I have often been accused of being too simplistic in my analysis of problems and suggestions for solving them. I am sure many who read my blogs on this site respond by thinking, “how can he say that the recession could have been avoided and that the solution is straight forward,” when most economists say the crisis was inevitable and reviving the economy will take years of work. But ponder one recent lesson we learned, “How was Bernie Madoff able to fool the best and brightest financial brains in his amazing ‘Ponzi’ scam?”

In any situation or problem there is a basic truth. The Great Recession was based on an explosion in credit creation allowed by innovative financial products - collateralized debt, mortgage backed securities, securitized debt, credit default swaps and more. I lump all of these under the name, “securitized debt,” which means debt that is bundled and sold as shares in an invesment. In essence, it is a bond, but with many borrowers bundled into debt assets sold to many investors. Many of these securities were backed by mortgages and other collateral, thus the name “collateralized debt” securities. Credit default swaps were insurance against the debts behind the securities defaulting. This is a fairly simplistic picture of a very complex world.

Now many say the problem was due to excessive “leveraging” or “borrowing” based on your assets to buy more securitized debt. The thing to remember here is that your assets consist of your equity and your investments which are largely, you guessed it, other peoples’ debts. What we had, again in simplistic terms, was debt became assets used to borrow to buy more debt that became assets used to borrow……. I was given to call this, debts become assets become debts become assets.

So there we were with a debt built on debt built on debt to a total level no one really knew or understood. A major factor was that this structure was built without the transparency given and control given by regulated markets for other securities. Everyone, including those in the business, was in the dark as to the full extent and composition of this enormous debt structure.

Given the lack of understanding of the structure it was no surprise that many panicked when they perceived cracks in the system. In their panic they shucked off securitized debt at a rate that deflated their value faster than a duck molting his feathers. Even worse, this massie sell off became the “market” against which all such assets had to be valued. This in turn put big holes in most financial institutions’ balance sheets since they all held securitized debt and its relatives.

My simplistic contention is that there was no reason for the panic sell off and massive devaluation of debts come assets come debts come assets. The whole structure rested on the very heart of the theory of lending, reasonable expectation of repayment. No matter how far the orginal debt may have been leveraged, if it is repaid, all the structure built on it is sound.

The key thing to understand here is that the panic selling started long before a notable increase in defaults on the loans, mainly mortgages, began to occur. The panic began when analists saw the underlying collateral, in the case of mortgages, property, starting to lose value. Thinking like investors they saw people not paying on mortgages that became more valuable than the homes on which the mortgages were issued. And once loans began to default in a major way, the highly leveraged debt structure would quickly collapse.

The panic led to the financial tailspin that led to recession that led to massive unemployment that finally did cause many people to default on their mortgages. In effect we had a self-fulfilling prophecy.

How could we have avoided the catastrophe? Easy, if we had had a better understanding of this new credit market and control over it. This better understanding would have allowed analists to more accurately assess the impact of property market declines on debt repayment. As long as defaults did not grow too fast, they would have been able to more accurately assess the values of the securitized debt to their long term, or maturity value, minus a realtively low default rate.

Sounds simplistic doesn’t it? But remember the foreclosure rate in 2008 held at a mere 2% of all mortgages. Yes, the foreclosure rate has risen to what I am now informed is over 4% as unemployment has sharply increased. But if we had not panicked, we would not have had this massive unemployment, so the foreclosure rate would probably still be below 2%, and the huge credit structure built on securitized debt would have been still in place.

“It was not securitized debt that caused the Great Recession of 2009, but erroneous valuation of these securities.” I have said this several times in my blogs but the bad valuation crowd persists in dire warnings about “toxic assets.”

Securitized or collateralized debt produced the greatest new source of credit ever seen. I say this since it accounts for the largest share of mortgages, by far, and mortgages constitute the largest component of our overall debt. Unfortunately this class of debt has never been fully understood or measured, since it is not bought and sold on an regular market, where transparency and rules control the action. This also makes it difficult to value these investments.

To get a better understanding, we can compare securitized debt to bonds, and, in fact, the securitized debt is usually sold as bonds. The difference is that a traditional bond is issued by one borrower. Securitized debt is a bundle of loans and one buys a share in that bundle. Instead of one borrower, you can have hundreds or thousands of borrowers represented by one bond. The main idea here is to spread the risk. Instead of having one borrower go bad and ruin thousands of bond holders, under the securitized debt bond, if one borrower goes bad, it does not ruin the whole bond and the loss is dispersed among thousands of bond holders.

