ONE

What Went Wrong

Back when Americans listened to music recorded on vinyl and cars had tail fins, buying a house was straightforward -- if not always easy. First you saved for a down payment, then went to a local bank or savings and loan to apply for a mortgage. The bank checked your income and credit records, verified that the down payment was ample to protect its investment in the unlikely event of a foreclosure, and provided the necessary cash from the savings deposits entrusted to it by your neighbors. What you saw was what you got: a mortgage with a fixed monthly payment that would be paid off twenty years down the road.

But big changes were coming -- most of them built around the entry of Wall Street into the home mortgage market. Actually, the seeds of these changes had been planted decades earlier. The Federal National Mortgage Association (later to be dubbed Fannie Mae) had been created during the Depression to increase the availability of home loans for middle-income Americans. One way it did that was to create a "secondary" market for mortgages, based in New York and Washington.

Why, you ask, would investors in some distant city be willing to buy mortgages on houses they had never seen that were owned by people whose names they didn't know? Fannie Mae set broad minimum standards for mortgages based on the assessed value of the house, the size of the down payment, the credit rating of the borrowers -- you get the idea. Then they bought thousands of mortgages that met their credit-quality standard and sold securities that represented claims on the interest and principle for tiny slices of each mortgage in the big pool. That made it possible for an insurance company in Omaha or a pension fund in Dallas to invest with confidence in, say, $10 million in ten thousand mortgages from California. Some of the mortgages might default, but the risk was predictable -- and shared with others who had invested in the same pool.

This secondary market for mortgage-backed securities got a huge boost in 1968 when Fannie Mae was privatized -- that is, sold to private investors -- and it adopted policies designed to increase its profitability. The pace of expansion further accelerated when Congress created a second private "government-sponsored organization," the Federal Home Loan Mortgage Corporation (Freddie Mac), with the goal of giving Fannie Mae some competition.

Banks discovered they could make more money in originating mortgages than by owning them. They began to sell most of their newly minted mortgages to Fannie, Freddie, and other investment firms for a profit, then use the capital they got back to do it all over again.

If "securitization" transformed high-quality mortgages into a standardized investment that could be sold and resold like stocks and bonds, why stop there? Why not create packages of riskier mortgages from loans with lower down payments and less creditworthy owners, then sell the resulting "mortgage-backed securities" to investors willing to bear more risk in exchange for more interest? And why should banks, which had largely switched from investing in mortgages to creating them, get all the action? Why not let specialized mortgage brokers find the home buyers, create the mortgages, and sell them to Fannie or Freddie or a private investment firm that would repackage them as mortgage-backed securities?

Why not, indeed. And for a long time, it looked like a good deal all around. Home buyers, especially those with modest incomes and less than perfect credit, now had a choice of lenders and lending terms. Institutional investors -- pension funds, bank trust departments, insurance companies, mutual funds, even foreign governments -- got to quench their voracious appetites for what seemed to be relatively safe investments that paid more interest than, say, a bond issued by Shell Oil or the U.S. Treasury. In 2001, new issues of mortgage-backed securities reached an astounding $1 trillion.

Wait, it gets better. Mortgage-backed securities created other new opportunities to make big bucks. Uncle Sam had been insuring the timely payment of home mortgages for middle-income families since the Great Depression of the 1930s, charging lenders a small premium for the guarantee. Fannie Mae and Freddie Mac continued the practice of insuring the mortgages behind the mortgage-backed securities they created and sold.

The credit insurance side of the business proved lucrative. With house prices rising by 50 percent between 2000 and 2005, homeowners who couldn't afford their monthly payments usually had the option of refinancing their mortgages instead of defaulting. The prospect of easy profits in guaranteeing mortgage repayments lured other investment firms into the act. Giant insurance companies such as AIG dived into the mortgage insurance business. While they were at it, these firms couldn't resist extending similar "credit enhancement" services in any direction the market pointed.

You want to guarantee the repayment of your $5 million loan to Company X five years from now? Just write a check to the Acme Insurance and Storm Door Company today for $100,000. The game was so lucrative that it was extended far beyond the sales of credit enhancements to the actual creditors. You haven't loaned any money to Company Y, but would still like to place a bet that it will default on its bond obligations in ten years? Write us a check now, and we'll pay you $1 million if Company Y does indeed go belly-up.

