Trying to discover what lies at the heart of the financial meltdown currently gripping the world is like trying to pick up mercury. Just when you get your fingers on it, it breaks into pieces.

Trying to discover what lies at the heart of the financial meltdown currently gripping the world is like trying to pick up mercury. Just when you get your fingers on it, it breaks into pieces.

The social malaise is much easier to diagnose, but few people, very few, have the courage to acknowledge it.

But let me start with the financial meltdown.

The Financial Meltdown

Since even the "experts" can’t agree on the cause of the problem, never mind give a rational explanation to the rest of us, I have tried to do the best I can to understand what is going on by reading as many commentaries as possible, then forming something resembling a "theory" that at least satisfies me.

I set out that theory below, followed by some conclusions I draw from it.

A Financial Meltdown Theory

All we have been told is that the credit flow has been blocked and that the effect of that is catastrophic – no loans, no new cars, job losses etc. And apparently, it all relates to "sub-prime" lending by banks.

There are also these things called "mortgage securities" which somehow contribute to the problem.

Essentially we are told that the drains are blocked and that the taxpayers of the world need to stuff a whole lot of money down the toilet to clear them. I wonder, however, if the problem is that no one has the courage to flush the chain for fear of what may happen.

So here’s the theory, as simply as it can be put – and simplicity is something in short supply these days.

Let’s take Bank 1. Bank 1 lends $1 to each of ten borrowers who want to buy a house. The annual rate of interest is 5%, and the term of the loan (mortgage) is ten years.

Let’s also say that the amount they lend represents 80% of the value of the property they take as security.

That means that the underlying assets securing the ten loans is $12.50.

And, all things being equal, Bank 1 will expect to get a return over 10 years of $0.50 per $ lent, amounting to $5.00 over 10 years.

So far, so good! But then Bank 1 discovers that there is a "market" in mortgages.

Bank 1 then repeats its lending say 3 times. It now has $30.00 lent on assets worth $37.50, and a return over 10 years of $15.00.

Thus, in 10 years time Bank 1 should recover the initial loans plus interest – that is, $45.

So Bank 1 now packages these loans into what they call a mortgage security. What they do is sell these 3 sets of mortgages for say $12.00 each, a total of $36.00. That is, each $10.00 package is sold for $12.00.

Bank 1 therefore makes an instant $2 on each set of 10 mortgages, or a total of $6.00 on the 3 packaged 10 loans – a profit of 20%.

Bank 2, which buys this package, now has an asset of $36 (the original $30 plus the $6 it paid for it). But that asset is now secured on only $37.50 of real property. Further, the return on the investment is reduced by the cost of the purchase.

The 10-year return on the mortgage security, or at least the original mortgages, is only $15. But Bank 2 has already spent $6 buying the package, leaving only a further $9 for the remaining 10 years. So if Bank 2 held the packaged mortgages for 10 years it would only realize a return on its investment of $9 - or approximately 2.7%.

But Bank 2 is ambitious, and caught up in the euphoria of quick and easy money, as is Bank 3. Bank 2 then sells Bank 3 the mortgage security at about the same percentage "uplift" as Bank 2 paid – some 20%. For simplicity sake, let’s say that Bank 3 pays $3 on each of the 3 packages – that is, $9 for the set of 3. Bank 3 therefore pays $45.00 for the whole set.

So at this point we have the following: Bank 3 is showing on its Books a $45 asset with an apparent 5% return on investment. In reality though, the Bank only has a $30 asset. The other $15 is a phantom asset. And the security underlying that asset is only $37.50 (the value of the property secured). In addition, there is in reality no interest (or income) remaining in the asset. If Bank 3 held the asset for the full term of 10 years it would only realize the original investment ($30) plus the $15 return over the 10 years – that is, a total of $45 when the term of the mortgage matures. Bank 3 has paid $45 for the hope of getting back $45 in ten years time. Not the wisest investment.

And Bank 3 has purchased this asset with money from depositors to whom it has to pay interest, or by borrowing from other Financial Institutions to which it will again have to pay interest.

But even that hope of recovering the investment in 10 years time rests on a number of factors. First, that the underlying investment is sound (that the security will cover the investment), and that the borrowers will be able to meet their payments. Secondly, it rests on the hope that no one will discover the problem. Yet, the problem will most certainly be uncovered by any of the first falling apart – that is, if property markets fall, or borrowers are not able to make their repayments.

And, as we all now know, that is exactly what happened.

Let's take the decline in property values first.

