A Psychology Lesson From the Markets

A Psychology Lesson From the Markets
Economic View
By ROBERT J. SHILLER
August 26, 2007

IT is no surprise that the Federal Reserve’s discount rate cut has not entirely reassured investors. The Fed can stop a run on the banks, but it cannot control the speculative cycle — a cycle built on psychology and misperceptions that has been sweeping much of the world for the last 10 or 12 years.

I have worked with Karl E. Case, a professor of economics at Wellesley College, with help from the Yale School of Management, in conducting questionnaire surveys of recent home buyers. In Los Angeles and San Francisco in 2005, when actual home prices were rising more than 20 percent a year, we found that respondents anticipated big increases far into the future. At that time, the median expected annual climb for the succeeding 10 years was 9 percent.

This expectation would mean that a house valued at an already high level of $650,000 in 2005 would be worth more than $1.5 million in 2015. For most people in 2005, it would also mean that they should buy a house soon, or forever be excluded from owning one — and that it would be better to stretch and buy the most expensive house they could afford, to capture the huge profits of homeownership.

Now, of course, prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year — a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation.

The problem is fundamental because the speculative cycle afflicts much of the world. Housing booms have not occurred everywhere, but they have been commonplace since the late 1990s in North America, Europe, Asia and Australia.

We have also seen similar worldwide boom cycles in the stock market over the last 10 or 12 years. Many countries shared in the huge market booms that peaked in 2000, and just about every major stock market around the world has boomed since 2003.

Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

Booms cannot go on forever. Downward price feedback sets in. That is when balance sheets become impaired and widening credit problems start to show up.

The puzzle is why this speculative cycle has occurred recently in so much of the world. What do all these countries share that drives them to speculative booms?

One might think that investor optimism is generated by rapid world economic growth that is using up scarce resources and driving up asset prices. Since 2004, the International Monetary Fund’s real per capita growth figures for gross domestic product worldwide have been fairly high: around 4 percent a year.

It is noteworthy that from 1995 to 2003, when these booms took root, that growth figure averaged only 2.4 percent a year. A good part of the extra growth since 2004 has probably been the increased spending caused by the speculative booms themselves.

The greatest recent economic successes have apparently been in China and India. Because these are the most populous countries, together accounting for 37 percent of the world’s population, their success has become an international symbol of spectacular growth.

But it is easy to overstate their importance. China’s and India’s economies are actually a tiny fraction of world G.D.P.— together only 7 percent. The popular impressions of suddenly rapid growth are thus mostly a perceptual error, like the optical illusions documented by psychologists.

The growth of capitalism around the world has caused trust in the social safety net to decline, even in the United States, where 401(k)’s are replacing traditional pensions.

People worry that they must increase their wealth to fend for themselves. One might think that this lack of trust would promote much precautionary saving, but world savings rates are not high over all. It has generally fit in better with popular perceptions of the booms to be smart investors, not great savers.

As we all try to adjust to a rapidly growing and increasingly capitalist world, we have been trying to discover who we are and how we fit into it. This has meant an enormous change in values.

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

That is why it is so hard to turn around investor attitudes once a downward psychology sets in. The Fed and other central banks do not have lithium or Prozac in their bag of remedies, and so cannot control it.

Robert J. Shiller is professor of economics and finance at Yale, author of “Irrational Exuberance” and co-founder and chief economist of MacroMarkets LLC.

Inside the Countrywide Lending Spree

Inside the Countrywide Lending Spree
By GRETCHEN MORGENSON
August 26, 2007
NYT


ON its way to becoming the nation’s largest mortgage lender, the Countrywide Financial Corporation encouraged its sales force to court customers over the telephone with a seductive pitch that seldom varied. “I want to be sure you are getting the best loan possible,” the sales representatives would say.

But providing “the best loan possible” to customers wasn’t always the bank’s main goal, say some former employees. Instead, potential borrowers were often led to high-cost and sometimes unfavorable loans that resulted in richer commissions for Countrywide’s smooth-talking sales force, outsize fees to company affiliates providing services on the loans, and a roaring stock price that made Countrywide executives among the highest paid in America.

