Capitalism Will Lead Us Back to the Future

When I first got into this business some 22 years ago capitalism was, well, it was capitalism. As an investor you researched your purchase decisions and you allocated stock and bond capital to companies you believed in. You allocated capital to companies who made something, a widget, anything, or to companies who provided a service. They needed this capital to grow and reinvest in their business. In fact, we helped finance one of the very first companies in the wireless cell phone industry. Imagine life without those little devices.

At the extreme you might have invested in a no-leverage pool of Ginnie Maes or Fannie Maes, mortgage-backed securities, which represented a direct, identifiable pro-rata interest in your share of these mortgages. You knew with some precision what type of and even where the underlying mortgages were actually located. Every month, as these securities paid down, you could expect to receive not only your interest payment, but also return of a portion of your invested capital as well. All pretty simple stuff.

Then what happened? Two things: an extreme proliferation of leverage and mortgage brokers. The bankers, investment and commercial, discovered that if they piled 30 times leverage onto their purchases that they could improve exponentially their return on equity. Then they discovered that they could contractually prioritize the cash flow stream from these mortgages and could magically turn some of them into AAA-rated securities (which they already were) and some of them into what was termed “toxic waste.” They did this on the backs of the rating agencies who, in their infinite wisdom, determined that house prices would continue to rise indefinitely by 6 percent a year or so.

Then they determined in another fit of vodka-induced lightening bolt of wisdom that if they took a portion of each of these reconstituted mortgage pools and further pooled them together they could create even more well-defined cash flow behavior, pumped up with another round of leverage. So, the underlying home mortgage was the original security.

The creation of the Ginnie Mae pool was the first derivative, one step removed from the direct, underlying mortgage. Leverage was sort of like the second derivative. Reconstituting the cash flow priority of a pool of mortgages was the third derivative. Packaging the reconstituted mortgages into more packages of their own (Collateral Debt/Mortgage Obligations) was the fourth derivative. Buying these securities with another round of leverage was the fifth derivative and so on.

Picture a used car salesman on steroids (no disrespect intended). Enter the mortgage broker. The mortgage broker’s job is to make a loan. He doesn’t have to make a good loan, he just has to make a loan period. He receives his commission and before 30 days are up he sells your mortgage into one of the circuitous mortgage pools outlined above and it is sliced and reconstituted beyond recognition by our Wall Street friends and sold to investors in literally every investment nook and cranny. He’s already gotten his commission and sold the mortgage to some investment bank, which in turn chopped it into a million pieces and sold a portion of them to a municipality in Iceland. The decision to lend was completely uncoupled from the responsibility of lending. Each of these two entities and every one of the middlemen along the route has diametrically opposed constituencies and motivations to appease and axes to grind.

In a perfect storm akin only to splitting the atom, along come Barney Frank (congressman, D-Mass.) and Chris Dodd (senator, D-Conn.).

These two distinguished gentlemen essentially forced banks, through written and unwritten legislative mandates, to lend to people who had absolutely no prospect of ever actually repaying their loans, all in pursuit of the American Dream of home ownership.

That’s what got us into this cesspool and I made you endure it again so I could say this: What will save us from this crisis is guys and gals like us at Garrison and you. People who get out of bed every day, puttheir feet on the floor and try to push this country forward will save us. People who genuinely care, people who are productive, entrepreneurs, business people, creative types, inventors, the next Bill Gates, Democrats/Republicans, these are those among us who will save us.   

Capitalism will return to what it was, what it was meant to be. It will return to investors like us and all of you who research their opportunities and allocate capital as efficiently as we can.

Capitalism will move back into the hands and into the care of the productive among us. w

(Glenn E. Atkins, CFA, is executive vice president and fixed income portfolio manager at Garrison Asset Management Co., a registered investment adviser in Fayetteville. He may be reached at [email protected].)