When property markets begin to decline, the first thing any prudent bank will do is reassess the value of its security. So, in the case of Bank 3, it will suddenly discover that it has an asset of $45 with a security of only $37.50.  Now, if the property market declines by say 20%, the security is reduced to $30, leaving a shortfall on the security of $15. Such a shortfall makes repossession for default a losing proposition.

Then there is the difficulty of borrowers not meeting their repayments. Let’s say again that 20% fail to do so. That means that instead of a $15 return on the investment over 10 years, there is only $12.

So Bank 3 now has a $45 asset secured on $30 real property with the possibility of recovering on interest only $12 over the next ten years.

It thus becomes difficult to hide the problem. Bank 3 has a phantom asset of $15 or, at best, a phantom asset of $3 if it hangs onto its mortgage security for the next ten years. But taking into account inflation, and the return promised to investors in the Bank, the Bank would have to find a great deal of money to keep up with the interest payments to its depositors, and cover inflation, even if inflation were negligible.

Now multiply this scenario a few million times and we get an inkling of the scale of the problem.

Someone has to pay for the phantom assets; but who?

Well, we now hear the sound of trumpets as the Cavalry comes charging over the hill – taxpayers' checkbook in hand – $700 Billion and more.

But even after the checks have been promised, things don't improve. Why would that be?

It's because no one knows who is to buy the nonexistent assets, the phantom assets.

In the United States, Congress has approved a package to take these nasty little securities off the banks’ hands. But what are they going to pay for – the underlying asset, or the whole package, phantom assets and all.

If it's the latter, then there can be no way the taxpayer is going to get anything like the $700 billion back. There is simply nothing there. In that event, the taxpayer takes the hit, and the taxpayer has been deceived by Congress and the Executive – no surprise there! And if this is indeed the plan, then $700 billion will almost certainly not be enough.

If government buys only the underlying mortgages (the original $30 plus interest), then the phantom assets will still be floating around out there. And while they’re floating around out there no one will be willing to pull the chain. Could that explain the sharp fall in the markets following the Bailout? I don’t know, and, I suspect, neither does anyone else, including the markets.

But that is only half the story. It's not just whether the drains are blocked, or whether any one is willing to pull the chain, but whether the consumer wants credit any more. And the answer to that is a resounding NO!

I suspect that people are simply sick and tired of being in hock to Financial Institutions that effectively dictate their every action; dictate the very way they live.

Consumers are also fed up with consuming for the sake of consuming simply to keep the wealthy wealthy.

Consumers are fed-up with being nothing more than slaves to business and government – and they know there will be short-term pain while the economy adjusts to cope with a reality that is not focused on consumption of every ridiculous product the advertisers package as the next "can’t do without." People are beginning to realize that not only can they do without the latest ridiculous gizmo from the technological world, but that they are in fact better off without it – financially, mentally, and physically.

People are simply sick of having their lives and actions dictated by a bunch of "city boys and girls" who have proved themselves to be incompetent and greedy at best, but more likely corrupt and dishonest.

They are sick of Credit Reference agencies (all three of them) defining their lives – their jobs, their finances, their families; Agencies that can destroy a person's life with 3 little numbers; Agencies that can turn people and families into financial and social outcasts with those 3 little numbers.

People want to be free – free of all these financial pressures that dictate their very identity. People are sick of being battery hens producing the Golden Eggs for the elect few.

The people have had enough!!

And when they have had enough there is only one place to turn – the place that has been neglected and abused while this orgy of indulgence has gripped society and individuals for the last few decades.

That place is the family. And that is what I shall address in Part 2.

***

[Update following the announcement of Secretary Paulson's new plan.]

In the first Part of this article I asked what the government was to pay for – “the underlying asset, or the whole package, phantom assets and all.”

Well. On October 10, 2008, Treasury Secretary Hank Paulson gave us the answer, and it’s not pretty.

The relevant part of Paulson's statement is this: “We are developing strategies to use the authority to purchase and insure mortgage assets and to purchase equity in financial institutions.

What this means is that the government will be purchasing the underlying (mortgage) assets directly, and purchasing the phantom assets by buying stock (equity) in these Financial Institutions.

To explain this in simple terms, let me go back to my model, and Bank 3.

We left Bank 3 having a $45 asset secured on $30 real property with the possibility of recovering only $12 over the next ten years. The underlying (real) value of the assets on Bank 3's Books is only $30 (the initial 30 loans of $1 each).

