Today's Jobs Numbers: CNBC Fans The Flames of Panic

Where does one begin on this topic?

First, the facts, so to speak. Today's non-farm payroll numbers came in so low that they recorded a net loss of jobs in the US economy recently. Expectations were for a much higher number.

The questions now on the table:

Is the US economy now in, or about to enter, a recession?
Has the Fed dithered in the face of obvious data requiring a rate cut?
Does Ben Bernanke now 'have mud on him,' as a CNBC on-airhead anchor so callously asked?
Will the Fed now cut the Funds rate later this month and by how much?

As I write this at 11AM, EDT, the equity markets are falling. The S&P500 Index is off by about 1.5%.

It probably will not help that CNBC is prominently featuring guests who are screaming that we are now in a full-blown recession. Among those CNBC chose to lead this ill-advised, partially-informed charge, is none other than their resident self-annointed know-it-all, Jim Cramer.

Cramer, a journalist and lawyer by training, has no bona fides in economics. Nonetheless, he was featured this morning on CNBC, loudly and confidently proclaiming that 'we've been in a recession for months.'

I'll believe it when Brian Wesbury and/or John Rutledge confirm it. But on Cramer's uneducated hunch? No, thanks.

Is it necessary, or even ethical, for CNBC to be featuring such uninformed babbling in the guise of news?

Throughout this morning's coverage, the anchorman named Carl (I can never recall his last name) and most of their guests continued to look for the darkest implications of the jobs number. Carl was the one asking several guests if this single employment number did not now sully Ben Bernanke's entire reputation as Fed Chairman?

The way I view this is as follows. A single month's payroll number is announced. Whereas, in years past, some experienced, educated and trained economists would work with the data to arrive at some tentative conclusions, now we have a world full of amateur economists, analysts, and investors all reacting at once to the news.

Remember, too, that roughly 90% of those hearing this news are less skilled at investing or analyzing than the top decile. But they may well control the movement of more money in financial markets.

Thus, we are probably in for several days, if not weeks, of poorly reasoned reactions by the vast majority of (mediocre) investors.

Are we genuinely in a recession? It's not clear yet. I read some interesting information in the Wall Street Journal today referencing some research out of Goldman Sachs. The work is based upon dividing the US into 20 regions, and forecasting recession based upon how many regions are simultaneously losing jobs. In the past, eight regions with shrinking employment led to recessions. Currently, as I recall the article, twelve are in decline.

Time will tell. On one hand, one payroll report does not tell all. On the other hand, as another CNBC guest noted, the monthly payroll numbers have been shrinking, though still positive, for a year.

It could well be that the Fed will cut the Fed Funds rate by a quarter, or even half a point later this month. However, now it's likely to be to cushion the pain of a softening economy, not simply to bail out New York and Connecticut hedge fund managers.

Who Wants To Compete with Steve Jobs & Apple?

After Wednesday's announcements, would you want to walk into the CEO job at a competitor of Apple's?

Let's review what just happened.

After only 2 months on the shelf, Jobs has slashed prices and increased capacity/functionality of the iPhone. This is not because the iPhone was a failure. This is Jobs and Apples putting the big competitive squeeze on their competitors.

How can you compete with someone who moves the yardsticks so significantly in so short a time? I'd guess that if the firm you joined as CEO had hoped to have a competitive phone out by Christmas, now you will toss it in the dumpster as already obsolete, in terms of price/performance.

Jobs is now racing down a value-added/volume curve, pricing ahead of current volume, and about to reap tremendous value-added from the market for new iPhones, iPods, etc.

Rather than bid down the price of Apple's stock, as sellers have effectively done this week, I think the price will ultimately head the other way. Once the mediocre investors have finished dumping the stock, and the wiser investors scoop it up at a cheaper price.

Sellers of Apple stock miss the big picture. The firm has quickly and consistently improved every element of its product lines- computers, music players, phones, and the new AppleTV. These are the actions of a strong competitor which is getting even stronger and more dominant.

So a few iPhone buyers got stuck paying a lot to be early adopters! So what? This is normal in the electronics sector. Being first with a new toy (remember the Apple Newton?) always means paying full list, and then some. Boo-hoo.

From Apple, they should expect rapid follow-on at better price/performance points.

Everything I see in Apple's broad new product announcements screams strength and improved sales and profits going forward.

This is classic, textbook Schumpeterian dynamics at work. Jobs is cutting the footing out from underneath his competitors as he introduces new features to Apple's products and raises the bar for what is now default performance.

Personally, I own one of the original iPod Shuffles. If memory serves, I paid $100 for a half-gig model. Now, a new Nano has several gig of storage, a video screen, and costs only $150. I'm seriously considering an upgrade, just because of this new product introduction.

You couldn't give me a job as CEO of one of Apple's competitors in phones or music players and/or online music purchasing right now.

CEOs, Corporate Performance, and Houses

Yesterday's Wall Street Journal featured, as one of its three front page articles, a piece by Mark Maremont describing academic research into the relationship between various events and actions in the private lives of CEOs, and the stock price performances of the companies they headed.

The fact that this article was given such prominence tells you that the editors of the Journal feel it is important and reputable. Perhaps the most interesting and methodologically valid piece of research presented in the article was one by Yermack (Penn State) and Crocker (Arizona State) relating CEO home building and subsequent stock price performance of their companies. While it's worth reading the Journal article in its entirety, the short version of this particular research effort's result is to find that those CEOs who built/purchased large homes ( >10,000 sq ft) saw their companies' stock prices, on average, decline 25% in three years, while those with 'other' homes saw, on average, increased stock prices of roughly 20% by year three.

No measures of statistical significance were provided in the Journal article, although one surmises that one is available in Yermack's and Crocker's paper. Their approach was novel and inventive. They chose a single point in time, the end of 2004, and secured housing data on 488 of the S&P500 CEOs.

The basic premise being described, of course, is that of a CEO engaged in building or buying a large home is taking his mind and attention off of shareholders' welfare, and concentrating, instead, on spending his compensation on luxurious trappings of power. Among the CEOs mentioned in this manner, by name were: Leslie Wexner (The Limited), Stephen Bollenback (Hilton), and Trevor Fetter (Tenet Healthcare).

So far, so good...and simple-minded.

You see, there is another possible, and reasonable explanation for this phenomenon. But you'd have to be open-minded about observing and measuring corporate performance in order to see it.

My proprietary research has indicated that once companies have consistently outperformed the S&P500 Index on a total return basis for five or more years, the chances of this performance continuing falls precipitously.

Thus, a CEO building a large house with the fruits of her/his successful efforts at outperforming the S&P in the prior years would make sense. And the probabilities of continued outperformance would be slim, anyway.

Thus, Yermack and Crocker may have simply validated that succesful CEOs reap the rewards of their efforts for shareholders, and the game is over for a few years.

