The big muddy

By Robert Elman on May 1, 2008

There was Enron. In 2001 Enron went into bankruptcy, but not before it had claimed the title as America’s most innovative Company, six years running. Enron was instrumental bringing down one of America’s leading accounting firms, Arthur Anderson. Its directors paid millions of dollars in restitution, its CEO was convicted of fraud, along with the CFO, investors lost billions of dollars, and innocent hard working employees, lost their retirement pension, and much of their future.

This behemoth that reported $111 billion of sales of natural gas, oil and electricity, was discovered to be a massive fraud of off book dealings and accounting fraud of historic proportions.

We thought that with the new laws that followed and the prison sentences imposed that, we would not be seeing future “Enrons”

But the need and greed met on Main Street, and the world is now confronted with the greatest financial crisis since the great depression. In less than four years we went from the Dotcom bubble to a real estate bubble.

To stimulate the economy, which had fallen into recession, then Chairman Allan Greenspan, head of the Federal Reserve, lowered interest rates, and kept them lower than ever before in the period just before his retirement. The seeds for a new collapse, had been planted

House prices were moving up smartly, mortgage rates were not only low, they were ridiculously low. It made no sense to rent property when you could purchase for little down payment and in many instances, zero money down..

In the beginning demand for property began to rise smartly, then sharply, then prices went vertical.

Everyone wanted in on the action. For every desire there was someone to fulfill the wish. I have been in the investment field for almost 40 years, and I had never heard of anyone being able to borrow money below the prime rate with zero money down. It meant exactly what it spoke to. Demand for real estate skyrocketed

From vertical, home prices went into the stratosphere, with annual increases of 25-30% not unheard of in places like California, Florida and Nevada.

Gary Shilling chillingly predicted the following in 2006 “I am convinced that the housing bubble is gigantic and will burst before long with massive implications here and abroad. In fact, it's the key to the global economic outlook”

That, was only the beginning. For this drama had many moving parts.

The culprits included everyone from the banks, mortgage companies, hedge funds, monoline insurers, real estate flippers, and those desperate to own a home at any cost.

Banks loan money at low rates. Banks package mortgages and sell these new instruments to creative resellers, who add other debt, and sell these to hedge funds, who repackage, leverage, and then sell again and again and again...

Once relieved of the mortgages and flush with cash, the banks are able to repeat and repeat this process. Ditto for the hedge funds et al. With rising home prices and continued low interest rates, homeowners were flush with cash obtained through home equity loans and home refinancing.

Not only were mortgages issued at subprime rates, but also in many cases, the valuations were inflated, which resulted in mortgages being issued for property worth less than the real value.

Once the market began to start its swoon in 2006, it did not take long for the first rung of this false ladder of homeowners to begin to throw in the towel. No one likes to pay down a load whose value is higher than the worth of the underlying asset.

And so we began to witness what I call the 9/11 of real estate. As each level of equity ownership slipped below the positive equity line, it became untenable for the debtor to remain in the game. They either threw in the keys, or were foreclosed.

We now began to witness the impact of negative leverage. Home prices turned down dramatically and as each level of ownership slipped underwater, the subsequent level approached that point of no return.

In my next article, I shall speak to the issue of debt insurers, and what roll they played in this, the worst credit crisis since the great depression.


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