Bank 3, therefore, has a phantom asset of $15.

Now, let's assume that when Paulson mentions the purchase of mortgage assets, he means troubled assets. In the case of Bank 3 that would be the 20% of those borrowers who were unable to meet their repayments – that is, assets worth $6.

What these Treasury wizards have now obviously discovered is that that wouldn’t solve the problem.

This is what happens to Bank 3. The government buys the troubled assets for say $6 (although the taxpayers can only hope that they will beat the Bank down on the price). That means that Bank 3 now has "real" assets of only $24 ($30 - $6). But it still has its phantom asset of $15. But that $6 will almost certainly be applied almost immediately to pay the interest accumulated on borrowings to pay interest to depositors and other investors in Bank 3, and not increase the capital base of Bank 3 (remember, because Bank 3 bought the mortgage package for $45, the return on the underlying real assets could not produce anything like the income necessary to pay investors in the Bank - Bank 3 had to borrow).

So that $6 rapidly disappears. That has the effect of increasing the size of the phantom asset – it is now $21 ($15, plus the $6).

Bank 3 has had to use capital to pay off its accumulating debt.

But even once the $6 has been spent, the interest payments still have to be made. But there is no income – it’s been eaten up by "financing" the phantom asset.

So that is where the stock (equity) purchase comes in. By purchasing equity, the government effectively "buys" the phantom asset.

But does government buy the original phantom asset of $15, or the new phantom asset of $21. If it did the latter, the taxpayers would effectively be paying for the troubled mortgages twice – not politically palatable.

So let's assume that it only buys the $15 part of the phantom asset by way of an equity "investment" in Bank 3.

Paulson didn't make clear how this equity purchase would work, but since the objective is to pump money into the banks, the equity purchase must be by way of the issue of new equity (otherwise, buying existing equity from shareholders would not see an injection of cash into the banks).

So, using our model of Bank 3, let's see what happens.

Assume for the purposes of simplicity that there were 45 shares in Bank 3, and each share was worth $1 before things started coming unstuck.

When it is discovered that there are only $30 worth of assets in Bank 3, and no income stream, the shares plummet. Let's assume the best outcome, and the shares plummet to the value of the underlying assets of $30. That means that the shares are now worth 30% less – not $1, but about $0.66, let’s say $0.65.

When the government buys the troubled mortgage assets, and the $6 is spent discharging interest of borrowings etc, the underlying assets go down to $24 – and the share price follows suit. Using the market decline over the last year, let's assume the share price tumbles by 40% in total – it is now $0.60.

When the government purchases equity it will thus have to "invest" $15 to get rid of at least part of the phantom asset. But that would still leave a phantom asset of $6.

But the question then arises as to the number of shares the government gets in return for this "investment."

No doubt the shareholders (assuming they get any say in this fiasco) would argue that government's investment be at par – that is, government gets 15 shares for its $15. That may appeal to Paulson, because he is hoping to kill two birds with one stone. He wants to get rid of the phantom asset, and at the same time influence the stock markets.

So, if government agreed to an investment at par in Bank 3, there would be 60 shares (45 plus government's 15) on assets of $39 ($24 plus the government capital of $15). The share price based on underlying assets would then go up from $0.60 to $0.65 – not exactly a stunning recovery.

But worse, that means that the taxpayer would take an instant hit of $0.35 on every dollar "invested" by government. In other words, apart from buying a phantom asset for $15, the taxpayer takes an instant loss on the investment of 35%. So that may not be palatable.

If government did have the taxpayers' interests at heart, it would have to ask for more shares, and that would mean existing shareholders taking a hit unless the number of shares can be set at an amount that would at least not cause them further losses. No doubt actuaries are working feverishly to establish a price for the equity purchase that would satisfy all parties. But let's say they come up with a compromise at say 20 shares. That would mean that Bank 3 has 65 shares representing a capital base of $39, but still with $6 in phantom assets. Share price in relation to assets would then decline to around $0.60 – back to where we started, and the taxpayers take a 40% hit on their "investment."

So let’s assume that that is more or less the scenario on this great bailout.

At this point, Bank 3 (with government help), will have to "clean up" its Books. Bank 3 will have to revalue its assets down from $45 (which includes the phantom asset) to $39, which includes the government investment.

So we can now see what government is hoping for. Having bailed out Bank 3 by purchasing its phantom asset, the government can only hope that Bank 3 will behave responsibly in the future. In that case, government must hope that having given the Bank a fresh start, its normal activities will begin to generate income that will, in the end, expand its capital base thus lifting the share price to a point where the government can cash in and tell the taxpayers that it has recovered most of their money.

