The Abysmal Pursuit: Why Sub-prime Lending Hit us Below the Belt

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The problem with mortgages going bad has been all over the papers. It may be that some non-fi nancial experts would like to have more understanding of what is going on. To be fair, so would the experts. But to start with defi nitions; sub-prime mortgages, in American usage, simply means mortgages written for families that normally would not be in a position to invest in a home. The good intent of the US Government was to loosen up mortgage requirements so that more could experience the 'American Dream' of owning a home. Unfortunately, many mortgages were written to fulfi ll governmental minimums that were destined to fail. As you will see, that would be only the start of the disaster. First let me paint a picture that will give you a context for understanding what is currently unfolding.

In his introduction to a course in the "dismal science" for economics students in 1919, Rudolf Steiner, the thinker behind such modern fi nancial institutions as RSF Social Finance in the USA, Triodos Bank in Britain and others, laid out a kind of economic map that may be useful as a background for understanding what is going on in the world economy today. He described the full range of economic considerations as a color spectrum starting and ending with the invisible zones of infrared and ultra-violet. The commercial part, the world we can touch, feel and see, can be imagined as though painted in the many-colored hues of the visible spectrum from red to orange, yellow to green, blue to violet. The warmth of the invisible infrared zone works as a metaphor for the subterranean substances that fi nd their way into the economy as commodities. The stuff that comes from the mysterious depths of the earth, through mining and agriculture, makes commerce possible. Most of us in the western world don't really think about where stuff comes from, or about all the warm activity in the soil that is essential to growing our food. He differentiates between the two, mining and agriculture, though they both take an effort of consciousness to appreciate, because agriculture is living and, if sustainable, is self perpetuating, while mining is purely extractive and fi nite in nature. On the other end of the economic spectrum lies the ultra-violet, also invisible, the realm of fi nancial machinations, manipulations and markets; in other words all that shows up in the end as wealth, i.e. buying power or the lack thereof. It is a realm of theory and often abstract calculations and valuations.

The sub-prime lending debacle is a story that takes place in the ultra-violet zone. It is the most recent casualty in the battle between governments' heavy regulatory approach to fi nancial fi rms versus the more laissez-faire approach that has been in favor for the last eight years. These swings from right to left, from liberal to conservative, have repercussions playing down into the hands of all producers and consumers as well as big multi national banks and micro-entrepreneurs in developing countries. Slight adjustments in policy affect the availability of capital for growing businesses and all these swings effect the price of things. In the United States, Federal Reserve Chairman, Allan Greenspan, acting like some spectacled God, mastered the ability to express in mysterious code future interest rate decisions that would increase or decrease the availability of capital. His comments about the world economies alerted investors indirectly to the fact the interest rates were likely to rise or lower in the near term. Ben Bernanke, who has succeeded Greenspan as the new Federal Reserve Chair, seems more clumsy so far, or at least it is not as easy yet to determine what he is going to do in relation to what he says. Meanwhile the decisions of other sovereign nations as to how they will adjust or leave currency and wage laws alone, regulate or liberate industries is a daily drama firing and cooling markets globally.

The focus of an article attempting to shed light on the sub-prime disaster will have to focus on this ultra violetpart of the economic spectrum and how it works down into the visible everyday concerns of our world, leaving the infra-red discussion for another time except for one thing: the price of gold and other commodities, especially wheat, are soaring, in part due to decisions or lack of control on the cool ultra-violet end of the rainbow. The overriding concern that plagues us today is the lack of morality or, worse even, meaningfulness in the ultra-violet world of rates/currencies/values. This is not a religious matter, but rather a practical concern that there have been no consistent ideals behind the decision making process. Trillions of dollars worth of currencies are traded daily on a mostly speculative basis, as traders attempt to second guess what tightening or lessening of controls will come down from regulators. This volume of trading dwarfs the amount of money traded in stocks around the world. There is a sense that economic systems lack a sense of centeredness with their vacillations from control to liberation of liquidity and market forces, either limiting or lavishing access to capital for struggling or growing businesses. It is my contention that this will not be resolved unless and until there is a global sea-change toward a common cause with a common understanding: we live in an interdependent world that needs to be sustained by ideas that become practical ideals. No matter what, though, let there be no doubt we are living in a world economy and the sub prime debacle is merely a symptom of global illness. We may try to live in isolated independent economies, or co-dependent ones that feel safe though static, but we need to recognize that we will only fl ourish in the interdependence of a living and multifaceted global economic organism.