Once liberated from the necessity of selling services to real creditors and debtors, the credit enhancement business took off like a jackrabbit at a greyhound convention. At its peak in 2007, some $62trillionworth of guarantees were outstanding -- a figure that is much larger than all the debt of all the debtors in the world.

Meanwhile, the big investment firms were hiring mathematicians (the insider's term: quants) to tailor esoteric new securities from the mortgage-backed securities as well as from other sorts of assets -- for example, securitized credit-card debt and securitized car loans. The advantage of thesecollateralized debt obligations, or CDOs, was that they could be sliced and diced in a zillion ways according to when the investors wanted their money back and how much risk they were willing to bear. A CDO might, for example, give the owner a claim on the first 80 percent of the interest on a specific pool of mortgages -- a pretty safe bet in most cases. That would leave the claim on the last 20 percent to an investor willing to take much bigger chances.

Of course, the more complicated these securities got, the harder they were for the mere mortals who bought them on behalf of pensioners, life insurance policyholders, etc., to understand. A problem, you say? Yet another opportunity, Wall Street replied.

A handful of companies had long been in the business of assigning credit ratings to newly issued bonds. They made their money by charging the bond issuers for the service. The debt of, say, General Electric might be rated AAA, the highest rating. A successful midsize auto parts manufacturer might only earn a BBB rating ("satisfactory credit at the moment") because it faced growing competition from China and its financial health was linked so closely to the auto-sales roller coaster.

It didn't take a lot of imagination to extend the ratings concept to all manner of newfangled securities -- including, of course, the ones backed by home mortgages. This effectively transformed metaphoric black boxes stuffed with only the quants knew what into assets any institutional fund manager thought he/she could understand. So now the Central Bank of China or the pension plan for municipal employees in six small towns in Norway (both real examples) could invest in impossibly complex securities backed some way, somehow, by loans made to, say, homeowners in Riverside, California.

Good Times Must End...

As the economist Herb Stein once said, "If something cannot go on forever, it will stop." The long boom in housing prices came to a shuddering halt in 2006 and began a steep decline that is apparently not over. Not surprisingly, housing developers and real estate brokers have been badly hurt, as have their employees and the myriad industries supplying everything from lumber to appliances to the bloated housing sector.

But this had all happened before -- in fact, it seems to happen every fifteen to twenty years. And while in the past the deflation of housing bubbles had led to real hardship for lots of people, housing busts didn't bring the mighty American financial industry to its knees. What was different this time around?

The bubble did inflate faster this time and affected housing prices in more regional markets. But the mega-shock was largely a consequence of changes in Wall Street that left all the big players (not to mention the rest of us) far more vulnerable to surprises.

Nasty Surprises

Bankers Don't Act like Bankers Anymore

When banks retained the mortgages they originated, they had a strong interest in making sure that borrowers kept up their payments -- or at least invested large enough down payments to protect the creditors in the event of foreclosure. During this last housing boom, however, most mortgages were quickly sold to investment firms to be repackaged as securities. As long as somebody would buy them, bankers weren't too picky about to whom they extended the credit.

That explains why banks were happy to make even "liar's loans" -- mortgages in which the applicants were required to declare their income, but the banks promised not to check whether they were fibbing. Still, why didn't the investment firms that bought the mortgages pay more attention to the risk they would never be repaid? Because these firms didn't have much incentive to care either, as long as somebody would buy the mortgage-backed securities from them.

This goes on and on. Why were the pension funds, mutual funds, insurance companies, etc., willing to buy all those mortgage-backed securities without really knowing what stood behind them? Because Freddie Mac or Fannie Mae or some big insurance company such as AIG was willing to guarantee repayment, or one of the credit agencies was willing to bless the securities with a high rating.

Wait; this has to end somewhere. Why was it so easy to obtain high credit ratings and credit insurance? That is a real puzzle. The best answer is that the people in these organizations who were in charge of judging the credit quality worried more about this year's performance bonuses than about keeping their jobs when the brown stuff hit the fan. Or maybe their bosses had made it clear that they wouldn't keep their jobs long enough to care unless they generated huge fees by giving good ratings or writing insurance for mortgage-backed securities.