As I look at the nearby, Yahoo-sourced stock price chart of The Limited (Brands), Hilton Hotels, and Tenet Healthcare, all mentioned by name in the research piece, I draw a different conclusion than the study's authors.

To me, up through 2004, while the Limited struggled from 2000 onward, staying roughly even with the S&P, Hilton outperformed the index, and Tenet outperformed for about 4 years, then fell sharply.

Thus, I find Hilton and Limited to not be examples of the behaviors suggested in the Yermack and Crocker research. Tenet may be. It's declined has persisted since 2003.

The frame of reference you use, and what you know about potential corporate total return performance, matters in how you evaluate subsequent CEO behaviors after a period of good or great performance versus the index. I don't find the study that the Journal article spotlighted to be so bullet proof now as I did when I initially read of it.

Now, I would be very interested to know how their results would differ if they applied my knowledge of the probabilities of corporate consistently superior performance over time, versus the S&P, to their existing work.

The Union Picket Line: How To Explain This Anachronism?

It's funny how some things grow to be anachronisms, yet we don't stop to notice until someone else points it out.

For reference, Merriam-Webster's Online Dictionary defines anachronism as:

2 : a person or a thing that is chronologically out of place; especially : one from a former age that is incongruous in the present

The anachronism du jour is the union picket line. Let me explain.

Recently, the school which one of my daughters attends began construction on a new building. As a letter from the school's head noted, the construction contractor was selected on the basis of price and quality. Evidently, the lucky winner does not employ unionized operating engineers. We know this, because members of said union now constitute a small pair of picket lines across entrances to the school property which are used for construction materials, workers, and other school visitors.

Thus, throughout the long, hot summer, we have been treated to the sight of unkempt, largely overweight males standing, sitting, or sprawling on the nearby sidewalk, sometimes sporting signs which I have no doubt purport to explain their presence. On occasion, one of them dons a cloth suit made to represent a rat. On other occasions, a large, presumably inflatable rat is located at the other entrance.

I frankly didn't give all of this hoopla much thought, until my daughters each asked, independently, what this odd-looking display was on the sidewalk outside the nearby school, and why these men were engaged in this activity.

Thus it occurred to me that there no longer is a plausible explanation for these sorts of picket lines. Eighty years ago, they made sense. Not in my town today.

In order to explain what strikes and picket lines were supposed to do, I asked my daughters to think about what would have to happen for these anachronisms to have a function. Together, we discussed how local customers of the picketed business or institution would have to behave in such a manner as to support the striking union members, refuse to give their custom to the struck entity, thereby causing it to succumb to the union's demands.

Further, we discussed how this might work if: the community was experiencing significant unemployment; the union members were visible, known community members, too; the organization being struck was viewed as unfair or with some suspicion; the replacement workers were viewed as accepting, or known to have accepted unfairly low compensation, and; the unemployment of said union members had a significant effect upon the community at large.

None of these conditions obtains in the present situation involving the striking union members. They are, for the most part, from other towns or states. Nobody local to the school or neighborhood knows them.

It turns out that schools undergoing building projects are a favorite target of the operating engineers union. My business partner noted that they recently struck a public school in his nearby town when it, too, was doing new construction. Public and private schools are hardly the sort of organization you consider to be borderline criminal or shady when doing something like constructing new buildings. Further, the taxpaying residents and/or parents paying tuition to the relevant schools know they will be paying for the construction, one way or another. Thus, seeing union members striking might actually give them a feeling of comfort, that the price of the construction is not artificially inflated by absurdly high union wages and benefits.

Construction in this area continues to be very active, so it's likely that any competent laborer who wants to work at this trade is employed. At competitive wages. The striking, non-working union members, if anything, look foolish and incompetent. They refuse to take available jobs at good pay, choosing instead to spend their day sitting in the hot sun wearing silly-looking signs and/or animal suits.

Finally, since they don't live in the area, their unemployment has virtually no effect upon the local economy.

To sum up, there is zero support from the local populace for this strike. The picket line fits the definition of an anachronism. It's a tool from a bygone era.

Perhaps in the deepest Bronx or Queens, such a picket line might have an impact. Or in some smaller, poorer, more blue-collar rural town in a predominantly "blue" state.

But not in this upscale, economically well-off, predominantly white-collar town in which many residents commute into New York City to work in the financial services sector.

Thus, the image of scabs being physically assaulted as they cross the picket line at the school across the street from my home, resulting in news coverage of the conflict, is fantasy. The strike, and its picket line, is an exercise in futility.

What does this tell us about the mental capacity, sensibility, and awareness of modern times of the leaders of the local operating engineers union in my area?

An Apocryphal Tale: The Ten Best/Worst Days In Ten Years

There's an old aphorism with which I am acquainted that goes something like this:

"In any ten year period, if you miss the ten best days of the S&P, you'll lose half (or some similar value) of the return during the period."

To some extent, while the concept seems reasonable, I have treated it somewhat apocryphally.

Until now.

Last week, in the midst of the recent market turmoils, with various pundits calling for, demanding, expecting, etc., a Fed rate cut later this month, I thought it propitious to revisit this old tale.

Here's what I did. Using a daily adjusted S&P500 price series from Yahoo, I created a ten year series, from which I calculated daily total returns.

I then sorted the total return series by returns, in descending order.

For the ten years beginning August 29, 1997, the S&P500 statistics are:

6.5% average annual return

.03% average daily return

.05% median daily return

1.14% standard deviation of daily returns

+5.73% best daily return

-6.87% worst daily return

So far, so good. We see that the past ten years have, largely due to 2001-02, provided an average annual S&P500 return which is slightly more than half of the long term annual average return of 11%. The median daily return is above the mean daily return, informing us that the distribution of daily S&P returns is skewed positively. This is despite the worst daily return being lower, in absolute value terms, than the best daily return. The standard deviation of the daily returns, at 1.14%, is far greater than the mean or median daily return, indicating a very volatile daily value.

But, what about the aphorism that led to this ad hoc research? What are the returns of the ten best (and worst) days of the S&P over this ten year period?

+48.4% summed return of the ten best days of the S&P during the period

-48.% summed return of the ten worst days of the S&P during the period

This gives us:

65.2% summed actual daily returns for the S&P over the ten year period

16.8% summed daily returns for the S&P over the ten year period, without the ten best days

113.2% summed daily returns for the S&P over the ten year period, without the ten worst days

Each group of 10 days, best and worst, comprise approximately 74% of the ten years' summed total returns of the S&P. If we compare these two 'ten day' returns to the long run average annual S&P return of 11%, they comprise only +/- 44% of the total return of an average ten year period.