Before going into some of the detail of the current economic confusion there are four assertions I would like to place before you. This will be followed by a high level view of the world in evolutionary perspective. This is to loosen the knot before untangling it. Finally, I will conclude with some hopeful thoughts about a sustainable future. First, though, here are the four assertions:

1. Materialism results in the endless pursuit of causes in the same realm as the effect.
2. If insanity is the repetition of behavior with the expectation of a different result, sanity tends to fi nd new ways of dealing with recurrent problems.
3. We are not so much human beings seeking the spirit, but rather spiritual beings seeking to become human.
4. Each generation is given what the last generation struggled to overcome.

Brief Historical Background

Three generations are overlapping and co-existing today: the last of those born before the end of WWII (1912- 1945), the "Baby Boomers" now in charge (1946-1979) and the "Net" generation (1980-2013), whose global social networks are breaking down the polarities of the past. If the oldest generation struggled to master the material world, resulting in plastics, synthetic fertilizer, nuclear fi ssion and artifi cial intelligence, then one could say that next oldest generation struggled to humanize this material world by questioning all established assumptions about what is right or wrong. Finally, the youngest generation today seems to combine the best of these previous two with an instinct for technology and a pragmatic sense of humanism. Their initiatives and true values represent the hope for overcoming the illness and imbalances of the world economy. They too will grow older and protective of their own, possibly compromising of values, yet inherent in the technologies and business models now being created there is an underlying strategy that supports innovation, collaboration and global interdependence. The sub-prime debacle is a knot left over from centuries of confl ict between classes, races, and nations that did not yet see the earth as a whole complex of interrelated interests. Since the photograph of the earth as a colorful jewel in the universe as seen from the moon, this awareness has grown exponentially, but it has been a long time in coming and still has a long way to go.

Apart from the Silk Road, between the Far East and the Mediterranean, and the uniting of Europe through the building of cathedrals and universities, the world economy really began with the voyages of the 15th, 16th and 17th centuries. But only with the introduction of the steam ship in the early 1800's did England and India begin a lively, Though one sided, exchange of goods on a regular worldwide scale. Like a backdrop in this evolving world commerce there was always a tension between private ambition/opportunity and governmental control. Germany did not emerge beyond its centuries as an isolated agricultural society until the mid 1800's and then with a jump-start due to governmentally controlled and funded production. England allowed production and trade to evolve as a private affair until the end of the Second World War, which had drained private resources, allowing Atlee to defeat Churchill as prime minister by appealing to the masses in poverty with his call for a Welfare State. This followed and paralleled USA President Roosevelt's public works platform in the late 1930's and put Government back in the position Lenin called the "commanding heights" (see the recent book of the same name by Yergin and Stanislaw). France, and Europe in general, took a more hybrid approach to this invisible battle of public good versus private entrepreneurship, and still today presents a mixed picture, with aspersions, both positive and negative, to the roles of Reagan and Thatcher, bringing back the appeal of Good and Evil Empires and the freedom they associated with making money relatively free from the entanglements of regulation. In the last decades, China, India, Brazil and other developing nations have emerged from their primarily agricultural societies with strong government backing, to leap into the modern world, skipping many of the awkward steps that characterized the development of the Western World as we know it. Cell phone reception is likely to be better in the Congo region than it is in many pockets of the USA. The internet is becoming ubiquitous and through it the world economy is becoming 'fl atter' or more accessible, at least in theory. China is testing the freedom of this viral network of information and markets, as it realizes the fact that it may either have to become more invasive in its regulatory stance or simply surrender to the new open source paradigm which gives access to information and internet based commerce (e-commerce) to all equally.

