America's problem isn't liquidity, it's insolvency

Years of predatory lending practices have left many Americans forced to choose between paying down their unaffordable mortgage or buying groceries for their families. For others, misfortune has created opportunity.

We continue to read articles in the financial press and elsewhere by widely-respected mainstream economists who have a tendency to quote mindlessly from Keynes' masterpiece "The General Theory of Employment, Interest and Money".

They couldn't be further from the truth, however, when they claim that the current credit cycle liquidity problems can be corrected with a little fiscal stimulus and cheap money to jumpstart the ailing economy. It is not liquidity that is preventing the money from flowing; it's insolvency! The banks won't lend to deadbeats anymore! HELLO! Sure, cheaper money helps high credit score borrowers refinance and pay less in interest charges, but cheaper money does nothing for the existing bad loans backed by No Income, No Collateral, and No Character.

When we were first introduced to credit back in the late 1960's, bankers learned about the 3 C's of credit: Collateral, Character, and Cash Flow. There was no such thing as a NINA (No Income, No Assets) loan. Indeed, back then it was virtually unheard of to lend money to an unqualified borrower.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

It wasn't until I arrived on Wall Street some 15 to 20 years later and was involved in the securitization industry (particularly the sub-prime industry) that I realized hundreds of institutions, employing thousands of employees, were willingly making millions of loans to borrowers with, yep, you guessed it, No collateral, No income, No character! Some of these were white shoe institutions with blue-chip stocks. (The article in the Wall Street Journal today, "The Rise of Mortgage Walkers", says it all).

Of course mortgage borrowers are walking away and feeling no shame as they fling the front door keys to the wind! I have been writing about this and speaking about it at conferences for years, and wondered why nobody listened.

As a result of many years of predatory lending, the United States is facing an insolvency problem that is unprecedented. Leverage must be reduced to restore faith in the solvency of institutions before anyone will trust them again with their hard-earned cash. Lending has begun to go back on balance sheet but it's already too late to save the ailing SIV's and if the monoline insurers fail, say goodbye to the asset-backed CP market.

How America became insolvent

Why is America looking so insolvent? Well, for one reason, the easy money policies of the past have resulted in at least three trillion of really dodgy loans issued for mortgages, automobiles, home equity lines of credit (HELOC), and credit cards. And, to top it off, last Friday the Bureau of Labor Statistics finally started to come clean as benchmark revisions showed that jobs created by the Birth Death Model were just a happy fiction; another 360,000 of jobs just vanished in the employment release.

Over the next few years, the character of many millions of Americans will be tested as they are forced to make very tough decisions on how they will live and spend money. Will they do the honorable thing and pay down their credit card or mortgage from Countrywide (after reading that the head of Countrywide left the firm with a gazillion bucks), or will they buy groceries for the kids?

This morning Wal-Mart announced their sales figures and, surprise, their store-offered gift cards are now being used to buy groceries and necessities, rather than iPods and DVDs. At the same time, credit cards are being maxed out for the same reason!

Predatory lending and the death of the American Dream

How can the Central Bankers, Wall Street bigwigs, rating agencies, appraisers, bond insurers, and investment bankers sleep at night when they know they stooped so low to make a profit. Each time they provided the liquidity to wrap, rate, sell and finance a mortgage, or security, they took advantage of innocent people.

Sure, every borrower should read and understand the fine print and be held accountable when they execute a legal document, but the magnitude of the predatory lending practices during this bubble reached proportions never seen before in history. Many borrowers are now literally struggling to survive and eat, and will soon be facing foreclosure. The Happy American Dream has been taken away and replaced by a nightmare. So;

When yesterday's liquidity looks in the mirror, it's insolvency that is staring back!

As this credit tragedy unfolds, I noticed last week while attending the Asset Securitization Forum in Las Vegas (which I fondly refer to as "lost wages"), there were over 6,500 Wall Street preppies there and over 1,500 had resumes and were looking for jobs. It looked to me like the entire conference was in a state of total denial. In my 25 years of attending these securitization finance conferences, this one felt more like a job fair than an industry conference. When I needed to adjust my watch to the correct time, I realized you never know what time it is in a casino because there are no clocks. Time doesn't matter there so it's never too late to gamble. Indeed, the players at the credit casino should have left the gaming table last year!

Not all of the attendees at the ASF Conference were bleak, though, and many were smiling, or perhaps smirking. The smart smirking ones were crossing the street to the Debt Buyers Association Conference and were looking to pick up trashed assets for pennies on the dollar. A number of people were also employed at firms that perform due diligence, but they cut deals with the State Attorney General to stay out of jail in return for immunity and fingering some big-name Wall Street houses.

These Wall Street firms forgot to disclose that the large number of loans issued to borrowers with no verifiable income, was off the charts. As a result, new law firms are sprouting up like weeds as they gear up for investor class-action lawsuits. Misfortune creates opportunity.

Surely, any author writing a book today about the state of the world economy should include a few extra chapters devoted to what's going on in the credit market. They would be called "Government Bailouts with your Money", "Massive Government Deficits", "Rising Unemployment", and, let's not forget, "The Great Inflation". Perhaps I should write the book.

Written by Richard Benson and published in Benson's Economic and Market Trends 31/7/2006,