So, if we took a number of samples of ten year periods of the S&P, we might very well find that the aphorism is true. Something approaching half of the value of the S&P returns over a ten year period may be accounted for by just the ten best, or worst, days of the S&P over the period.

So what?

Well, it demonstrates how good your 'market timing' had better be, if you are a market timer. Miss a few days, either way, and you have an entirely different return than the market, even if you are only invested in the S&P500.

Frankly, it is simply stunning. At least to me. I can think of no other word.

To learn that missing only 10 out of some 2,500 days of S&P daily returns can remove between 50% and 75% of the total return of the ten year period confirms my belief that market timing is folly. Or making daily market calls, like Jim Cramer did this morning, on CNBC.

My own equity investment strategy approach distinguishes between markets in which we should be long, and those in which we should be short. Long term. Period. No attempts to predict daily, weekly, or monthly market moves.

Our equity strategy typically mirrors large daily moves in the S&P, but with larger magnitudes.

Now that our major focus is applying the equity strategy via long-dated, out of the money call options, this is doubly true. Although, relative to comparable S&P500 calls, it's not yet clear if this behavior extends to options.

Nonetheless, the validating of this little apocryphal tale heavily reinforces my belief in remaining invested, long or short, continuously, and abstaining from going to cash, unless very briefly, amidst noisy long term market signals.

Wendys' Fall: Another Case of Schumpterian Dynamics

Wednesday's Wall Street Journal featured a piece on the demise of Wendy's, the fast-food, hamburger chain built by Dave Thomas. It's a classic story of Schumpeterian dynamism, and the ability of otherwise apparently reasonable people to become deluded into thinking that companies last forever.

The real story begins with the absence of founder, builder and pitchman, Dave Thomas, in late 2001, when he focused on the final stages of a cancer that would take his life early the next year. According to the Journal article, Thomas was no longer "deeply involved" in the company's operations by late 2001. The fact is, nobody could convey the chain's quirky image and its food's comparative advantages like Thomas did. At this point, sane people would have begun to question if things could ever be the same.

Would Apple be Apple without Steve Jobs? It wasn't when he left years ago, replaced by John Scully. Some firms are, like it or not, iconic. Shareholders need to be sanguine about this.

After Thomas' death, the remaining management bought a Mexican food chain, Baja Fresh Mexican Grill, for $275MM. But the new unit never performed up to expectations.

Kerrii Anderson, hired as Wendy's CFO in 2000, became interim CEO after the departure of Jack Schuessler in 2006. Her compensation rose from $3.4MM as CFO, to $4.2MM as interim head of Wendy's.

The particulars of how Wendy's performance began to slide are almost immaterial. Take your pick- an accountant running a consumer food business, meddling in the kitchens, manipulating franchisees to push for her as permanent CEO, and her oversight of inept commercials using a male in a wig with red pigtails to replace Dave Thomas as the Wendy's image.

Between disgruntled institutional investors, including Nelson Pelz, and poor sales growth, the company was in trouble. It sold the Baja Fresh unit for only $31MM- a little over 10% of what it paid for the chain four years earlier.

The remaining Thomas family members- his wife and children- were appalled at how the company was faltering. Quotes in the article have them saying,

"You can't tear the company apart to satisfy shareholders," in answer to Pelz' demands to sell Tim Horton's, and that,

"Mr. Thomas's widow and several of his children say they were sick over the news (the sale of Wendy's to another owner) and couldn't understand how management had let the company become so vulnerable (my italics)."

The inept Ms. Anderson 'remained remarkably upbeat' about Wendy's growth prospects. However, as I have written in prior blogs about CEOs such as Jeff Immelt, of GE, when a CEO has earned upwards of $15MM in compensation, they no longer have the same goals as their shareholders. Ms. Anderson had, by this year, been paid at least $20MM (five years as CFO at at least $2.5MM, plus the $3.4MM in 2006, and $4.2MM as CEO). She no longer cares whether the company actually prospers. As my partner, a native of Ohio, noted,

"Do you know how far $4MM goes in Dublin, Ohio? You can't spend that kind of money out there."

The fact is, from a business history perspective, Wendy's had to slow at some point. It was Dave Thomas' passionate creation, and was inevitably destined to either grow too large, or miss some market trend. Companies don't grow forever. Changes in management, especially the loss of a gifted, passionate, insightful CEO, can cause irreparable damage.

If anyone should have had the sense to realize that Wendy's was finished as they once knew it, with Thomas' death, it should have been his family. Odds are, Nelson Pelz is more realistic about Wendy's than the family or its management. He realizes that it now is probably worth more in pieces.

A little perspective, and a lot less emotion, might have saved all the actors in this drama some grief, energy, time and money. Wendy's was destined to falter after the loss of Thomas, without some equally-passionate, experienced leader. Certainly, a relative newcomer, and an accountant, at that, wasn't going to be going toe to toe with McDonalds and winning. Or with Nelson Pelz, for that matter.

Sometimes, it's better to simply acknowledge change and get it over with.

Economies of Scale in Autos and Computers

Tuesday's Wall Street Journal's Marketplace Section featured two seemingly unrelated articles- Acer's purchase of Gateway, and Chinese auto manufacturers making inroads in Africa.

On closer examination, however, I believe the two share an important link and lesson. They both embody some elements of Schumpeterian dynamics.

In the case of Acer, this Asian computer maker has wisely taken the opportunity to buy market share and brands by scooping up the number three US computer manufacturer, Gateway. By combining supply chains and brands, Acer hopes to, and probably will, gain some margin room while obtaining new branding and price-point flexibility. Clearly, Acer understands that the computer manufacturing game is now largely a commodity one, with a few exceptions, such as HP's recent Pavillion line.

However, for large parts of the market, Acer's ability to provide competitive functionality at lower prices may help it drive Toshiba, Lenovo, and others into less tenable market and profitability positions.

The focus of the other Journal article is the emerging market for new cars in West and Southern Africa. Whereas these areas historically were dumping grounds for used European models, the Chinese have arrived with new cars so affordably priced as to compete favorably with the used car stocks.

What's amazing is that all of the new entrants are Chinese, and no American, or even European names, are to be found. Nary a Ford, Chrysler or GM nameplate.

The article suggested that these auto makers can't really afford to aim so low in price as to compete with the Chinese in Africa. However, at least one Chinese manufacturer warned/promised that they would be moving upmarket, and into richer countries, on the back of the African experience and volumes.

I can't help but think that, a decade hence, we'll read various tomes from the likes of BCG, Bain or McKinsey consultants dissecting the final mistakes of the American auto makers. Can it really be so benign to allow the Chinese to gain a vehicle production foothold, uncontested, in an entire continent? Granted, it's Africa, but, still....

You can just see the Chinese lowering costs along expanding volume curves, gaining manufacturing experience and improving quality, as well as the ability to target small, profitable niches in Africa. Then turning these newly-acquired skills on the low end of the American market.

