Financial Engineering: If You Don't Like The Free Market, Change The Rules

Submitted by Ralph Dillon of Global Financial Data,

If you don’t like how things work in a free market, just change the rules and financial engineer whatever the results of which you like to achieve. And so, since 1995 we have been going from boom to bust from one bubble to the next as we try to navigate the financial markets that have been turned into a circus act.
You want to securitize home loans and dump them on the public? Package Collateralized Mortgage Obligations with AAA ratings. The masses cant afford a mortgage? No worries, have the Federal Government back and guarantee loans from Freddie and Fannie and simply change the underwriting rules so they can. Want to move the equity markets considerably higher? Start cutting interest rates to as close to zero as you can and force investors into equities.
In order to fully grasp what has been done here, you have to take a look at what is currently going on.
Last year in 2013, it is estimated that 60% of the homes purchased were purchased with cash. In contrast, since 1988 only 6% of the homes purchased were purchased with cash. Additionally, studies have shown that historically US homeowners typically finance 50-60% of the purchase price of a home. At the peak of the real estate bubble in 2008, some folks were purchasing homes with no money down and financing 100% of the purchase price. Even more staggering, are all the diffent types of loans that have been created to accommodate the appetite of Wall Street and the securitization of them. And finally, 75% of the loans written since 1988 have been conventional loans. That too has been re-engineered, at the peak in 2008, we had more flavors of loans than there are ice creams. Adjustable Loans, Interest Rate Only Loans and Jumbo Loans to name a few that can and did accommodate anyone who wanted to purchase a new home regardless of income and credit rating. It didn’t matter if you couldn’t afford it.
But why was this all done? Politicians will argue equality, Wall Street would argue modern global financialization and I would argue a way to get and stay elected.

All of this creative financial engineering started in 1995 when the rules governing underwriting mortgages for home ownership were changed. The idea being, that everyone should be able to own a home and share in the American dream.  With declining mortgage rates and very accomodative underwriting standards, home ownership exploded over 10 years. An expansion that has never been seen before as the chart below depicts. Look at the declining mortgage rates and what happened to home ownership in 1995 courtesy of these new underwriting standards.

And what does the financial engineering that was being done on Wall Street look like on home ownership when you overlay it with the S&P 500? As you can see by the chart below, the financial engineers had accomplished what they sought. To create a wealth effect and economic expansion that we too have never experienced before. Exactly in 1995.

And finally, what effect did the financial engineering to the US 10yr Bond have on the equity markets? Here is a look back to 1791. But look what was done again in 1995 to the 10yr and the S&P 500. The financial engineers drove interest rates to historic lows with perpetual easing in order to move the equity market. Results are where we are today. Historic low yields and an equity market at all time highs. Exactly what the financial engineers sought out to do. 


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