While reduction of risk is good, the large collections of loans that go into the securitized debt bond make it impossible to rate the bond issuer. Bonds issued by a corporation or a government entity are rated as an investment based on several criteria, assets of the issuer (although this is a moot point with a government bond), the issuer’s repayment history, and most importantly the issuer’s ability to repay, i.e. its earnings prospects, current and future. But a securitized debt instrument represents hundreds, if not thousands of borrowers.

Now we are all familiar with the requirements to get a mortgage. We have to prove our ability to pay with proof of funds on hand, income statements, statements of expenditures and so on. But this evidence of ability to pay becomes impossible to track when one speaks of a securtized debt instrument covering hundreds or thousands of mortgages. Thus there is no way to rate the issuer of a securitized debt instrument. One has to rely on general results for these loans and repayment of mortgages has a good record, generally.

Rating the issuer is important since that sets the price of the bond, i.e. the interest rate, which in turn yields the value of the bond. Since there is no way to rate the many issuers or borrowers involved in a securitized debt instrument, there is no way to value the bond this way. And here is where the problems began.

Since analists were not able to rate, and thus value, securitized debt in the normal way, they were left to finding indirect ways to value the bonds. They chose to do this by looking at the undelying collaterall of the bonds, in the case of mortgages, the properties involved. But since they could not see all the properties represented by a given securitized debt bond, they looked at the overall property market.

The important thing to remember here is that these analists began to sharply devalue the securitied debt instruments as soon as prices in the property market began to fall. They did not wait to see how this affected payment of the mortgages. They began to devalue these bonds long before loan defaults and foreclosures began to rise. And they devalued these bonds as much as 90%. When they devalued these investments they caused losses for nearly all financial institutions, since they were all heavily invested in securitized debt. This in turn severly depressed balance sheets everywhere and the financial institutions were no longer able to lend. Enter the credit freeze that led to the recession.

Properly valued, the securitized debt should have been valued according to the borrowers’ ability and propensity to repay. But that was not done. No, they devalued the securitized debt because the property market went south. That makes about much sense as devaluing a bond issused by the water works because the level of the dam has fallen.

Since the propensity and ability to repay was not the immediate problem, the securitized debt should have been valued for its long term or maturity value. This is easily done by multiplying balance due by the interest rate by the number of payments left and subtracting the loss to foreclosures or total defaults.

Fortunately the Feds recognized the mistake being made in valuations of securitized debt. The immediate reponse to the near total collapse of our financial system last October was the TARP program. At first the idea was to buy securitized debt from banks and thus take them off their balance sheets. But that was dropped when the Feds realized that this was a lengthy way to do the job and turned to injecting the TARP funds directly into banks to correct their balance sheets.

The plan worked. We averted the collapse of our financial system. More importantly, my position that the problem was caused, not by securitized debt per se, but by the erroneous devaluation of these investments, was proven true by the banks being able to repay the TARP funds in a matter of a few months. Moreover, the famous “stress tests” administered to the major banks showed that they were not “stressed.” In other words, the securitized debt they held that had been savagely devalued, regained its true value.

I still hear various voices stating that economic recovery is not here yet. The proof they usually offer is our still too high unemployment rate. Well as any economist will tell you, employment is a lagging indicator, in other words employment follows economic movements, rather than lead them.

Meanwhile central bankers around the world agee that we have stopped the financial downward spiral brought on by erroneous valuations of collateralizesd debt assets. The reason we could do this in short order is precisely because the delauations were erroneous. As soon as the false devaluations were put to the test, i.e. public funds used to rebuild bank capital positions, the downspin was arrested. It took brilliant managers of the public funds to do this and my hat is off to them. Not everyone agrees with this and many still say the banks holding securitized debt are still undercapitalized. They say they can still run into problems. Well as long as we stay away from using false valuations for these assets, we will do just fine.

It is true that the overall economy is still catching up to the correction of our financial markets. But it is coming. The OECD, the economic organization of the richest countries, has stated that recovery is happening this quarter, i.e. as you read this note. This recovery should bring along employment by the end of this year, so the biggest Christmas gift for many may be a new job.

As I have said from the beginning, this is an economic down-turn that we could have avoided. The problem was that our great new source of credit, securitized debt, was such an unknown and unmeasured phenomenum, that when we saw some relatively minor problems developing, we panicked into trashing these so-called “toxic securities” and in the process brought the world’s economy to its knees. The only way to avoid a reoccurence of this distaster is to make sure that we develop transparency and rules for this key source of credit.

Prince Charles of England has a new ad out featuring a forest frog with several celeberties, including Kermit the Frog, calling to save our tropical rain forests. The prince states that destruction of “our” rain forests releases more CO2 into the atmosphere each year than that released by all the autos, trucks, trains, planes and other means of transport.

