The Subprime Mortgage Crisis

When it comes to the subprime lending crisis, I tend to lean towards and Occam's Razor theory ... the simplest answer is usually the right one. Folks bought more house than they could afford yet banks had become decoupled from their customers as far as mortgage loans go. Back in the It's a Wonderful Life, George Bailey days, when the Savings and Loan made you a mortgage loan, the bank typically held the mortgage for the term of the loan ... 15 years for a 15 year mortgage, 30 for a 30. The standard for banks nowadays is to package the loans up and get rid of them soon after origination. Thus, it doesn't matter so much as to the quality of the loan but as to "how many of these can we do so we can make a quick profit."

To me, this is the heart of the problem. If the local savings and loan has no vested interest as to the quality of the loan then potentially, the quality of the loans will be substandard.

A Global Financial Tailspin

If a penalty is not present for those who take a risk and fail, what disincentive do they have to not try the risky maneuver again? I am a hands-off, deregulation man myself but after reading some of these articles and gaining an understanding of what went on, I think that if any regulation is needed it is in the bond market.

The stock market is fairly translucent, the bond market is opaque. This is what allowed the bond institutions to package up all of the junky mortgages and get them reclassified at a better rating. This was not the cause of the subprime mortgage catastrophe, but it certainly made it worse.

I believe it shouldn't be allowed to get to the point of failure in the first place, at least not on such a massive level based on a massive bet that was founded on unethical financial practices.

The more I read about this the more I come to understand that what happened in the secondary markets, the rolling of the bad loans into tranches which were then rolled into CDOs to mask the bad loans which were then insured with credit default swaps, it was like "Dumb and Dumber Go to a Casino." The problem is, they were having fun making these high stakes, ludicrous bets with billions of dollars. I find it hard to believe that a few key individuals could have been responsible for throwing us into a global, financial tailspin but the more I read, the more I believe this to be the case.

I believe in capitalism and free markets but when a few key players have the power to destroy the free market and opportunity for others, a referee must step in.

Festering Junk and the Law of the Few

I always thought it was a bit too simplistic to say that "greed" was one of the major causes of the massive, subprime financial failure, but the more I read about it ... it is apparent that greedy folk are abound on this planet. (And I don't mean greed as it applies to achievement. To me these are diametrically opposite beasts.) One article I read details the speech of a banker admitting that free checking is a "tax on poor people" because they, the bank's, counted on collecting fees through overdrafts and add-ons.

The sub-prime mortgage market allowed investors to tap into the largest asset base in the states, the home, and although one of the supposed key tenets was to allow home-owners to tap into cheaper interest money, it was like handing a loaded gun to a four-year old.

And then you enter the genius and stupidity of Wall Street. The genius side of the coin (which could arguably still be placed on the stupid side of the coin) came from the folks who invented the subprime mortgage tranches, credit default swaps and the "geniuses" at Goldman Sachs who came up with the CDOs. My understanding is that the tranches and CDOs were ways to hide the junk, B- mortgages mixed in with the not so blatantly, festering junk. The bond tranches were set up like a parking garage (house of cards or stack of dominoes, your pick) with the riskier, substandard loans on the bottom and the better ones on top. The folks on the bottom received the highest interest rates but got wiped out first. Yayyy.

Enter the Genius of Goldman Sachs.

To further mask just how crappy these bonds were, Goldman Sachs started using the CDO or collateralized debt obligation which is essentially subprime bond towers (tranches) within a tower ... or in other words and even bigger house of cards.(stack of dominoe’s etc.)

At this point I would argue that the financial world might not have been devastated by a nuclear bomb had things stopped here but ...

Enter the Genius of Those Who Caught On ...

At this point if you were privy enough to realize just how big the subprime market was ...

“Thirty billion dollars was a big year for subprime lending in the mid 1990s. In 2000 there had been $130 billion in subprime mortgage lending and 55 billion dollars’ worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 bilion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage - backed bonds in a single year.” - Lewis, p 23.

And where it was headed, you might just start betting against the subprime mortgage market.

Enter the Credit Default Swap

A credit default swap is essentially insurance on a mortgage bond, insuring against default. The trick is, banks weren't buying them, they were selling them! The individual holding the default swap stood to gain massively if the subprime mortgage market imploded in on itself. Selling a default swap just meant extra income via the insurance premium to the seller.

Enter the Stupidity of AIG

AIG, through the wrangling and tactics of Golman Sachs began selling these things by the bucketfuls and by bucketfuls I mean billion dollar buckets. AIG was taking the other side of the bet and as long as the bank that held the original bond did not collapse, the person who bought credit default swaps stood to gain massively.

