CASTLE ARCH

REAL ESTATE INVESTMENT COMPANY

Anatomy of a
Meltdown
What caused the game-changing
crashes of 2008?

How the events of the sub-prime

mortgage crisis created the perfect
storm for a market meltdown
TABLE OF CONTENTS

Anatomy of a Meltdown

1. Introduction 1

2. Irrational Exuberance 1

3. Follow the Money . . . 3

4. The Mortgage Broker Industry 4

5. Wall Street Enters Real Estate 7

6. Irrational Overreaction 10

7. Leverage and the Credit Crunch 14

8. Conclusion: Safety in the Long Term View 16

COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED

1. Introduction
Although some factors influencing
the modern financial crisis have
tendrils that reach way back into
history, to the Carter administration
and beyond, this article focuses on the
immediate events which precipitated
the current situation, particularly
those that have transpired over the last
dozen years.
2. Irrational Exuberance
As we entered the late nineties,
the Internet bubble was inflating full
force and Internet-based companies
experienced unprecedented growth.
It seemed like you could not swing
a cat without hitting an Internet
millionaire. At the close of the 20th
century the stock market was the
Figure 1
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
contemporary equivalent of the 1849
gold rush. Entire industries had sprung
up in only a few short years (one of
which was the stock “day trader”). In
contrast to the burgeoning market,
veterans of the market cycles were
starting to get nervous.
On December 5, 1996, Federal
Reserve Chairman Alan Greenspan
(Figure 1) gave a speech at the annual
dinner and lecture of the American
Enterprise Institute for Public Policy
Research, in which he said, “…
how do we know when irrational
exuberance has unduly escalated
asset values which then become
subject to unexpected and prolonged
contractions…”1
The quote was obscure. The
market acknowledged Greenspan’s
doubts with only a small slip,2 a
hiccough amidst the dot.com surge.
But, the point was made to those who
were listening. Greenspan and others
were intimating that they believed the
market was overvalued.
For the next two and a half years,
the bubble continued its reckless
expansion. People were talking about
a new economy where assets were
passé and the historical measures for
valuing companies like price/earnings
ratio, price to revenue ratio, etc., were
being replaced by Internet valuations

based on web site traffic, number of
“hits,” or how “sticky” a web site was.
On March 6, 2000, Alan
Greenspan gave a speech at the
Boston College Conference on the
New Economy where he indicated
that the markets were “groping for
the appropriate valuations of these
companies.”3 Greenspan cautioned
that “speculating” was not necessarily
the same as “investing” referring to
the masses of people buying into the
stock market with the same zeal seen
around the roulette wheel.
Unlike ordinary citizens, mere
spectators of the market, Chairman
Greenspan had the power to do
something about this “exuberance”
and in 1999 he began raising interest
rates. The Federal Funds Rate jumped
one quarter of a percent in June,
followed by accompanying increases
in the Discount Rate in August.4 Rate
hikes continued in late 1999 and early
2000.5 The Discount Rate had risen
from 4.25% to 6% between August
1999 and May 2000.
Through the 1970s and 80s,
the Federal Reserve had exerted its
influence primarily with the goal of
fighting inflation. Clearly, as the 1990s
drew to a close with inflation growing
at a slower rate than it had in 1996 and
productivity increasing, the Federal
Reserve had adopted a new proactive
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 2
role and was involved in doing what it
felt was required to aid the economy.6
Greenspan confirmed this when he
claimed that “market forces assisted
by a vigilant Federal Reserve…” were
the answer to protecting the economy
from economic instability.7
Historically, there has always
been a “lead and lag” to the impact
of interest rate shifts on the pace of
the economy. Usually the lag is about
six to nine months and interest rates
started rising in August of 1999.
Right on schedule, the market
peaked early in the year 2000. On
January 14, 2000, the Dow Jones
Industrials hit its highest valuation
at 11,723.8 The NASDAQ and the
S&P 500 both hit their highest points
in March at 5,049 on the 10th and
1,528 on the 24th respectively.9 As the
interest rate increases caught up with
the market, valuations started to fall…
and they fell fast.
The Dow Jones Industrials would
recover their bubble value again,
but not for almost seven years, until
October of 2006. The S&P 500, not
until a year later in September of
2007. The worst story, however, was
the NASDAQ. In just over a year, it
dropped from 5,049 to 1,639, a drop
of nearly 70% from which it has never
recovered. (In contrast, the DJIA lost
57% of its value between the crash of

1929 and the end of 1930.) Before
Greenspan began to lower rates again,
the market had lost over $5 trillion in
value.10 Greenspan had taught the day
traders a lesson: when he said there
was “irrational exuberance” in the
market, they had better watch out.
The Federal Reserve may have
underestimated the impact of the
bursting of the dot.com bubble, and
historically the Federal Reserve has
not been prone to knee-jerk reactions.
Unfortunately, its measured and
gradual approach to adjusting interest
rates was simply not responsive
enough to help the economy recover.
In a delayed reaction, the Federal
Reserve finally began to lower rates
in January of 2001 and continued
reducing rates into the summer
of 2001. By summer, rates were
down around 3.5%, the bubble had
utterly burst and the survivors were
regrouping. It felt like things were
improving, but then the market
received its coup de grâce…the
terrorist attacks of September 11,
2001.
Instead of the United States
economy gaining strength, it
collapsed. The Federal Reserve tried
to effect a recovery and dropped rates
to 1.25% by December of 2001, but
the economy was not reacting. By the
end of November 2002, rates were
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 3
below 1% (a 45-year low) but the
stock market still did not recover.
Investors were still reeling from
the losses they had suffered in the
stock market collapse. With the
market too weak to rally, money fled
the equity markets like rats from
a sinking ship. This capital went
into cash and cash equivalents until
investors could find a safer place to
invest.
Money fled the equity
markets like rats from
a sinking ship …
3. Follow the Money…
Who were these investors sitting
on the sidelines and looking for a
place to invest? They were Pension
Plans, Mutual Funds, Insurance
Companies, Private Investment
companies and the like. For the
most part, these are bulk investors
whose investments are managed by
fund managers. Often they do not
have a single decision-maker, but an
investment committee with a core
mandate around preservation of
capital. In other words, don’t lose the
money.