I am glad to see some other culprit being named for global warming. We could also talk about livestock releasing methane gas into the atmosphere by their evacuation of waste product. So why not call for killing off all these creatures?

The point is to strike a balance between the economy satisfying the needs of the people and taking care of the enviornment that surrounds us. Those who argue for saving our rain forests, reducing transportation, and getting rid of livestock tend to forget that these resources are important to many people.

The rain forests are cut for two main reasons, to clear land for agriculture and to harvest tropical wood. Should we stop mainly peasant farmers from using new land? Should we reduce the production of vegetable foods while reducing our consumption of meat? Should we resign people to living close to home and not seeing the world? Should we end efficient production of goods by ending the ability to transport those goods across great distances? The destructive practices demonized by environmentalists at the same time serve useful purposes enjoyed by the great majority of people.

Not only do environmentalists’ calls for “action” impinge on the desires of most, but they don’t seem to work. We are making the sacrifices but not getting results. An illustrative case here is the famous Kyoto Protocol, the litmus test for being environmentally correct. It should come as no surprise that Japan, home of the Protocol, has not met its goal to reduce harmful emmissions by this time, in fact, since the Protocol went into effect, Japan’s harmful emmissions have increased by something like 9%.

Again, the UN Conference on Climate Change to take place in Copenhagen in December must look at the facts, not fiction. It should look at reality and avoid fanciful notions. As I have stated before, it should look at adapting to climate change, and not seek to stop change. Remember, the only immutable law in nature is the self contradictory axiom, “the only constant is change.”

Well, President Obama presented his health plan to the nation. It is basically a good idea, although it still doesn’t speak to the main reason health costs are going out of sight, i.e. the scandalous fees earned by doctors. I like the central proposal of the plan, an insurance exchange which would encourage competition, at least among the insurers, if not the practitioners.

A Republican Congressman caused a furor when he blurted out, “You lie,” in response to Obama’s catagorical assurance that illegal immigrants would not benefit from his plan. It was a mistake for Obama to say this, since there is always the possibility that illegals can use the plan. But it was poor form for the Congressman to express his concern openly in that forum.

But did Obama lie? No, but he sure obfuscated on important points. He said that the cost of his new program would be paid for in large measure by eliminating “excesses” in Medicare payments. He said that he will eliminate “subsidies” being paid to insurance companies by Medicare. Well the only “excesses” and subsidies” he has so far indentified are the health plans I and 11 million other Americans now have. In spite of his promise that you will be able to keep your present health plan, the Obama plan calls for eliminating Medicare Advantage plans. I have now become an “excess” or “subsidy.”

To put the numbers on this move, the 11 million Medicare Advantage clients cost Medicare, I estimate, about $3000 each per year, or $33 billion a year in payments made by Medicare to insurance companies to take care of our medical costs. By eliminating this plan, Obama’s team sees Medicare saving $33 billion a year. But wait, let’s look at the actual costs. BlueCross, with whom I have the Medicare Advantage plan, paid about $7000 in medical bills I incurred last year, including treatments, exams, medicines and so forth. Thus by paying a flat $3000 to Blue Cross for me, Medicare SAVED $4000. If we multiply that savings by 11 million we see that eliminating the Medicare Advantage plan could mean Medicare having to pay an additional $44 billion, instead of saving $35 billion. I believe Obama’s numbers smack of a bit of slight of hand.

Obama’s plan calls for mandatory health insurance. Each and every citizen will have to buy health care insurance for himself and his family. The Obama team portrays this as being like having mandatory insurance to drive a car. The difference is that insurance to drive is placed on the automobile, not the driver, so to avoid paying for insurance, a person can choose not to own a car. Under the Obama health plan you are obliged to take out insurance and there are penalties for not taking out insurance, period.

I would imagine that there are other cracks in the plan. While the overall idea is good, these cracks allow for continued resistance to the program. The battle is far from won.

President Obama will speak to the American people tonight on his health care plan. The talk is billed as his effort to reclaim the initiative in the struggle to improve health care in the USA.

There is one glaring ommission he should address. Obama and all others, myself included, have stated catagorically that the problem with our health system is that it is too expensive. Again, we pay more than twice what Western Europeans pay for the same standard of health care. The Obama team wants to control costs by encouraging competition among health care insurers, with a public insurer entering the game to set the standards.

I am a bit tired of beating up on the insurance companies as the cause of our runaway health care costs. It is akin to blaming the outrageous costs of getting your damaged car fixed by a auto body shop, you know, $1000 for a fender bender, on the insurance companies. The outrageous cost is what the car repairmen charge, the insurance company merely pays the bill.

