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Three Questions for the Finance Guy - Paul Petillo - 10.17.08

First up, the single most common question I am asked, and it doesn't matter where I am, is this:

Unfortunately, we are now a society so deeply intertwined with Wall Street, that the saying "when America sneezes, the world get a cold" can now be easily switched to "when Wall Street sneezes, Main Street gets pneumonia".

There are certain things you need to keep in mind about the American economy. We consider wealth to be something tangible, something in our possession, and not necessarily something liquid (or easy to sell on a whim). Houses have fallen into this category and fully a third of all of the wealth calculated in the United States, stems from the net worth of our homes.

This amounts to a little over $19 trillion worth and this may come as a surprise, almost all of those mortgage will be paid off at some time. The actual foreclosure rate, while troubling makes up just a small portion of the total number of homes with mortgages.

The reason housing is considered a bubble was due to two factors: It was widely warned about and secondly, no one listened. The undercapitalization of Freddie Mac and Fannie Mae was well known and it was Alan Greenspan who issued the warning. But it fell on deaf ears.

Now to answer the question is to acknowledge that to get housing into the hands of folks who could afford it, credit needed to flow. But soon as it became apparent that the shenanigans on Wall Street (the creation of debt instruments that few understood and for the matter, wanted to) made it easy to borrow and chase a commodity that was appreciating faster than mortgage lenders could create the paper. Which was sold and re-sold and re-sold again until there was no telling who owned what.

So to bring this all back in line and to allow banks to review what was on the books, the lending stopped. And so main Street felt the effects directly. That will now trickle up to the business third of the economy and without credit or Wall Street's blessing, things begin to slow even more.

That is the simple answer. The more complex one relies on your ability to comprehend derivatives, a mostly computer generated example of how to create risk without, at least in the models based on theory, adding additional risk to the investment, Credit Default Swaps, a sort of inter-bank lending for short periods of time in order to take something off the books for a short period of time, and Mortgage backed Securities, bundled loans that have an undeterminable underlying worth.