The Net Generation

In the year 2000 a new generation began reaching adulthood. I call them the "Net Generation," born between 1980 and now, these are the pioneers of social networking. With technologies based on the ideals of freedom, openness and honesty, they have created practical platforms whose valuation based on advertising income has placed this group of tender non-business people inside the Standard and Poors list of the 500 largest corporations in the world (S&P 500) in record time. At the same time, Facebook, U-Tube, and most importantly, Wikipedia have opened a whole new world of value based on social networks. Though the content is almost unedited and input comes from whomsoever takes the time to submit it, Wikipedia overtook Encylopedia Britannica after decades of predominance, seemingly in nanoseconds, as the most used site for gathering in depth information on any subject.

Karl Konig, the founder of the Camphill Movement, a worldwide association of communities that have set a high standard for social therapy, in the 1960's presented an interesting description of the generation that is just beginning to tip toward retirement age. He characterized Them as a group of souls who were inspired to "come down" to live on the earth by viewing the bombing of Hiroshima from the other side of the "threshold." They (and I should say, "we") came with a sense of mission, to break down the establishment and bring peace and harmony to the world. By his theory, generations are about 33 years in coming (1946-1979). And by the looks of things the fi rst comers have largely failed. Free love fell from it's Paradise Now status and seemed to gradually transform into "free" trade, while some of the chanting teenage peaceniks of the 60's can now be associated with the character of Gordon Gecko in the movie, "Wall Street." He summarized his own alluring rationalization for insider trading and hostile takeover in one smooth phrase: "Greed is good." Such are the characters that make business, and my generation, look bad and the current unravelling of global confi dence is the result. Of course, many credit this same generation for creating new social forms and for breaking down tired, stuck ways of thinking. It is often a danger that in battling too hard against an enemy, you might end up acquiring some of the qualities you despise the most.

On the other hand, this new generation and some of the late comers from the last, born in the 70's, and known as Gen X-ers, are waking up the latent idealism in many Baby Boomer captains of industry, as though they've slept for the last 30 years and only now remember what they came for. Social Entrepreneurism is getting a great deal of media play, and the highpoints of this year's World Forum in Davos was as much about the young social entrepreneurs out to solve practical world problems as it was about boomer stars like Mohammed Yunus and Bill Gates with their sincere proclamations in favor of Good Capital.

Looking at Sub-Prime as a Symptom

Unfortunately, as long as economics is about taking care of one's own to the detriment of others, the rat race of markets will continue, regulations will be required and will stifl e productivity or lead crafty innovators to skirt them. Traders of abstract values extracted from real things (derivatives) will keep the market wheels spinning and big multinational corporations will do whatever it takes to make a profi t and boost their stock price.

Such is the case with the sub-prime mortgage debacle. It is not the fi rst time big banks have had to say "whoops," and it is unlikely to be the last, unless the new network paradigm is adopted. Many banks will argue that they were forced by regulators to avoid "redlining": the practice of excluding some depressed or minority dominated geographies from loan portfolios. From this perspective they complain that they had to write loans for those without credit. However, allow me to insert a personal anecdote to illustrate the dynamic that brought this disaster about:

At my fi rst introductory meeting as one of the regional Legg Mason fi nancial advisors (a nice term for stock brokers) who had been co-opted by Citigroup/Smith Barney, a very intelligent executive spoke convincingly about the advantages of being with a big bank - such as access to more investment options (not true!), better research (not true!) etc. Suddenly he changed his demeanor from a wise and experienced leader to that of a snake oil salesman, saying: "Just wait! You are going to make so-o much money on mortgages! In fact, to prove it, we are going to pay you $2000 for every application you get your clients to fi ll out...even if they already own a home!" This is how such debacles begin.

Not long thereafter I had a client looking to buy a house, and I got a mortgage expert on the line. The "expert" had been trained to persistently push adjustable rate mortgages or ARMs and she did so despite the fact that we wanted the historically low fi xed rate and did not need a no-money-down, interest-free deal. Without me on the line to stop the onslaught of sleazy reasoning my client would have bought in. This was in 2006 and all across the country thousands of advisors were enmeshed in such conversations. Since interest rates were so low, mortgage banks needed to step up the volume to get their earnings up. That was step one.

Along the next months I noticed that interest rates in my smaller accounts were being dropped by 2 points or more without warning, while the bigger accounts maintained the healthy interest rate attained during Greenspan's last year of tenure at the Federal Reserve. This is when I realized I had to get out and began my plans to join my friend and mentor at Benchmark Asset Managers so that I could truly serve my clients' best interest as a registered investment advisor with no big bank affi liations.