Sophisticated mathematical models for "pricing" risk, rendered practical by the blinding speed of modern computers, made tons of money for forward-thinking investment firms in the 1980s and 1990s in markets for new sorts of securities. So, few money managers had qualms about trusting the wisdom of the quants who designed all those unfathomably complex mortgage-backed securities and kept their firms' exposure to financial risk at bay.

But the computer models were no better than the weakest assumptions on which they were based. All too often they assumed that, in a pinch, (a) there would always be someone to buy the securities at their fair market value, and (b) everyone with an excellent credit record who owed money to their firms would be able to pay it back. With hindsight, both assumptions seem foolish. But how do you argue with a guy who made a billion dollars for the company last year simply by writing some fancy computer software?

The Bosses No Longer Understand Their Own Businesses

Investment bankers have never been shy about explaining how much brainpower goes into their operations. But until quite recently, success in the business really turned in large part on salesmanship, old-boy connections, and a willingness to work eighty-hour weeks. So the people who got to the top were rarely the ones who majored in math as undergraduates or spent their time at business school studying nonlinear optimization modeling.

As investment firms grew increasingly dependent on complicated financial models, the people in charge lost the ability to ask the right questions or even to pick the right people to ask the right questions. So they were caught off guard when things turned sour in 2007. They lost precious months catching up with reality as their businesses stumbled toward the brink.

What goes for investment company executives, by the way, applies to the regulators, too. Most of the enforcement staff were far better equipped to deal with familiar problems -- accounting fraud and failure to meet legal disclosure requirements -- than to recognize the risks in holding or insuring collateralized debt obligations. And their bosses, typically political appointees, didn't have a clue.

There's (Still) No Free Lunch in Financial Leverage

Archimedes, ancient Greece's Renaissance man fifteen hundred years before the Renaissance, is credited with saying, "Give me a place to stand, and with a lever I will move the whole world." The same principle applies to finance.

Try this example. If you loan out a dollar from your pocket at 10 percent interest, you end up with $1.10 a year later. But suppose instead you choose to "lever" the dollar by borrowing an extra $100 at 9 percent interest and lending out the entire $101 to others at 10 percent interest. Now, after you pay back the money you owe at 9 percent interest, you'll end up with $2.10 -- a whopping 110 percent return on the dollar of your own that you invested.

Leverage is thus the real deal for anyone in the business of making serious money as a lender. Regulated commercial banks -- the kind with government-insured checking accounts -- are legally limited in how much they can borrow to make loans. For good reason. Think back to our example. Suppose you lent out the $101, but got back just $90. Instead of making 110 percent on your own dollar, you wouldn't even be able to pay back all you owe. In plain terms, you'd be insolvent.

But the regulations on leverage for other sorts of investment firms are less clear-cut. Back in 2004, when Wall Street still viewed the world as its very own candy box, the five biggest investment firms asked the Securities and Exchange Commission for permission to increase their borrowing without expanding their capital cushions. They got it -- and promptly increased their financial leverage to unprecedented levels. For example, by the end of 2007 Bear Stearns was using just $11 billion of its own capital to back close to $400 billion in loans to other firms. So, when the housing bubble burst and even a tiny fraction of that $400 billion seemed at risk of not paying off, The Bear was in big trouble.

Of those five investment firms, Lehman Brothers went bankrupt, Bear Stearns was swallowed by the JP Morgan Chase bank, and Merrill Lynch sold itself to the Bank of America for a pittance. The two strongest, Goldman Sachs and Morgan Stanley, took shelter from the raging storm by transforming themselves into banks that could borrow at will from the Federal Reserve.

It's a Small, Small World After All

Perhaps the nastiest surprise has been how easily and rapidly trouble spread from home mortgages to virtually every other market for credit. That didn't happen in the 1980s, even when hundreds of savings and loan associations went broke and the government was stuck with a $200 billion bill. What explains the difference?

