Caveat emptor in the financial markets

Innovating Our Way to Financial Crisis

Op-Ed Columnist
Innovating Our Way to Financial Crisis
By PAUL KRUGMAN
Published: December 3, 2007
The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.

Excerpt:

Credit — lending between market players — is to the financial markets what motor oil is to car engines. The ability to raise cash on short notice, which is what people mean when they talk about “liquidity,” is an essential lubricant for the markets, and for the economy as a whole.

But liquidity has been drying up. Some credit markets have effectively closed up shop. Interest rates in other markets — like the London market, in which banks lend to each other — have risen even as interest rates on U.S. government debt, which is still considered safe, have plunged.

“What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.

Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.

In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn’t even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.
....
... the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.


Definitions:

1. C.D.O.: Collateralized Debt Obligation
   
2. S.I.V.: Structured Investment Vehicle
   
3. R.M.B.S.: Residential Mortgage Backed Security
   
4. A.B.C.P.: Asset Backed Commercial Paper
   

Comments: Confused? What's tragic is that it sounds like the experts are confused! More below:

Denver Post: Easy loans mean painful losses

Excerpts:

As a speculative buyer, Campbell, like many others, repeatedly took advantage of the easy-loan era that collapsed this year into the subprime-lending crisis. From 2000 to 2006, the percentage of home loans to investors doubled nationally, and the number of mortgage-fraud cases leapt 700 percent, from about 3,500 to about 28,000.

Legal documents describe Campbell as a man afflicted with debilitating diseases, including hepatitis and kidney failure. In a lawsuit last year, he asserted his sole source of income was a Social Security disability program and that his only assets were houses with defaulted mortgages.

Yet in Colorado, Campbell managed to secure new home loans from subprime lenders despite a history of foreclosures on his old loans.

From 2004 to 2006, he purchased at least 12 houses in Colorado in his name for a total of $8.2 million. He had two houses in Cherry Hills Village, the swank suburb south of Denver. He had a Denver house four blocks east of the governor's mansion and another across from City Park. He had a house in the mountains and a house on a Broomfield golf course.

Campbell signed deeds promising that at least nine of these houses would serve as his principal residence, enabling him to qualify for lower interest rates than an investor.

He also had a knack for taking cash from the closing table instead of putting money down by inflating sale prices to boost loan amounts.

Real-estate listing records show he bought one house for $350,000 above the original asking price and another for $251,000 above the original asking price. Nine of the 12 houses were soon foreclosed. Two others were foreclosed after he sold them to another investor.

... he had his hands in the $3 million purchase of the mansion at 801 Race St.

The house had sold for $1.3 million in December 2005 to Jeffrey Hammerberg, a licensed real- estate agent who remodeled it and tried to resell it four months later for $2.25 million.

When it didn't sell, Hammerberg lowered the price by $100,000. It still didn't sell. Yet in August 2006, real-estate listing records show, Hammerberg raised the price to $3.1 million.

The house sold for a reported $3 million in November 2006. The listed buyer: Jill Rodriguez. Her husband, Florencio Rodriguez, owns Mile High Realty and Mortgage, the mortgage broker Campbell had used to try to buy other houses in 2006.

Raising the price from $2.15 million to $3 million made it possible to borrow more money. Eighty percent of a purchase price is a typical loan amount. New Century Mortgage, a leading subprime lender that went bankrupt this year, provided $2.4 million, which was 80 percent of the reported sale price.

Ronald Low, a spokesman for New Century, said the company uses various measures to guard against mortgage fraud, including examining borrower qualifications and verifying appraisal values on a representative sample of its loans.

Comment: Caveat emptor is Latin for "Let the buyer beware".