Then step two started: fi xed income portfolios around the globe were laden with old low interest investments in fixed income and needed ways to leverage the portfolio and pick up the yield. Leverage, in this sense, means to borrow money and add investments to the portfolio that will give it more zip so it might outperform its peers. This outperformance is what attracts throngs of investors who can't sniff out the dangers in such a strategy. If the new investments go bad, of course the borrowed money must be paid back, causing the original investments to underperform their peers. The reason these investments were wolves in sheep's clothing was the fact that many of the original portfolios were rated as safe, investment grade portfolios. The underlying original holdings were simply boring. Now, what were added to these portfolios with borrowed money (so I guess it didn't count to the regulators) were the now notorious sub prime mortgages. "Sub prime" is an understated adjective describing mortgages with no backing, no collateral, given to borrowers with no history and no credit in many cases - i.e., less than prime.

Step three: as these mortgages are maturing interest rates have started kicking in, which raises the amount required in monthly payments beyond the means of some of the borrowers; we have not yet seen the bulk of these interest rate hikes and governments may stretch out the tide of foreclosures by forcing bankers to delay the interest increase. The problem, however is that no one knows the value of the portfolios carrying such loans or
derivatives of them, and though the banks keep writing
off billions we may not have yet seen the end of it.

Step four: banks do not have the liquidity to offer suffi cient loans to keep the economy growing so Bernanke, the new demi-god at the head of the Federal Reserve Bank, dramatically cut interest rates the day after a global downturn in equity markets. This was seen as a very ungodlike and reactive maneuver. Confi dence was not restored. The volatility continues with potential for further decay and masses of credit card bankruptcies following suit. It is too much to go into the possible unraveling of insurance products that were supposed to protect the downside of these now unmarketable portfolios. This may be old news by the time this article is published. The good news is that parallel with the unraveling of old paradigms, new paradigms are being born.

Postlude: Chaordic, Cancerous or Cool

"You never change the existing reality by fi ghting it.
Instead, create a new model that makes the old one obsolete." Buckminster Fuller Like Fuller and Einstein, Dee Hock was another pre- Hiroshima baby who thought in new paradigms. The term he coined was "chaordic," meaning: a combination of laissez faire (or chaos) and regulation (ie order). His experiment was to set up Visa, the credit card company, in such a way that anyone could in turn set up their own branded Visa cards and promote their own interest rate offers as long as they followed certain protocol and paid their dues to the company. He got it started then disappeared for two years while the money poured in with no one at the helm...the experiment worked. Or did it? A chaotic deluge of credit card offerings, like viral cancers, has put millions in debt beyond the means to repay, while others with cunning have gone for years in debt without paying any interest by switching cards constantly. It is unfair to blame Mr. Hock. His contribution was to pioneer and prove the potential of an important networking principle: that massive scaling is possible through modular networks of initiative moderately regulated.

True to the Hiroshima inspired generation, Judy Wicks, humanized this approach with the idea of "local living economies." One of the founders of the BALLE Network (Business Alliance for Local Living Economies) Judy is a 60's child who never lost her ideals and maintained that local businesses could change the world one cell at a time, by procuring and selling locally and sustainably. This takes the "chaordic" concept a step forward by imbuing its modular units with neighborliness. Credit cards tend to suck money out of local economies as much as they facilitate transactions. On the other hand communities that strive to build local cooperation and mutual support need to develop interrelated networks in order to bring this altruism to the global level.

The net generation seems to be the fi rst group who are able to marry global idealism to "local" pragmatism through the science of networks made possible by the internet. A chaotic but cool proliferation of initiatives is raising global consciousness, encouraging socialinteraction and forcing the most staid traditionalists to open up to open source problem solving and software as a service (SaaS). They are realizing that the limits of growth are not so much related to bricks and mortar capital costs. It is hard to imagine with this new wave of creative networking solutions that economic systems based on the deifi cation of government fi gures raising and lowering interest rates will last far into the 21st Century. Time will tell!

G. Benjamin Bingham is the Managing Director of Benchmark Asset Managers (www.benchmarkam.com) in Philadelphia, Pennsylvania, U.S.A.

[Published in New View magazine, Spring 2008]