But that hope rests on some very shaky assumptions.

First, it must assume that the troubled mortgage purchase will discharge all the debt the Bank accumulated financing its phantom asset. The taxpayer can only hope that Paulson's people will do their due diligence, and that the Bank will make full and frank disclosure.

Secondly, it assumes that there is still such a demand for credit that the "investment" will immediately be put to work to start generating income.

Thirdly, it assumes that the financial institutions will suddenly start behaving responsibly, and not try to circumvent every new regulation put into place – which is the normal MO for Financial Institutions.

Putting that kind of hope in an industry that has displayed utter incompetence and irresponsibility, even corruption and dishonesty, is a leap of faith to say the least, and a leap of faith that the taxpayers will pay for if it all goes wrong.

Quite simply, Paulson is using taxpayer dollars to pay for a whole bunch of non-existent assets, phantom assets, and putting faith in the very institutions that caused the problem in the first place to somehow take the taxpayers’ interests to heart.

What a joke! And what a mess!

***

[Update following the announcement of Gordon Brown's "Model" bailout plan.]

In the first UPDATE on Part I of this article, I analyzed Paulson's statement of Friday evening (October 10, 2008), and concluded government was planning to purchase the phantom assets the Financial Institutions had built up over the years under the pretext of a share purchase.

I said this: "So we can now see what government is hoping for. Having bailed out Bank 3 by purchasing its phantom asset, the government can only hope that Bank 3 will behave responsibly in the future. In that case, government must hope that having given the Bank a fresh start, its normal activities will begin to generate income that will, in the end, expand its capital base thus lifting the share price to a point where the government can 'cash in' and tell the taxpayers that it has recovered most of their money."

I only had to wait until this morning (Monday October 13, 2008) to see that prediction, and my analysis, materialize.

Britain's Prime Minister Gordon Brown (fresh from a Eurozone meeting in Paris), and Britain's Chancellor of the Exchequer (Britain's equivalent of Treasury Secretary) Alistair Darling (fresh from the G7 meeting in Washington, DC), announced their plan to save Britain's banks, and "lead the way" for the world in sorting out the Financial Meltdown.

This plan is the same as the one Paulson is reportedly adopting for the United States.

Keeping in mind the above quote from my first UPDATE, here are some extracts from Brown and Darling's Downing Street statement:

Brown: "We have agreed to make a series of commercial investments amounting to £37 billion of public money in a number of UK banks . . . The government will not be a permanent investor.  Over time we intend to dispose of all these investments in an orderly way."

Brown then went on to set out some conditions imposed on the banks "to ensure that the taxpayer gets a fair deal."

The third and fourth conditions are these: "Third, and most important, we have secured strong commitments to immediately restore and maintain the availability of loans for home buyers and small businesses at competitive business rates. The government will appoint independent non-executive board members to the two banks in which we are injecting capital. And finally, the taxpayer will secure a full and fair share of the upside which will come over time as the banking system recovers its strength."

In conclusion, Brown then said this: "We are showing today that we are willing to invest assets our country has to strengthen the banking system, but the most precious asset of all is something that if lost can only be restored, not by words but by actions, and that is the asset of trust and confidence."

Darling, in his short statement, said this regarding buying phantom assets from the banks: "The third element was to ensure that we helped banks recapitalise and build up their capital positions to take account of the turbulence that we see in the world markets today."

In follow up questions, Brown and Darling expanded on this fiction that the British taxpayer was making a good investment.

Brown: "These are investments that we are making in banks. This is not just pumping money in, these are investments we are taking in the form of shares. We believe that these shares will grow in value over the next period of time, but whatever happens these are assets that we have taken in the form of shares in return for the money that government invests . . . These are not payments that have been made without either strings attached or without an asset being taken in return, and we believe that this is the best way of safeguarding our banking system, but also a good investment for the nation that has become necessary as a result of events."

Darling: "So the bulk of the shares in relation to RBS and to the Lloyds TSB-HBOS group are ordinary shares, but they are investments, you know when eventually we come to sell them we will get the money for them and of course we will get dividends."

So, without getting too puffed up with vanity, it seems that I got it exactly right.

The taxpayer is being conned!

However, judging from the euphoria in the stock markets today, the financial folk are delighted – the gravy train is moving again.

Econ. & Public Policy, Science, Technology, Energy

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