Countrywide’s entire operation, from its computer system to its incentive pay structure and financing arrangements, is intended to wring maximum profits out of the mortgage lending boom no matter what it costs borrowers, according to interviews with former employees and brokers who worked in different units of the company and internal documents they provided. One document, for instance, shows that until last September the computer system in the company’s subprime unit excluded borrowers’ cash reserves, which had the effect of steering them away from lower-cost loans to those that were more expensive to homeowners and more profitable to Countrywide.

Now, with the entire mortgage business on tenterhooks and industry practices under scrutiny by securities regulators and banking industry overseers, Countrywide’s money machine is sputtering. So far this year, fearful investors have cut its stock in half. About two weeks ago, the company was forced to draw down its entire $11.5 billion credit line from a consortium of banks because it could no longer sell or borrow against home loans it has made. And last week, Bank of America invested $2 billion for a 16 percent stake in Countrywide, a move that came amid speculation that Countrywide’s survival was in question and that it had become a takeover target — notions that Countrywide publicly disputed.

Homeowners, meanwhile, drawn in by Countrywide sales scripts assuring “the best loan possible,” are behind on their mortgages in record numbers. As of June 30, almost one in four subprime loans that Countrywide services was delinquent, up from 15 percent in the same period last year, according to company filings. Almost 10 percent were delinquent by 90 days or more, compared with last year’s rate of 5.35 percent.

Many of these loans had interest rates that recently reset from low teaser levels to double digits; others carry prohibitive prepayment penalties that have made refinancing impossibly expensive, even before this month’s upheaval in the mortgage markets.

To be sure, Countrywide was not the only lender that sold questionable loans with enormous fees during the housing bubble. And as real estate prices soared, borrowers themselves proved all too eager to participate, even if it meant paying high costs or signing up for a loan with an interest rate that would jump in coming years.

But few companies benefited more from the mortgage mania than Countrywide, among the most aggressive home lenders in the nation. As such, the company is Exhibit A for the lax and, until recently, highly lucrative lending that has turned a once-hot business ice cold and has touched off a housing crisis of historic proportions.

“In terms of being unresponsive to what was happening, to sticking it out the longest, and continuing to justify the garbage they were selling, Countrywide was the worst lender,” said Ira Rheingold, executive director of the National Association of Consumer Advocates. “And anytime states tried to pass responsible lending laws, Countrywide was fighting it tooth and nail.”

Started as Countrywide Credit Industries in New York 38 years ago by Angelo R. Mozilo, a butcher’s son from the Bronx, and David Loeb, a founder of a mortgage banking firm in New York, who died in 2003, the company has become a $500 billion home loan machine with 62,000 employees, 900 offices and assets of $200 billion. Countrywide’s stock price was up 561 percent over the 10 years ended last December.

Mr. Mozilo has ridden this remarkable wave to immense riches, thanks to generous annual stock option grants. Rarely a buyer of Countrywide shares — he has not bought a share since 1987, according to Securities and Exchange Commission filings — he has been a huge seller in recent years. Since the company listed its shares on the New York Stock Exchange in 1984, he has reaped $406 million selling Countrywide stock.

As the subprime mortgage debacle began to unfold this year, Mr. Mozilo’s selling accelerated. Filings show that he made $129 million from stock sales during the last 12 months, or almost one-third of the entire amount he has reaped over the last 23 years. He still holds 1.4 million shares in Countrywide, a 0.24 percent stake that is worth $29.4 million.

“Mr. Mozilo has stated publicly that his current plan recognizes his personal need to diversify some of his assets as he approaches retirement,” said Rick Simon, a Countrywide spokesman. “His personal wealth remains heavily weighted in Countrywide shares, and he is, by far, the leading individual shareholder in the company.”

Mr. Simon said that Mr. Mozilo and other top Countrywide executives were not available for interviews. The spokesman declined to answer a list of questions, saying that he and his staff were too busy.

A former sales representative and several brokers interviewed for this article were granted anonymity because they feared retribution from Countrywide.

AMONG Countrywide’s operations are a bank, overseen by the Office of Thrift Supervision; a broker-dealer that trades United States government securities and sells mortgage-backed securities; a mortgage servicing arm; a real estate closing services company; an insurance company; and three special-purpose vehicles that issue short-term commercial paper backed by Countrywide mortgages.