What is missing from the President’s plan are real efforts to control costs. First, and foremost, would be to get some control over doctors’ fees. As I have stated before, the average annual income for a doctor in the USA is over $250,000 which is four times what a Swedish doctor friend of mine makes in his country. We have to control these fees. The only way to achieve this, is to have all payers resist, if not refuse, to pay these charges.

Perhaps having a public health insurance company would allow control on doctors’ fees. With the public company leading the charge, the private insurers could follow suit. However, this could lead to two health care systems, a low cost one, with a public insurer using fee controlled doctors, and a high cost one, with private insurers paying any fee asked by doctors. You would really be able to pay your money and take your choice.

Since I don’t really see any poltician ready to take on the doctors’ lobby, I suggest some other methods to cut the cost of doctors:

1. Allow Physican’s Assistants and Nurse Practioners to independently offer primary health care. These two highly trained and competent medical practioners earn about 25-35% of the average doctor’s income. This would allow competition between high cost and low cost service providers.

2. Allow medical services to advertise their prices, thus allowing true competiton. In the 1970s we broke the bans on lawyers advertising their prices to compete with each other. We should now break the bans on having medical services and practioners advertise their fees. The health insurance companies already do this, so we should extend this free competition to the ones setting the fees.

The only way to put an end to the rocketing cost of health care is to open it to genuine competiton. The health care providers will have to compete to gain business from individuals and/or their insurance plans. The insurance plans will have to compete to gain customers.

When we lived in Namibia one of my favorite pastimes was to go to the local “bookmakers.” No, not people making elaborate, leather bound copies of first editions, but betting parlors. And these were right out of the movie, “The Sting.” There were blackboards with guys chalking up the odds and erasing them as the race got closer in time. The races were broadcast over radio just like in the movie, “Seabiscuit.” History in the flesh.

I recall these sporting icons now when I contemplate the stock market. The action is fast and furious with electronic boards blipping changing prices. Yes, faster than the boys with chalk, but not that much faster. The parallel is that one becomes riveted on the blinking lights or the falling chalk dust. At these moments you realize the shallow gulf between gambling and investing.

Many argue that investing is not gambling since investing is based on volumes of research and tons of information, while gambling is less endowed with “hard facts.” These are obviously people who have never read the “Racing News” or the many bet sheets published by ranks of touts. I even once had a calculator that, after loading info from the racing press, would spit out the top three horses in any race. An uncle of mine used to take info from the press, his contacts, observations of the horses, and, most of all, careful analysis of the horses’ performances over the recent past into his calculations for betting. He was a consistent winner.

I recall when I was in that most nerve-wracking investment world, currency trading, that the real traders locked themselves in rooms full of computer screens with lights blipping everywhere. The traders would use mathematical systems to follow the “bouncing blips,” with wave theory being a favorite. A good friend and I were sitting in a training class when the instructor told us about using the “Fibonacci Series” of numbers to predict movements. My friend and I immediately exclaimed, “that is how you bet in black jack.” The teacher assured us that trading was not gambling, but we were not dissuaded.

So what to do in this world of rapidly rising and falling stock prices? Well, absorb all the information you can find. Do the math. Make your bets. My tip, look for stocks whose prices have been severely hurt by the excessive devaluations of 2008. Again, I am big on Fannie Mae and Freddie Mac.

All key economic organizations now agree that the financial freefall that caused the “Great Recession” came to an end in the second quarter of this year. I wrote that this had happened back in April and May stating that the pivotal date was 2 April 2009. The Organization of Economic Cooperation and Development (OECD) that represents the richest countries in the world now says that recovery in the world’s economy has begun in this quarter, the third quarter. I also reported this some weeks ago.

While I am happy to see that my predictions have come true, the swift recovery, the “Great Recession” seems to have lasted only 6 months, from the, “greatest economic calamity since the ‘Great Depression’,” supports my contention since last year that this was an avoidable event caused by erroneous devaluations of major financial instruments. I said that the disaster should never have occured, since the real value of the devalued assets was far higher than the depressed prices coming from panic driven analists. If there had been real major problems in the economy, we would not have been able to correct the situation so quickly.

Fortunately for the USA and the rest of the world we were blessed by having the right people in the right place at the right time. Hank Paulson, Ben Bernanke and Tim Geithner understood what had happened and took the right measures to curb the financial chaos thereby setting the stage for economic recovery. They litterly bet the entire ” US farm” on the underlying strength of the economy and the financial assets that had been savagely devalued. In doing so they took alot of heat but they persevered and saved the day.