If you needed fresh reasons to explain the slow, inexorable death of US auto production, here's another one. Complete denial on the part of Detroit that a clutch of rising Chinese vehicle manufacturers can use Africa as a springboard to enter the US with small, efficient, low-priced cars and steal another potential market before American producers can respond.

It's been the way most prior Asian auto producers have entered. Plus, with fuel economy and environmentalism running rampant these days, it would be reasonable to expect the Chinese nameplates to be more than competitive on fuel consumption, weight, size, etc. They've got a large market with which to experiment, getting smaller, less expensive cars 'right' before shipping them to the US.

Alan (Mulally), Rick (Wagoner), Bob (Nardelli)? Anyone looking east to see the source of your next competitor?

Ironically, the three blind mice probably won't take note of Acer's recent move, and consider how scale and creativity, together, can both protect against further share erosion, as well as be the basis for new growth and profitability.

Second-Rate Economists & CNBC

They're at it again!


Yesterday, CNBC featured two little-known 'economists,' one from UBS, another from PNC, who agreed that the US economy is now in danger of a recession. Both solemnly lectured that Fed Chairman Ben Bernanke had better cut the Fed funds rate next month by a quarter-point, or he wouldn't be managing the economy effectively.


Honestly, this kind of thing just turns my stomach. Who do these guys think they are? They are so far from being credible it isn't even funny.

This morning, on CNBC, for the eighteen-thousandth time since the end of July, the anchors are holding a 'debate' among various guests and pundits, as to whether the Fed should cut rates next month. You're not going to hear much else for the next few weeks, until that magical afternoon when the Fed announces its rate action, or inaction.

It seems to always be this way now. If there's anything but blue sky and sunshine in the financial markets or on their horizons, then CNBC spends most of its air time on "Fedwatch," conducting unending discussions, day after day, week after week, as to what the Fed will and should do at its next meeting, and why. Nevermind that there's insufficient data released daily, let alone weekly, to justify this. It's merely 'entertainment.'

However, as Brian Wesbury, a better-known and credible economist, wrote of the business media's tendency to hold pro vs. con on camera "debates," these mistakenly give people the impression that, say, economists are evenly divided on the subject of the likelihood of a recession, when, in reality, they are not at all 'evenly divided.'

In his August 9th editorial in the Wall Street Journal, Wesbury wrote,

"Any reasonable sample of economists these days would include at least 80% optimists. So why all the bad news?"

And, again, this very morning, while listening to/watching CNBC in background, I heard Erin Burnett report that in phone calls she had (Yes! She actually talked to real people- not just regurgitated her own journalistic opinions.) with banking executives around the country, most of them saw no reason for a Fed rate cut.

For what it's worth, Wesbury believes that,

"...people gather knowledge about the rest of the economy, the part they cannot see, from watching news. As a result, it could be that the format behind most business journalism skews perceptions and creates pessimism.....But what seems clear is that in the name of producing an entertaining product, and in an attempt to provide contrasting views, the true consensus of experts is rarely reported."

As I discussed this with my partner the other day, we returned to a topic we've touched on before. That is, when Harry Markowitz developed efficient market theory and the concept of portfolios, he probably never imagined a world in which the white noise would crowd out true information.

Recall, if you will, the world of the late 1950s, in which Markowitz formed his theories. Markets were telephone order-driven, brokerage rates were astronomical, there was no cable television, nor on-going business news throughout the day. With trading so expensive at retail, investment was the order of the day. Computers were non-existent, so forget program trading, too. Most business "news" was just that, and the amount of commentary on it was a lot less than today. Magazines like Fortune, Forbes and Businessweek (if it existed then) held much more sway than they do today.

It's hard to set a hard and fast rule among today's surfeit of business 'information,' but, surely, the babbling of some third-rate economist at a third-tier financial institution hardly qualifies as similar in quality, or, probably, 'information,' next to, say, a Fed president's remarks, or those of a Nobel Laureate in economics. Or the CEO of a well-performing, large hedge fund or private equity group. Not all the utterances we hear on CNBC, booked to fill up air time, are deserving of the description 'information.'

Most of it is, in reality, just noise. Recycled worries and warnings, and hand-wringing by people who, otherwise, would never be exposed to the wide world of business media viewers. Nobody said these guests and commentators are actually credible, or competent.

Yesterday, I actually heard one of the less intelligent CNBC morning anchors say something like,

'well, if bank CEOs aren't believable, don't you have to listen to large company CEOs, who have their ears to the ground?'

My laughter was immediate. CEOs with ears to the ground? You've got to be kidding!

When you hear drivel like that from a CNBC on-air anchor, you know you should heavily discount most of what you hear on the network that is not breaking news, and carefully choose which of their guest pundits to believe.

Confirmation of My Views on CDOs and Securitization

Yesterday's Wall Street Journal featured an editorial by Ethan Penner, one time Nomura employee in the mortgage banking group. Penner replaced my friend B, who had built the group some years ago.

It was very satisfying to read Penner echoing my own comments from this post, two weeks ago. Specifically, he confirms two of my contentions. First, that the manner in which differing asset types have been combined into CDOs, is far different in purpose, and effect, than the original uses of the securitization vehicles. Second, the ratings agencies played important parts in the debacle, highlighting their conflict of interest.

In one of my posts, I wrote,

"Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used."

In his piece, Penner phrased it this way,

"Of course, it is very important here to distinguish between CDOs that make sense and are a healthy part of the market, and ticking time bombs that should never have been created. As an example of the former, there are those issuers, the NYSE-listed REIT Capital Trust, who utilized the CDO structure to pool their homogeneous real estate credit assets and create a financing that matched up ideally. This sort of CDO is not only sensible but an example of how securitization can help foster a healthy financial system -- creating a liability for the issuer, Capital Trust, that matches exactly the term of the assets.

On the other hand, many CDO issuers bought all sorts of assets and combined them into proverbial "witches brews" that they foisted onto the bond market, sucking out profits and fees at issuance in a game that was ongoing as long as the deals held up. The buyers of these concoctions, reliant upon the rating agencies' models, were unlikely to ever get their arms around the risks that they were asked to underwrite. How a trader would be able to traverse the various markets represented by the diverse collateral underlying these bonds to provide a suitable secondary market bid is beyond me.

My guess is that a healthy CDO market will return, but it will only be available as a source of financing to those few professional risk managers with real expertise and only for homogeneous asset pools. I have pity for bond buyers with the other type of CDOs, as it is difficult to imagine how liquidity will ever return to their holdings."

Penner also reinforces points I made in this post, the following day, regarding how the ratings agencies abetted the mortgage originators/CDO packagers. In my post of a few weeks ago, I wrote,

"Yesterday's Wall Street Journal carried a fascinating article concerning how S&P's and Moodys' rating of so-called 'piggybacked' sub-prime mortgages, in 2000, led to today's credit turmoil.

