The Obamians and their accomplisses in the press who shill for them have blasted John McCain in recent days over his statement that the economy is sound. Politically, it wasn't the best move as such statements become fodder for the uncritical sound bite crowd. But fundementally john mccain is right. Unemployment is low, although it has risen in the last month, inflation is moderating, corporate earnings and GDP remain positive. For going through the biggest terrorist attack in history, a war, and now the biggest financial crisis, the bush economy is doing remarkably well. But then again, if bush isn't going to defend his record, why should anyone else. So the problem is not with the economy, but with the credit markets which john q public doesn't see on the evening news.

 

When mr public goes down to main street bank and gets a mortgage, the bank sells his mortgage to the countrywides of the world. They inturn get their money back plus some money for doing the loan so they can make another loan next month. There is too much risk for the bank to not sell. Now that countrywide has bought this loan, they don't want it either because of the risk, so they sell it to Fannie Mae. Part of the deal is that countrywide will continue to collect the payments and manage the escrow account, but the actual loan itself gets trucked off to Fannie and the client is none the wiser. Now fannie mae doesn't want to hold the loan either, because its too risky so they take a bunch of loans they bought and drop them on the door step of wall street. Wall Street in turn securitizes all these loans into bonds to sell them to mutual funds, insurance companies, pension funds, hedge funds and individual investors. What this effectively does is spread the risk of my mortgage and your mortgage to a bunch of different investors. And this is how the conforming mortgage market works. All loans that conform to fannie mae and freddie mac guidelines follow this path.

 

Back in the late 90's when interest rates were very low there was a bunch of money sloshing around the economy, housing was a great investment and congress was intent upon providing more opportunities to low income and minority borrowers. Ergo, lending guidelines gradually relaxed their standards. We got the now infamous no doc loans, stated income loans and no money down loans. The subprime mortgage market got extremely hot and investors from banks to hedge funds to insurance companies started loading up their books with these mortgage bonds. This brought a tsunami of new home buyers into the market and drove housing prices up even higher and all was right with the world. Lenders and investors were fat and happy and congress had a narrative to tell their constituents about how they have expanded housing opportunities.

 

When the economy started to slow, investors woke up one day and realized, wait, we have risk in our portfolios and if housing prices are not going to go up 20% this year, we need to scale back buying all these subprime loans. Within a few months, investors stopped buying these loans and the whole subprime market collapsed and some lenders had to close their doors. Now all of these financial institutions still have A LOT of these subprime bonds on their books, there is no market to sell them and nobody knows what they are worth. The Bear Sterns, Lehman Brothers and AIG's of the world don't have the assets to cover writing all these bonds off as a loss, so they either go under or they need to be bailed out. And in the case of Bear and AIG, the economic ramifications of letting them go under are just too dire of an option.

 

The plan put forward by hank paulson this week will have the government stepping in as a buyer of these mortgage bonds when nobody else will. They will offer institutions 30 or 40 cents on the dollar for their illiquid mortgage bonds. Once the economy gets back on its feet and the street gets a better idea of default rates the Treasury will then be selling these bonds back to investors hopefully for more than what they paid for them. The Treasury is not so much bailing out wall street, but stepping in as a buyer of last resort to provide a market for this debt where there currently isn't one. Paulsen comes from Goldman Sachs and is a superb dealmaker. There is a fire sale right now on mortgage bonds and this could prove to be a terrific investment 5 years from now.