Start with the fact that much of the action in finance has moved from tightly regulated banks to a global network of unregulated markets dominated by the giant investment firms. When the S&L credit crunch came in the 1980s, hardly anybody panicked because most of the money at risk consisted of federally insured deposits that were as safe as U.S. currency. This time around, however, the wealth at risk (investments in mortgage-backed securities) came from a million pockets in virtually every country in the world.

A lot of those investments were, of course, insured -- but not by Uncle Sam, the only insurer with unlimited funds to meet its obligations. And nobody really knew which firms were on the hook, or for how much. Indeed, senior executives at Merrill Lynch only belatedly discovered that the firm had insured tens of billions of dollars' worth of mortgage-backed securities in an effort to find buyers for them once the market had begun to turn sour.

What's more, it soon became apparent that credit-insurance liabilities were spread far beyond the usual suspects. As noted earlier, insurance companies had joined Freddie Mac, Fannie Mae, and a host of other investment firms in guaranteeing trillions of dollars' worth of securities in order to gain billions in up-front premiums. So when housing prices slipped and millions of homeowners were unable to keep up their mortgage payments or to refinance, the dominoes fell in a maddeningly unpredictable order.

Investment firms -- even firms that had been reasonably prudent -- couldn't borrow against the value of the mortgage-backed securities they owned because nobody knew what the securities were really worth. By the same token, nobody would lend to the insurance companies because nobody knew how much credit insurance they had sold, or how much they would have to pay off.

There's more. Regulated commercial banks weren't immune to the problem because many had found loopholes in the regulations that had allowed them to load up on mortgage-backed securities back when it looked like a way to coin money. Indeed, the credit market had become so tangled that participants were no longer able to distinguish the wheat from the chaff.

Thus began the vicious cycle. Houses became yet harder to sell because bankers were reluctant to give mortgages to even the most creditworthy buyers. Small businesses, which relied on bank lines of credit, were also affected because lenders worried that a recession was looming. As the panic spread, even the value of the short-term securities issued by giant blue-chip corporations that had no exposure to mortgagebacked securities began to be questioned.

Money market funds, which supplied the bulk of the $3 trillion in revolving credit used to finance day-to-day business operations in every industry across the globe, found they couldn't easily sell high-quality, short-term securities they owned when they needed extra cash to pay off their increasingly nervous depositors. Indeed, this critical short-term credit market would probably have collapsed if the government had not agreed to temporarily insure money market fund deposits and to act as a buyer of last resort when the funds couldn't unload securities at full value.

Who's responsible for this mess? The better question is, who isn't?

The senior executives of the major investment firms certainly deserve a place high on the dishonor roll. Can you imagine any other industry in which bosses with multi-million-dollar salary packages didn't understand how the products they sell actually work, or how defects in those products could bring down their companies?

Save some blame for federal and state regulators. Sure, they were outgunned in the expertise needed to assess risk on the new Wall Street. Sure, they were right to worry that the heavy hand of regulation could undermine the sort of innovation that has made New York the financial capital of the world. But they were naive to fall back on reassurances that the financial markets would, in the end, correct their own mistakes -- that a wildly profitable industry run by the best and the brightest would never risk hurting the goose that laid the golden eggs.

And don't forget the politicians. It's hardly a secret that, in today's Washington (and Albany and Sacramento and Austin) money talks. And nobody talks -- make that shouts -- louder than Wall Street. Probably the biggest mistake Congress made was to allow Freddie Mac and Fannie Mae, which had been created to make it possible for middle-income families to buy houses on reasonable terms, to behave like every other giant investment firm on the hunt for a fast buck.

What Does It All Mean forYou?

The financial meltdown, alas, is still a work in progress. While Wall Street will obviously never be the same, just how far the government will have to go to bring stability to the financial system is still up in the air. Accordingly, the risks that small- and medium-size investors face, and the ways in which they can protect themselves (or even profit) from the chaos, are likely to change. Still, a few lessons couldn't be clearer.

Your Broker/Banker/Investment Adviser Is Not Your Friend

It's second nature to distrust roofing contractors and used-car salesmen. But most Americans are all too willing to take professional investment advice at face value.