Amazingly, the ratings agencies first allowed the CDOs backed by these mortgages to be investment grade, then changed their minds last year. It evidently took five or six years for S&P and Moodys to sample and test the payment history of such mortgages, leading them to downgrade them to junk status.

Now, as Wilbur Ross said on CNBC yesterday morning, nobody should simply blame a rating agency for their own bad investment decision. And I agree with that.However, when buyers included institutions which could not buy those CDOs with today's ratings, but could earlier, you have to wonder how much the agencies' appetites for fees led them to inappropriately collaborate with the issuers, and look the other way over an obviously riskier type of home loan."

Penner seconds this by noting in his article,

"However, it's become apparent in these last months that the free market, combined with a complete dependence upon the three main bond rating agencies, may not, in its current format, be the perfect answer either.

Securitization may be the only business in the world where the appraiser is hired by, paid by, and thus works for, the seller rather than the buyer. It would be unthinkable, for example, in a real estate transaction for the seller of a property to expect that the buyer would accept a seller-provided appraisal as the basis of their valuation.

Yet, this is exactly what transpires in the bond market, where the sellers, Wall Street firms that aggregate assets and pool them into carefully "sliced and diced" securities, hires and works carefully with the appraiser, the rating agencies, to maximize their arbitrage. Importantly, appraisers at the rating agencies are paid a small fraction of the pay of the investment bankers they work with, and many aspire to work at one of the firms that they are representing, thereby creating a heightened conflict.

The potential for conflicts and misaligned incentives are more potent over time than even the best of intentions.

So, the first place one may look when tweaking the securitization model would be to re-align the interests of the governing bodies, that is, the rating agencies, more precisely with those they truly represent -- the bond buyers. There are numerous ways that this might be accomplished; suffice it to say here that a change is probably healthy and long overdue."

So true. Finally, we have confirmation from an ex-senior manager of a securitization manufacturer that the process finally went overboard. Rather than allowing the marketing of loans, suitably repackaged, to clarify risks, with concommitant returns, the process became a method for creating opaque securities with respect to risk.

Meanwhile, the ratings agencies- S&P, Moodys, Fitch- stood by and kept quiet, while accepting payment for blessing the evolving practices.

Still, as Wilbur Ross noted, shame on any investor, especially institutional investors, who try to blame the agencies and securitizers, when, as buyers, they bore the ultimate responsibility for knowing what they bought and elected to hold. Some investors will continue to find ways to make bad investment decisions, and blame the markets, regulators, rating agencies, etc. We can't really stop that. But we can at least identify the need for buyers of securities to be intimately knowledgeable about that which they are buying.

More on Mortgage Lending and Lower-Income Homeowners

Last Wednesday's Wall Street Journal carried Holman Jenkins' weekly editorial, which dealt with homeowners on the low end of the income distribution.

Citing the work of Carolina Katz Reid, then a graduate student at the University of Washington, Jenkins wrote,

"But a home financed by a mortgage is not just an asset. It's also a liability. We owe thanks to Carolina Katz Reid, then a graduate student at University of Washington, for a 2004 study of what she dubbed the "low income homeownership boom." She considered a simple question -- "whether or not low-income households benefit from owning a home." Her discoveries are bracing:

Of low-income households from a nationally representative sample who became homeowners between 1977 and 1993, fully 36% returned to renting in two years, and 53% in five years. Suggesting their sojourn among the homeowning was not a happy one, few returned to homeownership in later years.

Even among those who held on to their homes for 10 years, the average price-appreciation gain was 30% -- less than if their money had been invested in Treasury bills. This meager capital gain was about half that enjoyed by middle-income homeowners.

A typical low-income household might spend half the family income on mortgage costs, leaving less money for a rainy day or investing in education. Their less-marketable homes apparently also tended to tie them down, making them less likely to relocate for a job. Ms. Reid's counterintuitive discovery was that higher-income households were "twice as likely to move long distance if they're unemployed." "

I have to admit, I was stunned by this research. So much for the 'ownership society,' at least at the really low end of the incomes distribution curve. However, when you think about it, it's very sensible.

As a sometime homeowner, I can vouch for a home being a lumpy, often-illiquid investment which requires substantial cash for for maintenance. And it certainly can restrict mobility.

It's eminently reasonable to conclude that lower-income people are better off spending their assets on education and the ability to remain mobile, for employment purposes. Saddling them with a large, illiquid fixed asset does not actually make much sense.

Jenkins goes on to note,

"The irony is, were the owners of the subprime paper inclined to make themselves known and realize their losses, the majority of these loans would likely end up paying off. Buyers of the severely discounted paper would make a killing and the market's dispersed decision-making, which recently became its weakness, would return to its normal role as a strength. In any case, subprime lending accounts only for about 15% of outstanding mortgages, with an uncataclysmic $90 billion worth facing foreclosure.

Fluctuations in the S&P 500 wipe out as much wealth every ho-hum day without drying up credit globally. But today's caginess problem is partly a regulatory and legal problem, because something is clearly stopping holders of temporarily unmarketable mortgage paper from sidling up to their bankers and asking forbearance on the loans financing these positions.

His comment about a corresponding loss in equities from an S&P Index decline is a point I've made in a prior post. The current market turmoil is overblown, in that too much is made of the source of the losses, rather than the rather modest likely net losses when the dust settles. Capital markets is all about taking risks, and sub-prime-based paper is just another example of how that can result in losses. It's part of investing.

The Democratic presidential contenders are currently outbidding each other in ways to help "homeowners" (a dubious term in the present instance) avoid foreclosure. What might really benefit these citizens is being freed to return to renting, where some real bargains will likely be had in the months and years ahead."

Now there's a good point. With a swollen residential housing supply, rents will probably be on the softer side for years. Good news for lower-income citizens seeking to save money for investment in assets such as their children's, and their own, educations.

On Students As Marketing Research Subjects

Being a double marketing major, there was a recent Wall Street Journal article which caught my attention. Two Fridays ago, the paper reported, in an article by Carl Bialik, on the pitfalls of too often using college students in marketing research studies.

I recall a marketing professor from my graduate days lamenting the amount of bad research and horrific consumer behavioral inferences based upon how college students evaluated stereo equipment. Back in my day, that seemed to be a favorite combination in which many marketing professors, no doubt on the tenure track, embedded their research concepts.

The Journal article details quite a few examples in which either products and concepts not really germane to college students are tested among them, or college students, as a group, are considered to be homogeneous. Neither of which makes for particularly valid conclusions.

A Professor Robert Peterson, marketing professor at University of Texas, Austin, found 63 examples in published research involving psychological relationships where students differed significantly from non-students.