I would argue that a few key individuals truly turned a financial crisis into a global thermal nuclear financial meltdown. Had the credit default swap market not have taken off (e.g. those that wanted to buy essentially built the market by talking the banks into building and selling credit default swaps) and the insurers (AIG) not been so blind as to sell these things, I doubt we would still be experiencing the implosion of the housing market today.

In keeping with Malcolm Gladwell's proposition of the "Law of the Few" in which "the success of any kind of social epidemic is heavily dependent on the involvement of people with a particular and rare set of social gifts,"¹ as detailed in The Tipping Point, I would argue that the exacerbation of the financial crisis was caused by a few key individuals.

1.Gladwell, p 33.

Sub-Prime Mortgage Lenders - The Big Short

According to Michael Lewis, in his book The Big Short, not only were mortgage lenders lending to folks who couldn't afford the loans, they were providing second mortgages so that borrowers could tap equity in their homes (not to buy houses) allowing financiers to expand their business into the largest asset base in America, housing.

Lenders claimed that these products allowed the sub-prime borrowers to finance purchases at lower interest rates instead of using high interest credit cards. Although this is partly true, it allowed borrowers to take out second mortgages on trailers which much like cars, begin to lose their value the second you drive it off the lot.

In the 80s, mortgage bonds were divided into tranches in order to bucket off the risk of "prempayment." (Note: repayment and not default was viewed as the chief risk. The individual in the first tranch was synonymous to a person on the first floor of a house during a flood. They would get hit first if the loan was paid off early thus eliminating their cash flow, leaving them holding the bag when typically, interest rates were at a low. The next person would be on the second floor and get hit second but would realize a lower interest rate payment. So on and so forth.

As the subprime market began lending out second mortgages to the owner's of trailers (again folks, anything on wheels generally depreciates over time) the tranches were established to account for default risk. The person on the first floor receives a higher interest payment but gets hit first. The person on the second floor is next, followed by the third, so on and so forth ... just like a giant set of dominoes.

World Wrestling Entertainment

Always amazed by folks who think achievement is tied closely to greed ... if anything money will allow you to keep following through on your goals. Do you think Steve Jobs went home and rolled in piles of money or spent more time planning Apple's next product? And he was sitting on billions of dollars in cash in Apple. The money allowed him to continue innovating. If anything money is just another metric to gauge success in one area and certainly not the only metric.

Also, the majority of America's rich are first time millionaire's who gained their wealth through small business ... no silver spoons here folks. Those who aspire to keep up appearances through huge houses, BMWs and lifestyle "glitter" for the most part are truly broke, or balance sheet poor. The majority of millionaire's live in moderate neighborhoods and drive standard cars, valuing achievements over appearances. These findings have been published in Thomas Stanley's books, "The Millionaire Next Door" and "Stop Acting Rich."

Additionally, both Fox News and MSNBC get it precisely wrong folks ... the truth is much more moderate ... which is not as entertaining as the modern "Wrestling Entertainment" spectacle that modern media and politics have created. Turn it on, find out who the good guys and bad guys are, watch the wrestling match, repeat. This is just entertainment, not the truth of the matter for either side of the fence.

Steve Jobs

Your time is limited so don't waste it living someone else's life.

Don't be trapped by dogma which is living with the results of other people's thinking.

Don't let the noise of other people's opinions drown out your own inner voice.

And most importantly, have the courage to follow your heart and own intuition, they somehow know what you truly want to become.

Everything else is secondary.

- Steve Jobs addressing the 2005 Stanford graduating class

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The Science of Acceleration

1) Determine that demand exists, both existing and historic (we want to open a Blu Ray Store not a Beta Max Store)

a. Look at This Time Last Year sales, 10 year trend, 5 yr trend - looking for high sku demand.

b. Current demand

1. Internet

2. Retail items with correlation to internet items

3. Amazon/Wal-mart, competitors ... does the customer profile match?

4. What do the customers want - surveys on Facebook, in e-mails ... again, the 5 methods of determining demand ... a small trial run ... do two ... eliminate the loser. Ask a friendly non-competitor.

2) Saturation - if the item is already over critical mass and on the decline ... we do not necessarily want to promote it. Looking for a sweet spot here ... and item at 60 to 80% of its peak demand with ...

3) Acceleration or gamma ... we want an item that is picking up speed heading towards its peak, not away from it. Gamma is a measure of rate change in demand for an item over time, in this case, I imagine over a shorter period of time, at the most months since the e-mails are frequent and short-term.