Consider what was facing
investors at the beginning of this
decade. Interest rates were hovering
around 1% and inflation was at
2-3%.11 Investors were desperately
looking for something that offered
predictable returns with the primary
requirement that the investments
be safe. In other words, they were
looking for protection of their
principal.
Beyond this basic mandate,
these managers were looking to earn
returns great enough to stay ahead
of taxes and inflation. The painful
truth was that the return of “risk-free”
investments (U.S. Treasury notes)
would not yield enough to offset
inflation for the pension holders.
The search for a new place to invest
was fueled by the anxiety that many
investors had been burned in the dot.
com crash and that they needed to find
someplace to put their cash that would
generate a return, even a modest one.
The Federal Reserve was likewise
running low on options. With little
interest rate left to cut in order to
stimulate the economy, in the fall of
2001 Alan Greenspan encouraged
the financial community to develop
financial products that would make
it easier for people to buy homes. He
reiterated this position in a speech to
the Credit Union National Association
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 4
on February 23, 2004, saying that
“American consumers might benefit
if lenders provided greater mortgage
product alternatives to the traditional
fixed-rate mortgage.”12 The financial
industry took this as a challenge and
set to work developing more creative
financial products around mortgage
financing.
Historically, real estate had been
a low-risk investment. Real estate in
the U.S. had typically appreciated at
about 5.45% annually since World
War II.13 It is not the 7.8% average of
the general stock market, or the 10.4%
of the S&P 500, but it is perceived
as lower in volatility and safe. The
institutions (Pension Plans, Insurance
Companies, etc.) thought if only they
could find a way to sink money they
had waiting on the sidelines into real
estate, maybe they could still earn
adequate returns to beat taxes and
inflation, but do it within an industry
which had historically been steady,
calm and safe.
What was the political motive
behind Greenspan’s recommendation?
President Bush and the Congress were
in shock over the state of the economy
after the dot.com crash, the terrorist
attacks of 9/11 and the corporate
scandals of Enron, WorldCom, and the
like. The country was starting to wage
war overseas and a budget surplus

was turned into a raging deficit almost
overnight.
Washington knew that low interest
rates and easy access to money
would increase supply in the form
of increased gross domestic product
(GDP), which would depress the value
of the dollar. Deficits would be paid
back at the low rates, foreign countries
would be encouraged to buy/import
U.S. goods, and money would flow
through the economy. The money
people would find in their second
mortgages and home equity loans
would pour into circulation. They
hoped this would revitalize a post
9/11 economy that was practically
comatose.
Under these unprecedented
conditions, the Wall Street Investment
Bankers took Greenspan’s counsel
and turned their attention to the real
estate market, which precipitated a
fundamental transformation in the
world of real estate.
4. The Mortgage Broker Industry
Before 1990, banks and Savings
and Loan Associations would make
mortgage loans and keep the debt
themselves, “servicing” it over the
entire life of the loan. In other words,
banks would lend their own money
and the borrower made payments
directly back to the bank that loaned
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 5
the money until the loan was paid
off. As a result of a number of
fraudulent loans taken out on large
scale properties, the Savings and
Loan industry threatened to collapse.
In response, the U.S. Government
established the Resolution Trust
Company (RTC)14 to bail out the
banks and avoid a collapse among
the Savings and Loans. The U.S.
has a history of growing pains when
it comes to savings and loans and
the Government was taking steps to
ensure that the banking system in the
U.S. would not fail.
From that time forward, most
traditional banks almost completely
stopped underwriting and carrying
loans themselves. Instead, they
would sell the mortgages, or “paper,”
to third party lenders, entities like
Freddie Mac or Fanny Mae. These
two, which have been called “the
linchpin of the housing bubble,”15
were private companies (chartered by
congress) for the funding and holding
of “conforming” mortgages that met
government standards.
Fannie Mae16 and Freddie Mac
comprise the lion’s share of what
is termed the “secondary mortgage
market.” Essentially if banks were
mortgage “retailers,” the secondary
market were the “wholesalers.”
These entities would actually service