This crisis has proved how wrongheaded such trust can be. While many, perhaps most, of the people who are paid to help you decide how to invest and how to borrow are conscientious, they are at heart salesmen who generally radiate an optimism that is both infectious and misplaced.

More to the point, their pocketbook interests rarely coincide perfectly with yours. The mortgage broker only gets paid if he gets you to sign on the dotted line, and he won't be there to commiserate when you can't make the monthly payments. The investment adviser may be willing to help you build a sound savings plan, but he'll make a decent living only if he steers you into investments that pay him hefty commissions. The insurance salesman is right to warn you of the dangers of leaving your family without a breadwinner, but the insurance policies he's apt to push are the ones that reward him most generously.

None of this implies that you must plot an investment strategy entirely on your own -- hey, you bought this book. But it does put the burden on you to be clearheaded about the limits of advice from experts, and to seek help from sources whose interests more or less mesh with yours.

The Policeman Probably Is Your Friend

I don't mean some guy in blue carrying a Smith & Wesson. In this case, the police are a half-dozen federal agencies ranging from the SEC to the Federal Reserve that are charged with keeping Wall Street stable and honest. For the past two decades, the mantra of mainstream economists has been "disclosure trumps regulation" -- that is, it's far better to demand that bankers and brokers lay out exactly what they're selling than to play nanny by limiting the risks investors and borrowers are permitted to take.

As one of those economists, I'm not unsympathetic. Too often in the past, regulators have ended up defending entrenched interests at the expense of the public. But it's an understatement to say that, this time around, the approach didn't work out.

For one thing, Wall Street never delivered on its promise to disclose risk. The big investment firms almost made a game of avoiding disclosure, hiding risk in myriad ways. Indeed, they were so good at it that they concealed the risk even from key decision-makers within the firms. (Otherwise, Lehman Brothers would still be in business.) For another, we've found out the hard way that the mistakes made by hotshot investment managers reaching for bigger bonuses can cost others their jobs and their savings.

Probably most important, we've learned that there's a limit to what you can ask of ordinary Americans, who find that investing their savings or shopping for a mortgage is as daunting as taking the SATs. After all, somewhere in the documents signed by every home buyer who accepted mortgage terms he or she couldn't possibly afford was all the bad news he or she didn't want to hear.

All that's about to change. The big question now is whether the regulators will have the resources to do an adequate job of policing, as well as the discretion and wisdom to let free markets do their thing when they are working well.

Herd Instincts Are Powerful

Every time a bubble bursts, hindsight makes it clear just how stupidly investors behaved -- especially near the end. Think, for example, of how absurd it was to speculate in Miami condos in 2005, when prices had already reached the point that most people couldn't afford to live in them and the city skyline was cluttered with a dozen apartment buildings under construction. Or how nutty it was to take out a mortgage on a house in San Diego if the only way you could make the payments was to refinance the mortgage when the house became more valuable.

On second thought,stupidis the wrong word. Going along with the crowd is a potent -- and in many cases useful -- instinct. Do you really want to wait until you see the sabertoothed tiger with your own eyes before you make a run for it? So the trick is to think independently about investments, to resist the impulse to do what everyone else is doing because people made so much money doing it last year.

Fear Is an Expensive Emotion

What should you do when the stock market takes a nosedive and those mutual fund shares you bought for $20 are worth only $15? How should I know? Every day is a new day on Wall Street. Just because the market went down today doesn't make it more likely it will go down tomorrow. By the same token, today's tumble doesn't make an uptick more likely.

What I do know, though, is that fear breeds overreaction. Investors who are amateurs -- investors such as you who are accumulating savings for college expenses, retirement, maybe a vacation home -- are rarely as well informed as the professionals who move the market. Indeed, it used to be a popular (if not terribly successful) strategy on Wall Street to watch what small investors did, then do the opposite. The bottom line: invest for the long run, resisting the inclination to jump ship the minute the storm hits.Copyright © 2009 by Peter Passell

Excerpted from Where to Put Your Money Now: How to Make Super-Safe Investments and Secure Your Future by Peter Passell
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.

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Where to Put Your Money NOW How to Make Super-Safe Investments and Secure Your Future

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