Last year, Countrywide had revenue of $11.4 billion and pretax income of $4.3 billion. Mortgage banking contributed mightily in 2006, generating $2.06 billion before taxes. In the last 12 months, Countrywide financed almost $500 billion in loans, or around $41 billion a month. It financed 177,000 to 240,000 loans a month during the last 12 months.

Countrywide lends to both prime borrowers — those with sterling credit — and so-called subprime, or riskier, borrowers. Among the $470 billion in loans that Countrywide made last year, 45 percent were conventional nonconforming loans, those that are too big to be sold to government-sponsored enterprises like Fannie Mae or Freddie Mac. Home equity lines of credit given to prime borrowers accounted for 10.2 percent of the total, while subprime loans were 8.7 percent.

Regulatory filings show that, as of last year, 45 percent of Countrywide’s loans carried adjustable rates — the kind of loans that are set to reprice this fall and later, and which are causing so much anxiety among borrowers and investors alike. Countrywide has a huge presence in California: 46 percent of the loans it holds on its books were made there, and 28 percent of the loans it services are there. Countrywide packages most of its loans into securities pools that it sells to investors.

Another big business for Countrywide is loan servicing, the collection of monthly principal and interest payments from borrowers and the disbursement of them to investors. Countrywide serviced 8.2 million loans as of the end of the year; in June the portfolio totaled $1.4 trillion. In addition to the enormous profits this business generates — $660 million in 2006, or 25 percent of its overall earnings — customers of the Countrywide servicing unit are a huge source of leads for its mortgage sales staff, say former employees.

In a mid-March interview on CNBC, Mr. Mozilo said Countrywide was poised to benefit from the spreading crisis in the mortgage lending industry. “This will be great for Countrywide,” he said, “because at the end of the day, all of the irrational competitors will be gone.”

But Countrywide documents show that it, too, was a lax lender. For example, it wasn’t until March 16 that Countrywide eliminated so-called piggyback loans from its product list, loans that permitted borrowers to buy a house without putting down any of their own money. And Countrywide waited until Feb. 23 to stop peddling another risky product, loans that were worth more than 95 percent of a home’s appraised value and required no documentation of a borrower’s income.

As recently as July 27, Countrywide’s product list showed that it would lend $500,000 to a borrower rated C-minus, the second-riskiest grade. As long as the loan represented no more than 70 percent of the underlying property’s value, Countrywide would lend to a borrower even if the person had a credit score as low as 500. (The top score is 850.)

The company would lend even if the borrower had been 90 days late on a current mortgage payment twice in the last 12 months, if the borrower had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on his or her property.

Such loans were made, former employees say, because they were so lucrative — to Countrywide. The company harvested a steady stream of fees or payments on such loans and busily repackaged them as securities to sell to investors. As long as housing prices kept rising, everyone — borrowers, lenders and investors — appeared to be winners.

One former employee provided documents indicating Countrywide’s minimum profit margins on subprime loans of different sizes. These ranged from 5 percent on small loans of $100,000 to $200,000 to 3 percent on loans of $350,000 to $500,000. But on subprime loans that imposed heavy burdens on borrowers, like high prepayment penalties that persisted for three years, Countrywide’s margins could reach 15 percent of the loan, the former employee said.

Regulatory filings show how much more profitable subprime loans are for Countrywide than higher-quality prime loans. Last year, for example, the profit margins Countrywide generated on subprime loans that it sold to investors were 1.84 percent, versus 1.07 percent on prime loans. A year earlier, when the subprime machine was really cranking, sales of these mortgages produced profits of 2 percent, versus 0.82 percent from prime mortgages. And in 2004, subprime loans produced gains of 3.64 percent, versus 0.93 percent for prime loans.

One reason these loans were so lucrative for Countrywide is that investors who bought securities backed by the mortgages were willing to pay more for loans with prepayment penalties and those whose interest rates were going to reset at higher levels. Investors ponied up because pools of subprime loans were likely to generate a larger cash flow than prime loans that carried lower fixed rates.