mortgage loans originated by the
banks over the entire term. As of
September 2008, Fannie and Freddie
are no longer private companies,
but act as conservatorships of
congress—essentially government
owned. (When these giants of the
secondary mortgage market were
seized last month by the U.S. Treasury
department,17 they reportedly held
half of the entire $12 trillion U.S.
mortgage debt.)18
By selling off mortgages to the
secondary market, risks of default
that used to rest with the banks were
now passed on to those who actually
underwrote the loan. That meant
that writing loans was no longer the
sole domain of banks with lots of
capital, because there was no longer
a requirement for companies writing
loans to service them. A new industry
of “mortgage brokers” emerged and
grew rapidly. It was apparent that
simply “originating” loans could be a
very profitable business.
The typical process was that a
person looking for a mortgage would
sit down and fill out an application
with a local mortgage broker and the
money was provided by the third-
party lender at closing. The buyer
was happy, the seller was happy. The
mortgage company and the third-party
lender were happy.
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 6
What about “non-conforming”
loans? The application process was
one of evaluating borrowers on their
creditworthiness, but there were
people who needed loans who could
not qualify under standard terms.
The banks could never afford to
make these loans in the past, because
they were too risky. “Sub-prime”
borrowers were much more likely to
default (Figure 2).
Successive legislation designed
to assist minorities and low-income
families get home loans put a “crack
in the dike” that helped sub-prime
mortgages become more mainstream.
In 1977, President Carter signed into
law the Community Reinvestment Act
(CRA).19 This legislation sponsored
a program requiring banks applying
for permission to merge, relocate, or
obtain FDIC insurance to be examined
on whether they offered equal credit
to the “disenfranchised poor.”
FORECLOSURES STARTED
Figure 2

In 1992, a new act required Fannie
Mae and Freddie Mac to devote a
percentage of their lending to support
affordable housing targeting the same
demographic (in 2004 this percentage
was raised from 50% to 56%).20 While
this requirement did not specifically
compel Fannie and Freddie buy sub-
prime loans (in fact, a greater number
of sub-prime loans were purchased by
private companies), it threw the doors
wide open to a secondary mortgage
market that accepted sub-prime
mortgages.
… it threw the doors
wide open to a second-
ary mortgage market
that accepted sub-
prime mortgages.
In 1995, President Clinton revived
the CRA fueled by studies21 quoted
by the Federal Reserve which stated
that lenders who made loans to the
less creditworthy segments of the
population could indeed be profitable,
an argument against complaints that
taking on more credit risk was a threat
to lender profitability.22 I am sure that
if they had looked into payday loan
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 7
companies they would have found
them profitable as well. This does
not mean that they are good for the
economy.
Loans were typically not sold to
the secondary market one at a time,
but bundled together in a pool. By
pooling their loans and selling them
off, the door was opened for less
than A credit borrowers. Mortgage
brokers found that a bundle of mostly
prime “A” paper could have a small
percentage of “B” and “C” sub-prime
loans tacked on and the third party
lenders would accept them along with
the conforming “A” loans.
Borrowers qualify for loans based
on ratios that compare their income
with the monthly payments required.
With interest rates at historic lows,
many borrowers were finding that
they could qualify for bigger loans.
In order to get borrowers to qualify,
lenders offered buy downs, balloons,
“interest only” and Adjustable
Rate Mortgages (ARMs) where the
payments were tied to interest rates
(Federal Reserve or LIBOR) that
were at 45 year lows. New home
buyers were everywhere; current
homeowners were either upgrading
into luxury homes or taking the newly
found equity out in home equity loans.
Qualification standards were
relaxed and there was little or no

MORTGAGE ADVERTISING
Figure 3
scrutiny when someone wanted to
qualify for a mortgage. People with
bad credit were even given “teaser”
loans which had adjustable rates,
which ballooned in three to five years.
Mortgage brokers wrote these loans
knowing that the borrowers could
not qualify for the regular payment.
The market was rife with advertising
claiming “Good credit, bad credit, no
credit: no problem” (Figure 3).
People could qualify for basically
any size of mortgage using what
is known as a “stated income”
loan, where paying slightly higher
interest rates waived requirements
for thorough checks on employment,
income and assets. Many people
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 8
lied about their income or assets, but
qualifying restrictions were so lax,
that mortgages were available for
people who simply stated their income
or assets without verification. This
type of loan became known as a “liar”
loan.
Lenders were offering home
equity loans for over 100% of the
home’s value and new homes were
sold with 100% financing. This meant
that where mortgages used to require
significant down payments, now
borrowers could get into a home with
little or no “skin in the game” at all.
The real estate industry was
transforming.

5. Wall Street Enters Real Estate
The dot.com era brought its own
changes to Wall Street. In the old
days, traders and Investment Banks
made money from commissions
as their customers bought and sold
stock. The Internet changed all that
by ushering in an era of ease and
convenience via electronic trading.
Investment Banks could not compete
with the likes of E-trade or Ameritrade
which were charging around $10
apiece for electronic trades. There
were limited placed for Investment
Banks to make money. They focused
on insurance products, money
management, advisory services
and the most profitable avenue,
underwriting Initial Public Offerings
(IPOs). They were adapting to a new
revenue model, and were looking
for additional places to earn profits
to make up for the lost revenue from
commissions that they previously
had when customers bought and sold
stock.
As the Investment Bankers got
involved, they started applying the
methods of the stock market to the
mortgage market. They needed a
way of inviting that cash sitting
on the sidelines to come back into
the market. Against a historical
background of real estate investments
as safe territory, they said, “Why don’t
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 9
we bundle the loans that the third-
party lenders are buying and put them
into a pool of mortgages and create
a new financial instrument.” They
created the idea of Collateralized
Mortgage Obligations (CMOs).
The investment committees
at these Pension Plans, Insurance
Companies, Mutual Funds, etc. are
typically made up of people with an
education and background in finance.
These are people who have attended
the same top-notch universities for
their graduate finance degrees or
MBAs. At almost every school, the
same historical growth models and
risk evaluation tools like the Capital
Asset Pricing Model (CAPM) are
taught. For these graduates, investing
is a number-crunching science and
evaluating risk is no more than simply
factoring a Beta (β) score. β now
represented the risk associated with
the (potentially hundreds or thousands
of) mortgages in a CMO. It purported
to assign a risk value that accounted
for all the variables, credit scores,
loan to value ratios (LTV), term, rate
fluctuations, etc. in its constituent
mortgages.
In order to make these CMOs
more attractive to investors, the
Investment Bankers set out to create
a bond offering. Their thought
process was, “Let’s sell these CMOs

