With Apologies to Bremerton

Remember the "new economy"? More importantly, do you remember when that notion of ever-increasing equity prices was kicked in the nuts by reality in the dot-com bust? Yeah, I forgot about that one too.

But I recognize the feeling, the "something doesn't feel quite right" feeling that I had as real-estate prices soared in the first half of this decade. The easy home-equity credit that we landed allowed us to put a new kitchen our 4 bedroom Seattle fixer, rather than move to Bremerton for something equivalent (for those who don't know, Bremerton is the Newark of the Pacific Northwest). It also apparently fueled demand for houses, condos, co-ops, and coops, pushing up prices.

That something ain't quite right feeling is getting some reinforcement today, with the Fed's bailout of AIG, the bankruptcy of Shearson ... er... Lehman, and the sale of Merrill Lynch to BofA. The market down 1000 or so points in two days. Pretty grim. One of the grimmest that I recall.

Several notable recessions were preceded by prolonged periods of easy credit, leading to euphoria in the financial markets, and ended by sudden and sever downturns. The 1873 recession, the great depression, for example. We should have recognized it again this time, but it is soo hard to see the unpleasant truths when everything is going up up up!

Apparently, sub prime mortgages started to have delinquency problems in early 2005, about the same time that home prices started to taper off. Funny, the stock market did not register much of a response to this until 2007, two years later. At that time, a small number of financial institutions halted redemptions in their funds because they were having difficulty valuing the complex fund assets.

These complex assets, or structured finance products, were originally thought to mitigate risk. I remember as an options trader, making markets for counter parties who were seeking to offset some underlying risk in their portfolio with straight-up currency options. It worked for them. However, while options are complex and difficult to value, the "structured" instruments issued against pools of mortgages were way more complicated.

At the time they were issued, they seemed great. So great that their inherent risks seemed nonexistant. So great that having them on your balance sheet was as good as cash or government bonds. So great that Moodys and Standard & Poors might give you a triple-A-plus.

But, once the underlying asset went down (e.g. the steady stream of mortgage payments), so too these asset tanked.

In retrospect now I think that all the inflation we have seen in the last few years - oil, food, concrete - was fueled not by China's insatiable demand, but rather by an excess of money. An excess of money fueled by super-easy credit, and secured by the ability of regular Joes to make mortgages payments on houses with crazy prices.

I hope that all the regular Joes out there are doing OK. It's not their fault. I don't even think its the government's fault, or the banks fault. It's a phenomena.

And, as Einstein said... er, well, read the previous post.

Note: I leaned heavily on the BIS 78th Annual Report for this post.