As a result, former employees said, the company’s commission structure rewarded sales representatives for making risky, high-cost loans. For example, according to another mortgage sales representative affiliated with Countrywide, adding a three-year prepayment penalty to a loan would generate an extra 1 percent of the loan’s value in a commission. While mortgage brokers’ commissions would vary on loans that reset after a short period with a low teaser rate, the higher the rate at reset, the greater the commission earned, these people said.

Persuading someone to add a home equity line of credit to a loan carried extra commissions of 0.25 percent, according to a former sales representative.

“The whole commission structure in both prime and subprime was designed to reward salespeople for pushing whatever programs Countrywide made the most money on in the secondary market,” the former sales representative said.

CONSIDER an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first year — a loan known in the trade as a pay option adjustable-rate mortgage. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months’ worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.

When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.

The company’s incentive system also encouraged brokers and sales representatives to move borrowers into the subprime category, even if their financial position meant that they belonged higher up the loan spectrum. Brokers who peddled subprime loans received commissions of 0.50 percent of the loan’s value, versus 0.20 percent on loans one step up the quality ladder, known as Alternate-A, former brokers said. For years, a software system in Countrywide’s subprime unit that sales representatives used to calculate the loan type that a borrower qualified for did not allow the input of a borrower’s cash reserves, a former employee said.

A borrower who has more assets poses less risk to a lender, and will typically get a better rate on a loan as a result. But, this sales representative said, Countrywide’s software prevented the input of cash reserves so borrowers would have to be pitched on pricier loans. It was not until last September that the company changed this practice, as part of what was called in an internal memo the “Do the Right Thing” campaign.

According to the former sales representative, Countrywide’s big subprime unit also avoided offering borrowers Federal Housing Administration loans, which are backed by the United States government and are less risky. But these loans, well suited to low-income or first-time home buyers, do not generate the high fees that Countrywide encouraged its sales force to pursue.

A few weeks ago, the former sales representative priced a $275,000 loan with a 30-year term and a fixed rate for a borrower putting down 10 percent, with fully documented income, and a credit score of 620. While a F.H.A. loan on the same terms would have carried a 7 percent rate and 0.125 percentage points, Countrywide’s subprime loan for the same borrower carried a rate of 9.875 percent and three additional percentage points.

The monthly payment on the F.H.A. loan would have been $1,829, while Countrywide’s subprime loan generated a $2,387 monthly payment. That amounts to a difference of $558 a month, or $6,696 a year — no small sum for a low-income homeowner.

“F.H.A. loans are the best source of financing for low-income borrowers,” the former sales representative said. So Countrywide’s subprime lending program “is not living up to the promise of providing the best loan programs to its clients,” he said.

Mr. Simon of Countrywide said that Federal Housing Administration loans were becoming a bigger part of the company’s business.

“While they are very useful to some borrowers, F.H.A./V.A. mortgages are extremely difficult to originate in markets with above-average home prices, because the maximum loan amount is so low,” he said. “Countrywide believes F.H.A./V.A. loans are an increasingly important part of its product menu, particularly for the homeownership hopes of low- to moderate-income and minority borrowers we have concentrated on reaching and serving.”

WORKDAYS at Countrywide’s mortgage lending units centered on an intense telemarketing effort, former employees said. It involved chasing down sales leads and hewing to carefully prepared scripts during telephone calls with prospects.

One marketing manual used in Countrywide’s subprime unit during 2005, for example, walks sales representatives through the steps of a successful call. “Step 3, Borrower Information, is where the Account Executive gets on the Oasis of Rapport,” the manual states. “The Oasis of Rapport is the time spent with the client building rapport and gathering information. At this point in the sales cycle, rates, points, and fees are not discussed. The immediate objective is for the Account Executive to get to know the client and look for points of common interest. Use first names with clients as it facilitates a friendly, helpful tone.”

If clients proved to be uninterested, the script provided ways for sales representatives to be more persuasive. Account executives encountering prospective customers who said their mortgage had been paid off, for instance, were advised to ask about a home equity loan. “Don’t you want the equity in your home to work for you?” the script said. “You can use your equity for your advantage and pay bills or get cash out. How does that sound?”