to Pension Plans, Mutual Funds
and other entities that are looking
for long-term secured payments
with predictable long-term payment
schedules and both protection of and
return on their principal.” Investors
would be able to purchase a bond in
a CMO.23 Armed with β scores, the
Investment Bankers took the new
instruments and got credit rating
agencies like Moody’s or Standard
& Poors to give a credit rating to
each CMO. With a credit rating, the
only remaining requirement was
insurance. They obtained monoline
insurance24 through companies who
consulted their actuarial tables for
the probability that a few mortgages
would default. They had no way to
estimate the probability of systemic
widespread defaults. This meant
that although the insurance satisfied
the investment requirement, it was
essentially worthless because it had no
capacity to cover multiple defaults.
But the Investment Bankers had
done as Greenspan requested, they
had applied their financial creativity
and developed new products that
turned real estate paper into a security.
One that allowed investors burned
by the volatility of the stock market
at large, to now tap into the stable
and safe real estate market on terms
they were used to. In fact, Greenspan
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 10
himself noted ironically that “although
these instruments cannot reduce the
risk inherent in real assets, they can
redistribute it in a way that induces
more investment in real assets…”25
The Investment Bankers had
also created a condition where they
could tap into a new revenue stream.
The CMO offerings would follow
the same criteria all the Chartered
Financial Analysts (CFAs) managing
institutional funds had learned in
school. Investment Banks stood to
make 2-3% on some very hefty trades
in what became the equivalent of IPOs
for the new bond offerings.
With the bond offerings in
place, the market for CMOs was
wide open—no longer did sellers
need to find an investor capable of
taking down an entire CMO; smaller
investors could buy a portion of one.
Even more attractive, they could
buy portions of several CMOs with
different credit ratings and different
rates of return in order to diversify
their investments. These CMOs
claimed to yield 6-7% and institutions
were looking to increase their
portfolio returns, which the higher risk
bonds backed by sub-prime CMOs
would accomplish.
The money that had fled the
market with the crash of the dot.coms

now flooded back in an insatiable tidal
wave.
… money that had fled
… flooded back in an
insatiable tidal wave.
The effect was massive “pull-
through” demand on the market,
which caused a twofold reaction.
First, there was a greater ability for
mortgage brokers to generate loans.
And second, subprime borrowers
were now just as good as creditworthy
borrowers because the additional risk
could simply be reflected in the β
score. In fact, the creative approach
that was fueling the real estate
market was based mostly on the non-
conforming loans.
It made sense that home buyers
with poor credit or low income would
have a higher β score. If the investor
bought bonds backed by the CMO,
then the risk of defaults would be
diversified across many mortgages
and a greater return could be had
for the pension fund. Essentially, a
greater return would be expected
from a riskier investment (as would
be expected in the stock market) and
the risk could be mitigated through
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 11
diversification. As a result, CMOs
were glutted with subprime loans.
Subprime was actually preferred in
many cases.
For the mortgage industry, there
were a lot of origination fees just
waiting to be collected—there is
never a shortage of people with eyes
bigger than their wallets; people
wanting homes who cannot afford
them. Mortgage brokers and lenders
were teaming up to give loans to
people with bad credit, never asking
themselves why these people had bad
credit in the first place and not caring
about the risks as long as there was a
dollar to be made.
For a little while, money was
everywhere if someone wanted to buy
real estate. The borrower had to pay a
little more, but a home that was totally
unaffordable under realistic market
conditions was now within reach.
Whether borrowers could afford these
homes or not was not the problem of
the mortgage industry as long as they
could find someone in the secondary
market willing to buy the loans (and
thanks to the CMOs, there was a
nearly unlimited supply of secondary
sources waiting to purchase them).
Being in the business of originating
loans instead of servicing them meant
that mortgage companies in general
 Page 12

UPSIDE DOWN ON THEIR MORTGAGES

Figure 5

were a lot more interested in quantity market in 1998, 1999, and 2000. Now,
than they were in quality. everybody was making money in real
Not only did the Investment estate.
Bankers like these CMOs for their Like Dr. Frankenstein, Greenspan
institutional clients, they liked them looked at his monster and was
for themselves. Essentially drinking scared and disgusted even though he
their own Kool Aid, Investment Banks CHAIRMAN GREENSPAN
also invested heavily in subprime
mortgage backed CMOs.
6. Irrational Overreaction
While the stock market might
have been tepid in its reaction to
lower interest rates, the real estate
market was not. Fueled by low rates
plus the new financial products,
housing and real estate were starting
to boom. 2004, 2005, and 2006 were
the equivalent in real estate to the
“irrational exuberance” of the stock Figure 4

COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED


shared responsibility for its creation.
Greenspan saw another case of market
values being out of sync with intrinsic
fundamental asset value, only on a
much more massive scale. Like he
had in the dot.com bubble, he took
action and began raising rates. But,
rather than the slow and ponderous
approach typical of the Federal
Reserve, Greenspan started a crusade
and relentlessly raised interest rates 17
times.26 He raised the Discount Rate
roughly every two months for a period
of 24 months.27 The Federal Reserve
did not offer a single reduction over
a period of 38 months from June of
2003 to August of 2007.28 Interest
rates only started to come down again
when the damage was beginning to
surface.
This rampage by the Federal
Reserve created a snowball effect
which is shocking the current market
and from which the economy will
likely be recovering for most of the
next decade, if not longer.
The problem was that securities
and real property bear significant
inherent differences. The foundation
on which this house of cards was built
rested on two flawed assumptions
regarding non-conforming loans—two
fatal errors that analysts counted on
in calculating their risk assessment.
As long as either one of these tenuous
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 13
propositions held true, the house of
cards would stand.
First, they banked on appreciation
of the real estate assets. Real estate
appreciation in the United States
had been a safe bet over the long-
term. Over the past century, housing
appreciation had averaged 3-4%, and
it had averaged over 5% since 1950.
Second, borrowers typically
increase their incomes over time.
So risk assessments were made that
banked on a better economy in which
borrowers would be able to afford
higher payments through better jobs,
pay raises, etc.
This assessment surmised that as
the promotional terms expired, buyers
would be earning more money and
should be able to afford the increased
payments. If they could not make the
payments, the borrower could always
sell or refinance out of their teaser
and balloon loans to a less volatile
mortgage. Appreciation of the asset
should be enough to cover retirement
of the debt.
The problem is, investing is as
much art as it is science; and that
stretches beyond the abilities of most
financial analysts.
The analysts did not anticipate
that the enormous demand for real
estate would lead to inflated prices
and negative appreciation. It goes

back to basic supply and demand.
When demand goes up faster than
supply, prices also rise. So, the market
forces driving appreciation had been
manipulated. Demand both inflated
prices and instigated a surfeit of
new construction. Residential and
commercial inventories were years
ahead of the rate of absorption and
prices were years ahead of their time.
… investing is as much
art as it is science …
By driving the volume so high,
the market had effectively sold the
required housing inventory for the
next three or four years. Homes that
could have been legitimately sold
to creditworthy buyers were now
overbuilt inventory for a market
that was in too big a hurry to cash
its post-dated check. As the market
began to correct itself, sellers found
that they were competing with a
glut of new construction inventory
and prices plummeted. Since the
mortgage industry had been pushing
people into higher and higher priced
homes relative to their income, many
borrowers found themselves with
mortgages larger than the value of
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 14
their homes. This shut off two avenues
of escape for borrowers caught in
climbing ARMs; they had no ability to
sell or to refinance.
Second, the safeguard of increased
borrower capacity should have been
obviously tenuous with the glut
of subprime borrowers. Earnings
potential for subprime borrowers is
erratic and volatile. It is monumental
hubris to think that this could be
distilled to nothing more than a β
score. Problems that might have
been limited if the sales volume
had held steady were exacerbated
by the infusion of huge numbers of
sub-prime buyers. Add to that the
number of ARMs given to borrowers
of all types. Even borrowers with the
capacity to absorb some increases
could not withstand a rampant
sustained increase in interest rates.
For example, let’s say a sub-
prime borrower is offered a 30-year
mortgage for 100% of the value of a
$300,000 home. He is given a teaser
rate of 1% for the first year, with a
step to 4% at year 2 and then his rate
adjusts monthly at 3% over the prime
rate (typically 1-2% over the Federal
Discount Rate). The first year, his
principal and interest payment is $964
each month. We will add $200 for
property taxes and home insurance,
bringing his total monthly out-of-

Figure 6
pocket expense to $1,164. Since
qualification standards are typically
one-third of the borrower’s gross
income, we will say that this borrower
is earning $3,500 a month, or about
$42,000 a year.
By contrast, a creditworthy
borrower obtains a 5% fixed rate loan.
With taxes and insurance, his payment
on the same $300,000 is $1,810 per
month.
In the second year, the sub-prime
borrower sees his interest rate jump
to 4%. His payments are now $1,632.
A jump of over 70% and now equal
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 15
to 47% of his gross income and he
is paying only a little less than the
creditworthy borrower.
The third year, his rate begins to
“float” based on the Federal Discount
Rate. In the latter part of 2003, the
Discount Rate was 2%. Add 2% to
reach the Prime Rate and another
3% for his loan terms and this year
his effective rate is 7%. That equates
to a monthly payment of $2,196. A
second jump of 74% and now he’s
paying 63% of his gross income
toward his mortgage. In two years this
loan has eaten up an extra thousand