Now how risky was that bet? To reiterate a subject that I have beaten to death, the economic firestorm was ignited by analists devaluing securitized debt and its ancillary product credit default swaps by as much as 90%. What they did not realize was that this source of credit had become the principal source of credit fo the economy and in doing so killed the credit markets. This in turn shook the whole financial industry and in turn the economy itself.

As I have stated ad infinitum, the devaluations were erroneous. The massive defaults on mortgages on which the devaluations were predicated never occured. The foreclosure rate due to defaults on mortgages never exceeded 3% of all mortgages. Thus the Feds had a 97% chance that their bet would work. Well 97% certainty is very good in the world of high stakes gambling and the Feds won.

Yes, I understand that unemployment is still high. However, blame it on the erroneous valuations made by panicky analists, not on the debt instruments themselves. Securitized debt still remains a very good investment since it yields a high return with 97% certainty. No other investment comes even close to such a high return to risk factor. I hope we have learned our lesson.

I read alot these days holding that, with Iran convulsed by post election turmoil, we should hold off placing more economic sanctions on the country. We should let the “Twitter and YouTube” revolution take out the recalcitrant regime of Almahdinejad. Placing more sanctions now will only allow the regime to regain influence by pointing to the “foreign devil” as the real enemy of the people.

I have two comments. First, I do not share the presumption held by many in the USA that there is vast unrest in Iran with the people ready to shuck the theocracy. While Almahdinejad may not have gotten 40 million votes in the election, it is clear that the vast majority of the voters voted for him. Since the 1980s there has been a very vocal group in the USA repeatedly saying that the “silent majority” composed of the young, the educated, and the pro-western will rise up and toss out the mullahs and their running dogs. Well thirty years later the mullahs still control the country.

My second comment relates to the effectiveness of economic sanctions. In my diplomatic career I contributed to, presented and implemented economic sanctions. As a first time officer I blocked an illegal shipment of arms under a US embargo on arms shipments to certain warring parties. My largest role in sanctions was to write a small part of the Anti-Apartheid Act of 1986 that banned much trade with, and investment in, South Africa. As a reward I was sent to our post in Johannesburg to enforce the sanctions. My major role there was to explain how the sanctions affected specific cases and insure that no one violated the rules. I was also the US speaker at the largest conference on sanctions ever held in South Africa, a conference held by the Johannesburg Chamber of Commerce. I did not respond to the attacks levied against the sanctions by the South African speakers, but did carefully explain what they were, and how they affected various business transactions.

Some years ago, at a luncheon hosted by the German Consul General in New York City, his wife, at whose side I was seated, turned and asked, “Mr. Cecchini, what do you think about sanctions, do they really work.” She had obviously read or heard about my work with sanctions. I replied that I had not seen any government fall or even make major changes because of economic sanctions. Nor did the sanctions ever really cause any serious dislocation in trade and investment. I explained that there are always ways to get around sanctions. However, I went on to say that, in spite of the reality of sanctions, I fully supported them. I told her that I supported them because they are a clear and unequivocal demonstration of our opposition to a regime. Yes, you can dismiss them as simply an elaborate public relations program, but the message is clear, “we don’t like what you are doing and we are no friend of yours.”

I urge the Obama administration to continue economic sanctions against Iran, especially now that Germany and France seem prepared to ratchet up the sanctions pressure on Almahdinejad. I do not envision bringing down the mullahs. However, we must continue to clearly show our opposition to Iran’s attempt to gain nuclear weapons and our dismay with its regime.

I wrote recently that the market for securitized debt, and its ancillary product, credit default swaps, the so-called insurance for the securitized debt, which are collectively the main instruments traded in the “derivative market,” has recovered and is back in business. I called for more rapid implementation of new regulations on this formerly unregulated financial business that led to the “Great Recession.”

The Obama team has developed some new controls that are being debated. A significant one is a “super” supervisor for federally chartered banks. Many urge that this “bank tsar” oversee all banks, including state chartered banks. It makes sense since all banks participated in the “derivatives” market. However, a major player has come out against extending the supervisor’s rule to all banks.

Sheila Bair, the head of FDIC (Federal Depositers Insurance Corp.), that insures your bank deposits against loss due to bank failures, does not want someone else to supervise the state chartered banks she now controls through FDIC rules. She believes that “community based banks” should continue to be regulated by her organization, rather than by a new “bank tsar.”

Well the concern is the nature of the transactions, not the nature of the buyers. The “bank tsar” is aimed at controlling investment in “derivatives” rather than controlling the nature of the buyer himself, e.g. a federal or state chartered bank. It would be a shame to see a “bureaucratic turf war” stymie the work to build better regulation of the “derivative” market.