to their (and OUR) detriment. (A "Word History" is below)

To be continued....

*** See "Part One" for basic flow of mortgage business.

^^^ I say "American mortgages," because these securities were marketed all over the world, not just in the U.S. Most often, large groups of investors, rather than individuals, directly invested in these mortgage securities, as they were seen as "safe;" although many individuals may have indirectly participated through these investment groups. What this means is, you didn't buy into these securities yourself, but you went through Company XYZ, which had many investors, and the company did the actual investing.

+++ CNBC, a cable business channel owned by NBC, specifically did a story on Narvik, a city in northern Norway, that invested in these American mortgage backed securities. The city has had to cut services due to losses suffered on these securities.

### I'm sure you remember "ENRON," for example. While this was a different subject, the basic principle was the same. The auditors of ENRON's book were "supposed" to be independent; thus giving investors a true picture of the company's finances, but in fact, they had a very cozy relationship with the company. The relationship was so cozy, that it wasn't until just days before ENRON's collapse that the auditors issued a "warning;" that is, they downgraded their assessment of the company's finances.

Word History:
Rich-This word goes back to the Indo European root word "reg," which served as the basis of a whole series of our words (and I hope to deal with these in future installments), but in this case, the notion of "rule" was the underlying meaning. Hmm, "rule" and "rich," can you imagine that? Anyway, Old Germanic seems to have borrowed the word from Celtic (another Indo European language group related to Germanic, and thus to English, but a bit further down the "family tree"), probably from Gaulish. The Germanic form was "rikijaz." The developing Germanic dialects/languages had various forms of the word: Old High German had "rihhi," Old Norse had "rikr," Old Frisian had "rike," Gothic had "reiks," and Old English had "rice" (not pronounced like the grain, but seemingly like "rye-keh"), all of these forms with the general meaning of "rich, powerful, mighty, ruler." Further, Frankish (another Germanic dialect) bequeathed its own form of the word, "riki," (also meaning "wealthy") to French as "riche." The French pronunciation, like "reesh," influenced English, softening the hard sound of the "c," and gave us our modern way of saying the word. The connection between "wealth" and "power" went back to ancient times, but it began to fade in English, and left us with just the notion of wealth, and then further, during the 1300s, of food being "rich." Even in Old English the wealthy were called "the rich." Other modern Germanic languages also use their own forms of the word: German has "reich," Dutch has "rijk," Swedish and Norwegian have "rik," Danish has "rig."