dollars each month in income and his
expenses have exceeded those of the
creditworthy fixed-rate borrower—all
before interest rates start to climb.
Over the next two and a half
years, the Discount Rate will climb
to 6.25%. This equates to an effective
interest rate of 11.25%, or a monthly
payment of $3,114. This represents
89% of his gross income. This
borrower cannot physically make this
payment with what is left over after
his payroll taxes are deducted. He is
making payments that are reasonable
for someone earning $113,000 a year
on a $42,000 annual income. He
cannot afford to stay in this home,
so to avoid foreclosure, his options
would have been to either sell it or
refinance with new terms, but the
market was not adequate to allow
him to take either of these options,
so, with no money of his own at risk
(due to the 100% financing), and with
little regard for his credit score (he
entered this mortgage as a sub-prime
borrower) he walks away. Whoever
holds his loan is left to foreclose on it.
In excess of the increased rate of
foreclosures that might be expected
with sub-prime borrowers due to
the characteristics of their personal
finances, the requirement of no money
down and a manipulated market was
a recipe for disaster. Borrowers like
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 16
the one in my example had homes that
they could not sell, payments they
could not make and nothing in their
homes to lose. It was one of the most
painless times in history for borrowers
to let their mortgages default.
As all of this was unfolding,
the Federal Reserve continued to
raise interest rates. Alan Greenspan
did not just blunt the exuberance
or slow the economy with his rate
hikes; he single-handedly smote
the underpinnings of the barely
resurrected market with a deluge of
foreclosures.
Greenspan … single-
handedly smote the …
market with a deluge
of foreclosures.
With the “lead and lag” nature of
interest rate shifts on the economy,
it took until the latter part of 2007
to see the tip of the iceberg in terms
of what a financial disaster had been
created. August of 2007 saw the
rates beginning to lower again, but
the true magnitude of the problems
were only beginning to surface. The
analysts, who predicted that only a

small percentage of those who held
adjustable rate mortgages would
default and Alan Greenspan’s opinion
that “the odds are favorable that
current imbalances will be defused
with little disruption,”29 were just dead
wrong.
7. Leverage and the Credit Crunch
A critical factor that also served to
compound the crisis is leverage. Most
people do not know that a traditional
financial institution can lend five
dollars for every dollar of deposits
or equity it has. That also means that
for every dollar that is lost in default,
five are kept back from the market.
In other words, if 20,000 homes at
$100,000 apiece (total value of $2
billion) default, the actual impact on
the market is five times greater. It is
as if 100,000 homes defaulted or $10
billion in cash was pulled from the
market.
Investment Banks are not
leveraged at the same rate as
traditional banks, however. They
are leveraged much more. Lehman
Brothers was leveraged at a ratio of
35 to 1. In the above example, the
same 20,000 foreclosures would pull
$70 billion from the market. In other
words, $2 billion in foreclosures feels
like $70 billion! The ripple effects of
each default are magnified. This is the
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 17
root of the “liquidity” crisis. Nobody
had been “checking under the hood”
to see who would make the final
payment.
I have already mentioned that
Investment Banks were heavily
invested in their own CMOs. By
having a heavily leveraged position
and a market primed for massive
defaults by spiking interest rates
and a mortgage industry that was
force-feeding people with bad credit
homes that they could not afford, the
economy was pushed to the brink
of disaster. The good faith that was
holding the system together by a
thread was dependent on nobody
losing yet. After all, if the practices
were so bad, wouldn’t we have seen
some signs, maybe some casualties by
now?
In order to understand the overall
market, the macro level picture, it is
essential to understand the market
at a micro level—the level of the
individual.
Markets run on the emotions
of greed and fear. Without fear, the
markets are fueled by greed, which
the financial news often talks about
as “faith” or “confidence.” When
mortgage defaults started to rise, the
first “market” sign that faith in the
bloated and corrupted system was

Figure 7
beginning to falter came in March of
2008 with the fall of Bear Stearns.
In 1998, a hedge fund called Long
Term Capital Management (LCTM)
failed. It had been established in
1994 by an impressive pedigree of
individuals including economic Nobel
laureates Myron Scholes (of Black
Scholes fame) and Robert Merton,
and had generated annualized returns
of over 40% in its early years using
complex mathematical models for
convergence trades.30 Exhausting
the opportunities for such trades,
LTCM branched out into other areas
and subsequently lost hundreds of
millions of dollars. The Investment
Banking community felt pangs of fear
and rallied to rescue the company.
By September of 1998, the Federal
Reserve Bank of New York had
orchestrated a bailout involving
Barclays, Chase, Credit Suisse,
Deutsche Bank, Godlman Sachs,
Merrill Lynch, J.P. Morgan, Morgan
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 18
Stanley, Salomon Smith Barney, and
Lehman Brothers among others. One
firm conspicuously, however, did not
support the bailout.
That firm was Bear Stearns, the
country’s fifth largest investment
bank.31 When Bear Stearns got
into trouble in early 2008—two
of its hedge funds which had big
investments in sub-prime mortgages,
folded in July of 2007—and as
investors became increasingly wary
of heavy investment in the mortgage
industry, the Investment Banking
community remembered that Bear
Stearns had not participated in the
bailout of LCTM. The rumor on Wall
Street was that, as retaliation the
supporters of the LCTM management
bailout led a rash of short selling of
Bear Stearns’s stock. Bear ended
up agreeing to a Federal Reserve-
supported sale to J.P. Morgan Chase
for $2 per share on Monday March
17, a 93% drop from its trading price
on Friday March 14. The aftershocks
of Bear Stearns would send more
of the market into “fear” mode
and over the remaining months to
September and October, the Chicken
Littles of the market would slowly be
acknowledged as prophets and sub-
prime mortgage backed securities
started being referred to as “toxic.”