Other documents from the subprime unit also show that Countrywide was willing to underwrite loans that left little disposable income for borrowers’ food, clothing and other living expenses. A different manual states that loans could be written for borrowers even if, in a family of four, they had just $1,000 in disposable income after paying their mortgage bill. A loan to a single borrower could be made even if the person had just $550 left each month to live on, the manual said.

Independent brokers who have worked with Countrywide also say the company does not provide records of their compensation to the Internal Revenue Service on a Form 1099, as the law requires. These brokers say that all other home lenders they have worked with submitted 1099s disclosing income earned from their associations.

One broker who worked with Countrywide for seven years said she never got a 1099.

“When I got ready to do my first year’s taxes I had received 1099s from everybody but Countrywide,” she said. “I called my rep and he said, ‘We’re too big. There’s too many. We don’t do it.’ ”

A different broker supplied an e-mail message from a Countrywide official stating that it was not company practice to submit 1099s. It is unclear why Countrywide apparently chooses not to provide the documents. Countrywide boasts that it is the No. 1 lender to minorities, providing those borrowers with their piece of the American homeownership dream. But it has run into problems with state regulators in New York, who contended that the company overcharged such borrowers for loans. Last December, Countrywide struck an agreement with Eliot Spitzer, then the state attorney general, to compensate black and Latino borrowers to whom it had improperly given high-cost loans in 2004. Under the agreement, Countrywide, which cooperated with the attorney general, agreed to improve its fair-lending monitoring activities and set up a $3 million consumer education program.

But few borrowers of any sort, even the most creditworthy, appear to escape Countrywide’s fee machine. When borrowers close on their loans, they pay fees for flood and tax certifications, appraisals, document preparation, even charges associated with e-mailing documents or using FedEx to send or receive paperwork, according to Countrywide documents. It’s a big business: During the last 12 months, Countrywide did 3.5 million flood certifications, conducted 10.8 million credit checks and 1.3 million appraisals, its filings show. Many of the fees go to its loan closing services subsidiary, LandSafe Inc.

According to dozens of loan documents, LandSafe routinely charges tax service fees of $60, far above what other lenders charge, for information about any outstanding tax obligations of the borrowers. Credit checks can cost $36 at LandSafe, double what others levy. Some Countrywide loans even included fees of $100 to e-mail documents or $45 to ship them overnight. LandSafe also charges borrowers $26 for flood certifications, for which other companies typically charge $12 to $14, according to sales representatives and brokers familiar with the fees.


LAST April, Countrywide customers in Los Angeles filed suit against the company in California state court, contending that it overcharged borrowers by collecting unearned fees in relation to tax service fees and flood certification charges. These markups were not disclosed to borrowers, the lawsuit said.

Appraisals are another profit center for Countrywide, brokers said, because it often requires more than one appraisal on properties, especially if borrowers initially choose not to use the company’s own internal firm. Appraisal fees at Countrywide totaled $137 million in 2006, up from $110 million in the previous year. Credit report fees were $74 million last year, down slightly from 2005.

All of those fees may soon be part of what Countrywide comes to consider the good old days. The mortgage market has cooled, and so have the company’s fortunes. Mr. Mozilo remains undaunted, however.

In an interview with CNBC on Thursday, he conceded that Countrywide’s balance sheet had to be strengthened. “But at the end of the day we could be doing very substantial volumes for high-quality loans,” he said, “because there is nobody else in town.”

Rate Cuts Won't Cure Ailing Market

Ben Bernanke and his Fed cohorts will get cheap money flowing with a series of interest-rate cuts. But that won't fix the credit crunch.

By Jon Markman 8.23.07

In a country whose populist heroes are kick-ass rebels Jack Bauer, Jason Bourne and Bart Simpson, it is perhaps only fitting that our latest would-be real-world savior is an economist and banker whose monkish beard makes him look almost countercultural.

Unlike his fictional counterparts who always save the day with a snappy remark or a chop to the throat, Federal Reserve chief Ben Bernanke is working from a terrible script that is doomed. He seems like such a nice man that it's a pity he could go down in history as the first one-term Fed chief in decades, not to mention the accidental steward of one of the world economic system's darkest periods.