Despite the Mr. Bialik's admonishment that the real fault lies with those who would apply such narrowly-based research results to non-students, I don't believe that's quite true. Studies using students for the sample, if they involve PhD work, are probably held out as offering real world conclusions. It's doubtful that so many student-based research projects would be done for nothing more than methodological validations.

No, I think the entire ethos of business school professors and graduate students using the available student population is an age-old, and recurring problem. Who knows how many products or services have had their basic concepts 'proven' this way?

It's an illuminating window onto a rather sordid and well-kept secret among the marketing department cognoscenti of academia.

David Malpas On The Current Financial & Economic Outlook

A little over two weeks ago, which now seems like a year ago in these markets, David Malpass, chief economist of Bear Stearns, wrote a wonderful editorial in the Wall Street Journal concerning the distinction between credit markets and the 'real' economy.

Now, many economists and other pundits are declaring that we are on the edge of a recession, and that recent credit market problems have crippled, or are crippling, the 'real' economy.

To the contrary, Malpass wrote,

"Equity markets have recently lost over $2 trillion in the U.S. and even more globally -- many times the likely amount of mortgage and corporate debt losses in the foreseeable future. This is in part a correction from the sharp global equity run-up through mid-July. Current prices still signal growth ahead.

Another aspect of the market disruption is a dramatic stand-off between bond buyers and sellers: Buyers in both housing and debt markets are using the market discontinuity to claw prices and terms back to Earth. The slowdown talk weighing on equities also reflects the Wall Street view that debt, mortgage and takeover businesses have replaced General Motors as the economy's bellwether. According to the bears: As goes the credit market, so goes the economy.

Fortunately, Main Street is not that fickle. Housing and debt markets are not that big a part of the U.S. economy, or of job creation. It's more likely the economy is sturdy and will grow solidly in coming months, and perhaps years.

U.S. growth has endured other waves of equally loud pessimism -- over high gasoline prices, low (pre-revision) estimates of job growth, a supposedly negative personal savings rate (revised to positive on July 27 by the Commerce Department) and even the 2003 tax cut on labor and capital. Remember the argument that tax cuts would put the economy on a path toward fiscal collapse and recession? Now, the U.S. deficit is set to fall below $150 billion by Washington's September fiscal year-end, thanks to strong tax receipts."

Thus, Malpass calls our attention to some pretty badly mistaken prior economic calls by some of these so-called 'experts.' On the subject of using housing as a piggy-bank, Malpass wrote,

"The bearish view is that Americans live, breathe and spend their houses and mortgages. Yet the July 31 consumer confidence survey by the Conference Board jumped to 112, the highest in the six-year expansion. Data and theory show clearly that houses are not the be-all and end-all of the economy. Jobs matter more. For many, the value of future employment is much greater than their home equity. The low jobless claims and unemployment rate -- clear signs of a strong labor environment -- raise confidence and likely future wages. This outweighs changes in wealth, whether from declines in house prices or the stock market, especially for lower-income workers.

Neither the economy nor job growth has been dependent on housing. Residential construction declined to 4% of GDP in the second quarter -- right on the 1990s average -- having boomed excessively in 2004 and 2005 and subtracted heavily from GDP in 2006. But strength in commercial construction more than offset the weakness in residential construction, allowing overall construction to add to GDP for the first time in a year.

Concerns about high inventories of unsold homes are exaggerated. At 537,000 per the Commerce Department, the June inventory equals 7.4 months of 2007's average sales. This is only a bit above the 6.7 months average inventory from 1980-1995. The leaner inventories in the 1996-2005 "sellers' market" resulted in part from the super-low interest and mortgage rates earlier this decade, and the 1997 cut in the capital-gains tax on houses.

Those overstating housing's impact on jobs often use dates spanning the 2001 recession, as in the widely quoted calculation that 37% of the net new jobs were in housing. That was true only between March 2001 and September 2005, because housing jobs grew in the recession while other jobs shrank. A fairer picture of the role of housing in the expansion is to start counting from any month after the recession. From the end of 2003 through present, jobs from residential construction plus real estate and mortgage brokers created only 3.6% of the net new jobs, 5.3% if all credit intermediation jobs are also included.

Nor has consumer spending been dependent on "cashing in" on the housing boom. The increase in mortgage equity withdrawals in 2004 and 2005 funded big net additions to household financial assets, while consumption growth remained steady. Mortgage equity withdrawals slumped throughout 2006, yet consumption growth was particularly fast in the fourth quarter of 2006 and the first quarter of 2007."

Thus, Malpass dispels the common notion among many in the business media that all Americans have done for the past decade is borrow against their rising home values to spend, spend, spend! Rather, Malpass notes they have invested, invested, invested! A housing value decline might cause some loss of demand for financial assets and, thus, some price declines, but not wholesale loss of consumer spending as a driver of the overall US economy.

On that theme, what about the egregious rises in sub-prime mortgage payments coming soon? Won't those rises in monthly mortgage payments be the final death blow to the US economy? Not so, wrote Malpass,

"In the long list of worries about consumption, the threat of mortgage-rate resets is providing the latest fixation. It shouldn't. Payments on some $500 billion of adjustable rate mortgages are scheduled to go up in 2007. If the mortgage rate is adjusted upward by an average two percentage points, that's $10 billion in added payments. To put this in perspective, wages for nonsupervisory workers increased by $296 billion over the last 12 months. The July 27 revision alone added $130 billion to the last year's total U.S. personal income, raising it to $11.5 trillion, reflecting the hard-to-track dynamism of the U.S. economy.

The constant warnings of a housing-related collapse in domestic consumption overstates the importance of housing in the economy, while understating the importance of jobs and economic growth, both of which have been solid. Of course, sellers of both houses and bonds would like more froth in their markets. But buyers, and likely the economy as a whole, will probably benefit over time from the wrenching return to more normal market conditions."

It is truly a pleasure to read a balanced, reasoned, informed opinion in a major news medium which contradicts the current hand-wringing that, thanks to a few sub-prime mortgages that were made, securitized, and sold as investments, our entire economy is about to be brought to its knees.

It's not. The sliver of the housing market that is sub-prime is but a piece of an otherwise dynamic and resilient US economy, still the envy of the world's other economies.

Brian Wesbury's Excellent Analysis of The Current Credit Market Situation in the WSJ

We're very fortunate to have a lucid, informed and competent economist of the stature of Brian Wesbury writing frequently in the Wall Street Journal.

On Monday, Mr. Wesbury wrote an inspired piece entitled "The Fed's Job."

In brief, he makes the point that, throughout our country's history, people have wrongly diagnosed economic problems as 'a lack of liquidity.' Now, Wesbury explains, the problem is leverage and uncertainty- but not liquidity.