The “faith” that existed in the
market crumbled to the point that in
today’s market banks do not even
have enough confidence to loan each
other money. The inter-bank loan
process is freezing for lack of trust.
With banks and Wall Street losing
faith and succumbing to the fear that
drove the market to successive record
breaking losses, is it any wonder
that individuals are also losing faith?
At the same time that they get the
news that the people who invest their
pensions or retirement funds have
not only breached their mandate
to generate returns, but have failed
at the critical mission to “not lose
the money,” they are told that the
government has decided to co-opt
them as a huge collective co-signer on
debts that have already gone bad.
The markets run on the emotions
of greed and fear… and now we are
experiencing fear.
8. C
 onclusion: Safety in the Long
Term View
The country is in the midst of a
downturn as it repeats its dot.com
experience of banking on “blue sky”
instead of real value. In fact, Alan
Greenspan admitted that his “intent
was to replace the Dot.com Internet
stock bubble with a real estate home
investment and lending bubble”
COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED
Page 19
as the only way to prevent a deep
recession.32 Inheritors of that decision
are left to contemplate whether the
former recession or the current one is
worse.
The markets run on
the emotions of greed
and fear … and now we
are experiencing fear.
I suggest that the current correction
is certainly larger and deeper. A critical
difference in the financial scope is that the
volume of sales in the real estate market
is not driven by what people can pay;
it is driven by what people can borrow.
So, a problem that was bad in the stock
market has became catastrophic in the
real estate market with the only bright
light being that real estate is a tangible
asset with some level of underlying value
as opposed to the vapor assets of the dot.
com era.
The sense of upheaval in the market
during this reset reveals a lot about
the players. There is plenty of finger-
pointing going on. Even Greenspan
shrugs off his responsibility saying,
“The core of the subprime problem lies
with the misjudgments of the investment
community.”33
And then there are those who are
taking steps to shore up the system.
 Page 20

Congress and the Federal Reserve have who rated the credit of the CMOs. And,
enacted a fiscal policy in an effort to for that abdication they have paid dearly.
facilitate inter-bank loan processing. But, in the face of the market
They are making investments directly meltdown, experienced investors are
into banks and the banking system. calm and looking at the economic
The big government bailout represents situation with an eye to the long-term.
an effort of the Federal Reserve, the These investors put their money where
Treasury Department and Congress to fundamentals have been thoroughly
buy commercial paper that facilitates vetted. They watch for population growth,
money to start flowing into the market which follows regional job growth. For
and there is a global coordinated effort to those who are prepared, these cycles
cut interest rates. provide abundant opportunity.
It is my belief that these are the steps I am extremely positive and
that needed to be done. In 1929 there optimistic on the market when investors
was no fiscal policy, and yet eventually are holding a long-term view and can
companies recovered. Everything was overlook the interim volatility. This too
Laissez-faire. It is my opinion that many shall pass. 
of these steps will prove to be necessary
and wise. I think that the government will
probably end up making a lot of money,
but it is essential that steps are taken to
provide the perception that the banking
system is safe.
Contrary to what seems to be the
overriding public opinion, I do not lay
the entire blame for the current crisis at
the feet of the investment community, but
they do bear partial responsibility. I think
these Investment Bankers were trying to
do a good job—the job they were trained
for, but this crash has now proven that
finance is not merely a science. Multiple
ways of analyzing must be evaluated and
implemented when making these types
of investments. I think that they in fact
abdicated their responsibility to assess the
risk of these investments to the analysts

COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED

 Page 21

ABOUT THE AUTHOR

Kirby Cochran is an educator, speaker and thought leader in the field of management and
finance and is a leading expert on capital structure and shareholder value. He has been teaching
new venture financing and entrepreneurship to graduate students for over a decade. Kirby
currently serves as an adjunct professor in the Finance department of the David Eccles School
of Business at the University of Utah. A veteran of the venture capital industry and a pioneer
of emerging approaches to raising capital, Mr. Cochran has been at the forefront of the growth
company financing and management trends for over twenty-five years.

In his new series of articles entitled Leadership Insight, Mr. Cochran reveals secrets used by
entrepreneurs and CEOs to drive growth in their companies. This information has always been
difficult and painful for Senior Managers to acquire, found only in the ruthless university of
experience and obtained through costly tuition at the school of hard knocks.

North Point Advisors, the firm founded by Mr. Cochran, advises growth companies on the
implementation of the best practices discussed in Leadership Insight for increasing shareholder
value.

ACKNOWLEDGEMENTS
Chad Jardine, our close associate and friend, was responsible for much of the leg work and
physical writing of this article. His contribution allowed the principles and practices of our
consulting process to come to life in book form and bring our insights, personal experiences and
unique “voice” to a new audience via the printed page.

COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED

1. Greenspan, Alan. 1996. Remarks made at the Annual Dinner and Francis Boyer Lecture of the American
Enterprise Institute for Public Policy Research, Dec 5, Washington D.C. http://www.federalreserve.
gov/boarddocs/speeches/1996/19961205.htm Note: this statement became the title of a book by
Robert Shiller published by Princeton University Press in 2000. More information is available at
http://www.irrationalexuberance.com
2. Wikipedia. Irrational Exuberance. 2008. http://en.wikipedia.org/wiki/Irrational_exuberance (accessed
October 16, 2008).
3. Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College
Conference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/
BoardDocs/Speeches/2000/20000306.htm
4. The Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount
Rates. 2008. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
5. Ibid.
6. Engdahl, William F. Aotearoa: a Wider Perspective. http://aotearoaawiderperspective.wordpress.com/
the-financial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/the-
financial-tsunami-part-iii-greenspans-grand-design/
7.  Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College
Conference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/
BoardDocs/Speeches/2000/20000306.htm
8. Yahoo! Finance. Dow Jones Industrial Average (^DJI): Historical Prices. 2008. http://finance.yahoo.
com/q/hp?s=^DJI&a=09&b=1&c=1928&d=09&e=16&f=2008&g=d
9. Yahoo! Finance. NASDAQ and S&P 500: Historical Prices. 2008. http://finance.yahoo.com/q/
hp?s=^IXIC
10. Engdahl, William F. Aotearoa: a Wider Perspective. http://aotearoaawiderperspective.wordpress.com/
the-financial-tsunami-the-preeminent-role-of-new-york-banks-and-wall-street-investment-banks/the-
financial-tsunami-part-iii-greenspans-grand-design/
11. Inflationdata.com. Historical U.S. Inflation Rate1914-Present. 2008. http http://inflationdata.com/
inflation/inflation_Rate/HistoricalInflation.aspx
12. Greenspan, Alan. 2004. Understanding Household Debt Obligations. Remarks at the Credit Union
National Association 2004 Governmental Affairs Conference, Feb 23, Washington D.C. http://www.
federalreserve.gov/boarddocs/speeches/2004/20040223/
13. Freeby50. More on Historical Home Appreciation. http://freeby50.blogspot.com/2008/05/more-on-
historical-home-appreciation.html
14. Wikipedia. Resolution Trust Corporation. 2008. http://en.wikipedia.org/wiki/Resolution_Trust_
Corporation (accessed October 16, 2008).
15. Freeman, Richard. Executive Intelligence Review. ‘Fannie and Freddie Were Lenders’: U.S. Real Estate
Bubble Nears Its End. http://www.larouchepub.com/other/2002/2924fannie_mae.html
16. Note: In what could be seen as a predecessor to the CMOs, Fannie Mae was allowed to issue Mortgage
Backed Securities (MBS) by the Federal Government in 1968.
17. Hagerty James, R., Ruth Simon, Damian Paletta. 2008. U.S. Seizes Mortgage Giants. The Wall Street
Journal Online. September 8, 2008, http://online.wsj.com/article/SB122079276849707821.html
18. Duhigg, Charles. 2008. Loan-Agency Woes Swell From a Trickle To a Torrent. The New York Times.
July 11, 2008. http://www.nytimes.com/2008/07/11/business/11ripple.html?ei=5124&en=8ad220403f
cfdf6e&ex=1373515200&adxnnl=1&partner=permalink&exprod=permalink&adxnnlx=1224014956-
Lxg46M4tsZkyi+JNJnlybg

COPYRIGHT © 2009 KIRBY COCHRAN. ALL RIGHTS RESERVED

19. Wikipedia. Community Reinvestment Act. 2008. http://en.wikipedia.org/wiki/Community_
Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008).
20. Reeser, Joe. 2008. The Real Cause of the Current Financial Crisis. OpEdNews.com. September 27,
2008. http://www.opednews.com/articles/2/The-Real-Cause-of-the-Curr-by-Joe-Reeser-080926-83.
html
21. Note: One of which was entitled The Community Reinvestment Act and the Profitability of Mortgage-
Oriented Banks on March 3, 1997.
22. Wikipedia. Community Reinvestment Act. 2008. http://en.wikipedia.org/wiki/Community_
Reinvestment_Act#cite_note-Canner-26 (accessed October 16, 2008).
23. Engdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tip
of the Iceberg. Globalresearch.ca. November 23, 2007. http://www.globalresearch.ca/index.
php?context=va&aid=7413
24. Wikipedia. Monoline Insurance. 2008. http://en.wikipedia.org/wiki/Monoline_insurance (accessed
October 16, 2008.)
25. Greenspan, Alan. 2000. The Revolution in Information Technology. Remarks before the Boston College
Conference on the New Economy, Mar 6, Boston, Massachusetts. http://www.federalreserve.gov/
BoardDocs/Speeches/2000/20000306.htm
26. The Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount
Rates. 2008. http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html
27. Ibid.
28. Ibid.
29. Andrews, Edmund L. 2004. Greenspan Shifts View on Deficits. The New York Times. March 16, 2004.
http://www.nytimes.com/2004/03/16/business/16FED.html?ei=5007&en=840134c450c6059b&ex=1
394859600&partner=USERLAND&pagewanted=print&position=
30. Wikipedia. Long Term Capital Management. 2008. http://en.wikipedia.org/wiki/Long-Term_Capital_
Management (accessed October 16, 2008).
31. Waggoner, John and David J. Lynch. 2008. Red Flags in Bear Stearns’ Collapse. USA Today. March 19,
2008. http://www.usatoday.com/money/industries/banking/2008-03-17-bear-stearns-bailout_N.htm
32. Engdahl, William F. 2007. The Financial Tsunami: Sub-Prime Mortgage Debt is But the Tip
of the Iceberg. Globalresearch.ca. November 23, 2007. http://www.globalresearch.ca/index.
php?context=va&aid=7413
33. Reuters. 2008. Investors, Not Fed, To Blame For Crisis-Greenspan. Reuters.com. April 7, 2008. http://
www.reuters.com/article/marketsNews/idUSL0742422520080407

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