It's going to take me a few moments to explain, so bear with me. Here's the problem: Last Friday, Bernanke earned a round of applause from the media by bowing to White House and Wall Street pressure and slashing the rate that the Fed charges the nation's least-creditworthy commercial banks for loans from the public till. He also allowed these sketchy banks to put up their worst loans as collateral and radically lengthened the time that they are permitted to hold onto these borrowings from the standard single day to a month or more.

In doing so, the common belief is that Bernanke provided a much-needed shot of adrenaline to the financial system. Yet this medical metaphor, which seems so apt, really misses the point. What the Fed really did was perform an imperfect version of the Heimlich maneuver on the credit markets, dislodging a blockage in one section of its windpipe only to allow the chicken bone to embed itself more firmly elsewhere.

The Fed is now about to embark on a long series of interest-rate cuts in the face of a global economic slowdown, but it has no proof that cheaper money can, by itself, unwind the worldwide credit crunch.

It could work if Bernanke and other U.S. financial officials are able to persuade the biggest institutional investors here and overseas that it will work. Or it could end up lighting an inflationary brush fire that combines with a recession to create the perfect storm of unending investor pain.

All I can tell you is that the last time this was tried in a pre-contraction environment, it failed miserably. From January 2001 to June 2003, the federal funds rate fell from 6.5% to 1% even as the S&P 500 ($INX) fell by 26%, from 1,320 to 976. The lesson: An earnings collapse beats low interest rates every time.

Bring on the pain

Some veteran market observers have remarked that if the Fed had not cut the rate it charges at its "discount window" to 5.75% from 6.25%, providing the illusion of more liquidity, the Dow Jones Industrial Average ($INDU) could have crashed 1,000 points on Friday or Monday.

Well, this may sound harsh, but in the fullness of time we may pine for the crash. Because instead of a short-term crisis that would have wiped out a few overleveraged hedge funds, brokerages and individuals -- causing terrible pain to innocents as well, no doubt -- we may instead wind up with a debt debacle that stretches on for years and years and harms many more.

The plain fact of the matter is that every few decades since the dawn of paper money, long periods of outstanding economic growth have led complacent noblemen, companies, governments and private citizens to borrow large sums amid boundless optimism that that they will pay the principal and interest back on time. Inevitably, reality has caught up with these sponges at the worst possible moment, and they have been forced to surrender their collateral and pride.

Talk back: Time to bring back debtors prison?

In ancient times, creditors were often permitted to torture debtors, and up to the mid-1800s debtors prison was the destination for irresponsible borrowers.

Exploding packages

Today the situation is quite different in a fascinating way. Blame for bad risk-taking is so spread out, and collateral so ephemeral, it's hard to know whom to punish and what to seize. Even as recently as the 1980s, thrifts took real balance-sheet risk by providing mortgages to individuals.

There were loan officers whose jobs were on the line if they made bad loans, and regulators scrutinized the process. In the last housing bust, several S&L chiefs went to jail for their roles in fraud and mismanagement.

Oh, for the good old days -- a much simpler time before financial engineers figured out, with evil genius, how to distribute risk more widely. In the mid-2000s, when money became super-cheap under former Fed Chairman Alan Greenspan, S&L officers were replaced by mortgage "originators" who were paid merely on volume and were not graded by the after-sale performance of their loans.

Continued: A global game of hot potato

These loans were then distributed to banks such as Wells Fargo (WFC, news, msgs), which in turn sold them to be bundled into securities by brokerages like Bear Stearns (BSC, news, msgs), which in turn repackaged those bundles -- called mortgage-backed securities -- into a new class of financial instruments known as "structured finance" vehicles. These instruments, in some cases known as "collateralized debt obligations," or CDOs, basically smooshed thousands of very high and very low credit risks into a single new income-producing package that could be dolled up enough with marketing, duct tape and pixie dust to earn high marks from credit-rating agencies like Moody's (MCO, news, msgs).

In a global game of hot potato, these income-generating time bombs were then sold to hundreds of hedge-, pension- and money-market-fund managers in Asia, Europe, the Middle East and the United States who had vast pools of money to invest and wanted more yield than they could get from Treasury bills.