This is at variance with such biased commentators as financial entertainer Jim Cramer, self-interested Senator Chris Dodd (Democratic Presidential candidate and Senator from the home state of many hedge funds, Connecticut), and CNBC economist wannabe, Steve Liesman. All three of these observers have been shouting loudly for various 'liquidity' bromides, ranging from the Fed cutting the interest rate by one-quarter to one-half of a point, to allowing Fannie Mae and Freddie Mac to 'invest' in jumbo mortgages.

Thankfully, Wesbury explains why all of this is unnecessary, but, never the less, in the long tradition of populist blowhards crying for easy credit.

To wit, Wesbury wrote,

"Blaming monetary policy for economic and financial market turmoil is a time honored tradition. Maybe the most famous bashing was in 1896 when William Jennings Bryan, an original populist, ranted against hard money and for inflation: ". . . we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."

Monetary policy makes an easy scapegoat because printing money (like drinking a cup of coffee) is an easy way to give an economy a temporary boost. But if what ails the economy or markets was not caused by tight money in the first place, a temporary boost will not help. It may cover up the symptoms temporarily, but in the end it does not solve the underlying issue (a lack of sleep).

In fact, easy money always leads to greater problems down the road -- either rising inflation, or a reduced sensitivity to risk, as markets come to expect rate cuts to bail them out.
Lately, modern-day William Jennings Bryans have been loudly calling on the Fed to cut interest rates and inject cash into the banking system. They believe more money would stop financial markets from seizing up any further.

This would make sense if money was already tight -- or to put it another way, if a lack of liquidity was the real issue. But trades are clearing, banks are well capitalized, commercial and industrial loans are growing, credit-worthy borrowers are getting mortgages, and the economy is still expanding.

...the current turmoil in the financial markets has nothing to do with a lack of liquidity. More importantly, there is little hope that any liquidity the Fed would inject into the banking system would actually get to the sectors of the market where only sporadic, fire-sale pricing of securities is taking place.

Some are arguing that a sharp decline in the three-month Treasury bill yield, to 3.85% from roughly 5% during the past few days, shows the need for a huge infusion of cash that would force the federal funds rate down. But the drop in T-bill yields is a reflection of three issues: a flight to quality, a guess that the Fed will lower rates at its next meeting and a very liquid market."

Well, if liquidity, per se, is not needed, then what precisely is going on currently in financial markets? Wesbury continues his article with this explanation,

"The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.

As an example, let's take a very low probability event and assume that losses triple from here. Let's assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.

From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.

But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace."

Thus, Mr. Wesbury comes to the logical and sensible conclusion that what we are witnessing is not a shortage of liquidity, but the realization on the part of a lot of supposedly-smart hedge fund managers and other institutional investors, that they weren't so smart in their headlong use of sub-prime mortgage-based instruments without understanding the underlying risks to those mortgages. It's no different than any other case of sophisticated and/or institutional investors making poor investment choices- they lose money. In the cases of many of the hedge funds, some of whom call Senator Dodd's state home, they have used leveraged money, and are, quite likely, now insolvent.

So we have populists crying for the relief of wealthy hedge fund investors and managers, at the same time that they also cry for relief for the sub-prime mortgage borrowers! At least it's equal-opportunity financial forgiveness. However, it's unnecessary.

In his conclusion, Mr. Wesbury goes on to state,

"There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.

The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it's not. A few rate cuts will not help.

What William Jennings Bryan was really complaining about in 1896 was falling commodity prices, especially falling farm prices. What he and the other populists ignored was that these prices were falling because of productivity, not tight money. His "Cross of Gold" speech was a clear stepping stone to the creation of the Fed in 1913. Since then, inflation has been much higher than it would have been under the gold standard. But all that inflation never did save the family farm.
Similarly, even very easy money today can't put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can't help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask."

Amen, Mr. Wesbury. Ben Bernanke is wisely providing 'liquidity' to banks, in order that they may accept and offer, for repos, paper of dubious quality, in order to assure that credit markets continue to function, and do not impeded the normal course of our non-financial economic sectors. Truly, that's all for which we should ask from the Fed. Beyond that, borrowers and investors must accept the consequences of their own financial decisions.

How New Exotic Investment Products Misled Retail Investors

Last Tuesday's Wall Street Journal carried an article detailing the many exotic financial investment opportunity's available to the average retail investor in today's market environment.

Between ETFs covering many asset classes, mutual funds implying "market neutral" performance, and vehicles allowing relatively easy entry into foreign currency, foreign market funds, and commodities investment/trading, today's retail investor can enter the realm of complex financial instruments, electronically, totally unaided.

According to the Journal story, this is bringing the sort of results you'd expect- margin calls, losses and bewildered retail investors.

What seems to be happening is that uneducated retail investors are entering financial markets which are largely dominated by sophisticated institutional traders and investors. In such environments, it's almost a given that any sort of turbulence, as we have been experiencing of late, will leave the retail investors holding the losses. Typically being late to market gains, and late exiting declining positions.

Then there is the damage done by implying to retail investors that they, too, can construct effective asset hedges. The same non-performing hedged positions which have caused so much financial loss among leveraged institutional investors and traders is, of course, also causing losses among less-leveraged retail investors.

This brings to mind the opposing forces of financial innovation and regulatory vetting of individuals and institutions as qualified to invest in various instruments.

Basically, it's another version of the old liberal versus conservative viewpoints,

'Should we protect people from themselves?'

Liberals would tend to say "yes," while conservatives would tend to say "no."

I'm not sure we can ever really protect retail investors from foolish behavior. Going back to the go-go equity markets of the 1960s, or the Bonneville Power Authority bond defaults of the 1980s, it doesn't take much in the way of financial opportunities to allow average retail investors to lose their money via bad management.

What astounds me, though, now, is how a retail investor can so nearly replicate, albeit at higher costs, the sorts of financial investment and trading strategies which many sophisticated institutional traders and investors also employ. It's a frightening realization.

Damned If You Lend, Damned If You Don't.....

Yesterday, in this post, I provided a clear example, thanks to the Wall Street Journal's excellent article from last week, of how inappropriate financial behaviors on the part of everyone from borrowers to investors have helped to create the current, sub-prime mortgage-based credit market turmoil.

One point which I had planned, but neglected to add, was that, had the mortgage banking industry failed to provide something like sub-prime, piggyback mortgage loans, they almost surely would have been excoriated by some parties for denying 'affordable' housing finance to the less-economically well-off.

As if sensing my omission, today's Wall Street Journal carries a front page piece detailing Illinois' new steps to mitigate the assumption of undue financial risk and obligations, in the form of risky mortgages, by the economically less well-off in that state.

