I was talking with my mentor, whom I owe probably more than my life, he is the one that has brought me to this world of the trading and investing, and he was explaining me what exactly happened for the banks to get where they are. I did explain some of this couple of days ago, but this explanation it’s much better:
“The banks in United States do not print or create money, the FED is the one that does that. The Fed creates money and let that money to the banks, with a interest rate that is assign by the Fed itself. Unlike some believe when the FED lower the rates of FED FUNDS is not lowering no mortgage rates, or any public loan rate. It’s lowering the rate which banks could use to lend to each other or ask for money to the FED.
In 2002 for example for every 100 million dollars loan that a bank asks to the FED, the FED let them the money at a 1% rate. The bank right away let this money as a Mortgage loan at a rate of 5% to regular citizens. In this way they were making a 4% profit out this money that they never use in the first place. But it gets better, once the bank let the money for Mortgages; they sold those Mortgages loans to Fannie Mae or Freddie Mac asking for an extra 1 to 4% to his institutions. (The banks made profit twice in the transaction).
Freddie and Fannie use to take those mortgage loans, and made them “Mortgage backed securities” and sell them to traders and hedge funds. The problem, was that Greenspan allowed the party for too long (4 years) and the banks accumulated a debt of more than 5 trillion dollars against the FED.
When Greenspan realized of the problem that he caused the tried to fix it, increasing the FED Funds rate from 1% to 5% in 14 months, BIG MISTAKE! The banks that were in debt with the FED were losing now money instead of making profit.
The Banks trying to get liquidity decided to let go what they call “Collateralized Debt Obligation” This swap work in this way:
You sale a Bonds to a trader, for 250,000 dollars in a period of 12 months, and if in those 12 months the bonds of FANNIE & FREDDIE did not loss their value, you as trader, wouldn’t just lost those 250,000 dollars, but IF, those bonds from FANNIE & FREDDIE loss value, then you as a trader, would it earn 10 millions per bond certificate.
The banks never though that his bonds from FANNIE & FREDDI wouldn’t loss value, because they were support by the government, but what the impossible happened traders like John Paulson made a profit of 5 Billion dollars on 2007, and also Bruce Kovner, but who is paying for all this?……………..is not Alan Greenspan or the CEOS that allowed this disaster, it will be us, that 100 million of Americans that invest on the market”
First of all I want to thank my friend for the explanation “Dominicanmahco”, and add to this great explanation, that no matter, where or who, it’s our nature: the ones with the power and resources take advantage of the others; you could see this since the days of the ROME Empire. That’s why I you can’t argue in favor of regulation yet, everyone want to blame the deregulation of the banks, or Wall ST. The problem is not Deregulation like Obama and McCain are arguing, it’s matter of applying the law when someone breaks it. The answer is neither raising taxes like Obama is proposing, it’s just applying the law when is need it, but instead we are rewarding the ones that are responsible of this mess, and bailing them out it. The result, more money need it from the FED, which will drive inflation to through the sky, we already seeing Oil bumping 16 dollars today.