I know it sounds crazy, but these CDOs were bought by supposedly sophisticated customers who thought they knew what they were getting, but really had no bloody clue. It didn't really matter for the longest time, when U.S. home prices and incomes were rising and everyone could pay their mortgages. But now that foreclosure rates in parts of California, Florida, Ohio and Michigan are double last year's, home buyers are walking away from their investments. Money has stopped flowing into the humble mortgages underlying so many of these supposedly bulletproof instruments -- undermining the whole house of cards.

Last week, the crisis that led the Fed to act came from the trillion-dollar market for a type of short-term debt known as commercial paper. Buyers of these instruments had suddenly determined that toxic CDOs were being used as collateral in supposedly safe CP, and collectively backed away from the table in a stunning rebuke of issuers.

Said veteran banking analyst Richard Bove in a note to his institutional clients at Punk, Ziegel: The lenders realized "how unbelievably foolish they had been in throwing money after deals that they did not understand; instruments that they had not underwritten; and securities that provided no interest-rate protection against risk."

Cranking up the printing presses

The world cannot run without free-flowing commercial paper, so in order to prevent total worldwide economic collapse, European central banks and the Fed printed an astonishing amount of money -- almost half a trillion bucks -- to flood the zone. Then Bernanke topped it off with the discount-rate cut.

What's wrong with this? It perpetuates the cycle of blamelessness and only prolongs an inevitable splat. As Bove points out, homeowners years ago learned to roll over credit card debt into home-equity loans. Then the rise of negative-amortization home loans allowed people to buy homes with no down payments. Next came "evergreen" loans in which borrowers pay interest but little principal. Then came loans in which lenders actually funded interest costs. More recently have come so-called "covenant light" loans in which borrowers are often allowed to meet their obligations by automatically receiving new loans for the amount of the payment.

Continued: Potential for disaster

Bove notes that the financial system has essentially regressed from one in which borrowers were expected to pay back their debt, to one in which principal was forgotten so long as the interest payments were made, to one in which even interest payments are being refinanced. Now Bernanke has institutionalized this practice by bailing out errant commercial paper holders.

With the growth in total U.S. financial debt outpacing GDP growth, 8.7% to 1.5%, Bove concludes, our economy is not capable of generating the income necessary to meet the debt-repayment requirements. The potential for disaster is mind-blowing, and any steps taken to paper this over are only prolonging the unavoidable wipeout.

My guess is that the Fed will try to inject liquidity into the system many more times over the next few months with scant success. It will take years to unwind this mess, which is probably not a problem that monetary policy, by itself, can solve. On the other hand, who knows? Bernanke could catch a break and pull off a miracle recovery.

So play it like this: The S&P 500 Index is already below its 200-day moving average, which tends to distinguish bullish phases from bearish phases. But the really important uptrend line that traders are watching extends up from 2003 through the 2004 and 2006 lows. So long as the S&P 500 remains above that level, which is 1,370, all is well. A weekly break below that level will lead to cries of the end of the five-year bull market, and they're likely to be correct. So if that occurs, close out your long positions, buy government bonds or government bond exchange-traded funds, and save your physical and mental capital for better times.

If you want to buy something, consider regional banks, which will see their borrowing costs lowered by the Fed at a time when their payouts to customers via passbook savings accounts and CDs will also fall. These were among the few winners in the 2001 rout, so they could work again. You can participate by buying one of the industry's exchange-traded funds: the iShares Dow Jones U.S. Regional Banks (IAT, news, msgs); KBW Regional Banking Index (KRE, news, msgs); or Bank Regional Holders (RKH, news, msgs).

Or you can buy an individual regional bank such as First Busey (BUSE, news, msgs), Virginia Commerce Bancorp (VCBI, news, msgs) or Smithtown Bancorp (SMTB, news, msgs) that have solid long-term records.

Fine Print

To learn more about the Federal Reserve system, visit its Web site. To learn more about structured finance, visit Securitization.net. Learn about the many forms of collateralized debt obligations at Risk Glossary. . . .

To learn more about a debtors prison, check out this page at a Virginia preservation site. Charles Dickens' father was jailed in a debtors prison and the young author was forced to go to work at age 12 in terrible conditions to support his family. This hardship led in part to his literary work.