Sure enough, within the first few paragraphs of the article, regarding an earlier attempt at the same task, we read,

"Instead of winning plaudits, the pilot program quickly became mired in charges that it would make it harder for minorities to buy homes."

So, there you have it. At the same time that some are criticizing lenders and mortgage brokers for rapaciously victimizing the poor or less financially-educated who want to buy homes, attempts to minimize the recurrence of such inappropriate lending are already being branded as racist and discriminatory.

Damned if they lend to the poor, and damned if they don't.....the financial sector has become today's whipping boy for some who want the current credit turmoil magically vaporized, yet not by returning to older, tested home lending standards which resulted in higher-quality mortgages which could be more confidently securitized.

The Sub-Prime Mortgage Chain: Borrower to Investor

Last week's Wall Street Journal carried a detailed example of how sub-prime mortgages originate. I found the story both shocking and heartbreaking. Mostly, though, I found it emblematic of a culture of greed, at every step of the home loan process, from borrowers to investors.

For the full impact of the story, I've reprinted large sections of it below,

The price was a major stretch at $567,000. But the couple, who had sold a home a few years earlier to move to a better area, was tired of renting. Mr. and Mrs. Montes convened a meeting with their two teenage daughters around the kitchen table to hash out the implications. "We agreed we wanted to be homeowners again," says Mr. Montes, "even if it meant the end of vacations and not eating out as often."

Like many people who jumped into the rising housing market in recent years, they had little money for a down payment and chose a loan that would hold their monthly payments down for the first two years, then "reset" to a much higher level. Mr. and Mrs. Montes say their mortgage broker assured them they would be able to refinance in a couple of years to keep their payments affordable.

With a December "reset" on their loan looming, however, the refinancing option now looks impossible. A friend who works as a loan officer called with some bad news this week: Similar homes in their area have been selling for $535,000 to $565,000 recently. That means the Monteses' loan balance may exceed the value of their home.

And with thousands of mortgage banks and brokers threatened with extinction, lenders that embraced all kinds of risky loans two years ago are enforcing increasingly strict standards. They are refusing even to consider extending new credit to people like the Monteses who lack any equity in their homes.

They live in a solid neighborhood and are both employed and in good health. "My wife and I make pretty good money," says Mr. Montes. Mrs. Montes works as a school secretary. Together, they earned nearly $90,000 last year.

But they already pay about $38,400 a year on their home loans, even before taxes and insurance. In December, when their primary loan "resets" to a higher rate, that cost will rise to about $50,000 a year, Mr. Montes says.

When the Monteses decided to buy the bungalow in 2005, they had only a so-so credit record and little savings. So they settled for a "subprime" loan, with costlier terms than those available in the prime market.

The Monteses' primary loan is the type that became the dominant subprime mortgage during the housing boom of the first half of this decade -- and now has become a symbol of misguided lending, swept away by regulatory fiat and investors' flight from mortgages deemed too risky. These loans are known in the trade as 2/28 mortgages. The interest rate is fixed at a relatively low rate for the first two years (5.45% in the Monteses' case), then floats at a predetermined margin above an interest-rate index for the next 28 years. In many cases, that "reset" of the interest rate after two years leads to a monthly payment increase of 30% or more.

U.S. lenders originated about $600 billion of subprime home loans in 2006, or 20% of all home mortgages, according to Inside Mortgage Finance, a trade publication. About 56% of those subprime loans were 2/28 mortgages, says Keith Ernst, senior policy counsel at the Center for Responsible Lending, a nonprofit research and lobbying group in Durham, N.C.

The Montes family got their loan through a mortgage broker in Rancho Cucamonga. Using what was then a common formula, the broker offered to arrange for two loans, one to cover about 80% of the home price and the other, a so-called piggyback loan, for the rest. For the first two years, their total monthly mortgage payments are about $3,200. The loans are initially interest-only.

Mr. Montes recalls feeling edgy about whether he would be able to afford the higher costs -- about $900 more per month -- due to take effect after two years. But he says the broker assured him he could refinance before those costs kicked in.

Mrs. Montes says she was apprehensive about the broker's assurances. "But I blame that on that I don't understand the lingo they were talking," she says. "It's a scary experience.... All I could see was all these numbers flash before me.... I said, 'Mario, I hope you don't get into something that is going to hurt us.'"

The Monteses received a letter informing them their property taxes had been reassessed based on the $567,000 sale price instead of its previous $389,000 value. That raised their taxes to $6,000 from $2,900 a year and would have increased their monthly payments (including the mortgages and taxes) to $3,931.

Mr. Montes says the family may try to sell the house, but that would be tricky in today's weak market. Or they could try to trim other expenses and keep meeting the higher monthly home payments that are due to take effect in December.

There is very little wiggle room. Mr. and Mrs. Montes also have two car loans, with payments totaling about $700 a month, and are borrowing more money to help put their elder daughter through college.

Those are the basic facts.

To me, it was shocking that the Monteses didn't even plan on affording the added cost of their original mortgage after the reset point, being advised by their mortgage broker that they would refinance before then. Not to mention that the wife of the couple confessed to not even understanding the loan document which she would be signing. Yet, this is the most expensive purchase most people will ever make.

Their income was insufficient to make the original mortgage payments even as low as 30% of that base. The article notes that fully 20% of all mortgages in 2006 are now this type, which is surprising to me.

The last time I applied for a mortgage, I kept my total mortgage-related (PITI) payments to 25% of my income, took an ARM with a repricing cap of 2.5 percentage points of interest each five years, and planned on affording it.

What I saw in this article is an example of people who should have waited until they actually had the money for a reasonable down payment, and then should have been more sanguine about their prospects of affording the mortgage they chose. Additionally, they seem gullible, in that they simply believed a mortgage broker's promise that they could refinance the mortgage. Perhaps they should have planned on affording the one for which they applied?

The broker, of course, hardly did anyone a favor by putting the Monteses into a barely-affordable mortgage. The institution which lent the money for the house didn't seem to have done a very careful job stress testing the Montes' ability to afford the mortgage.

Then the loan was likely bundled up into a security. I don't know what the 'seasoning' period is nowadays, but years ago, lenders typically had to hold their mortgage loans for a year, if I'm not mistaken, before other investors would buy them in CMOs.

This story displays a shocking tale of greed and overreaching on everyone's part, including the Monteses. They should never have expected, in their financial position, with other loans to service, to be paying as much as 42% of their income for housing, before taxes and insurance.

It's no wonder that this is the last year of the housing expansion. With loans like these, to borrowers like these, it was clearly time for mortgage merry-go-round to stop. I can't honestly express any sympathy for investors who purchased instruments backed by loans like those of the Montes.'

This was a total lending, underwriting and investing system failure. But it's not a banking failure, per se. Those who bought these loans, packaged as whatever, deserve the losses they take, just as if they had made unwise equity or currency investments.