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Notes from Berkshire Hathaway’s Annual Meeting, 2009

link: http://www.gurufocus.com/news.php?id=54571

Berkshire Hathaway Specifically:


Berkshire’s property Casualty insurance and utilities businesses are probably the best in the world. Insurance business was growing especially for GEICO. Last year GEICO spent about $800 million on advertising. Advertising money at GEICO is well spent. It’s nearly impossible to calculate how much each dollar of advertising comes back in the way of insurance premiums. But Munger specifically said that if they spend $800 million and get more than $800 million in increased insurance businesses, then that’s $800 million pretax that doesn’t show up on the income statement.

Float increased as a consequence of GEICO’s additional business and from the acquisition of Swiss RE. (Swiss Re’s $2 billion Float is long duration float.)

Buffett commented that in 2000 Berkshire’s Stock price was substantially below intrinsic value, that currently the market price is moderately below Intrinsic Value, but not as large a discount as it was in 2000.


Derivatives:

Berkshire will make good profits on the puts and likely suffer some losses on the swaps. Berkshire modified the puts to a 10-year term down from 18-years and reduced the strike price to 994 from 1514.

Munger commented that entering such derivatives contracts should have limits but that they were and are well short of that limit. He also said he thought the derivatives business is silly, unnecessary, and poor business practice. “Derivatives brokers basically sold bad products to clients.”

Buffett and Munger both said with conviction that there’s a huge need for an overhaul of margin requirements. Buffett said that the creation of the derivatives markets basically undid the margin requirements put in place during the depression. Margin requirements were put in place for good reasons and the laws remain relatively unchanged. Few people would argue in favor of eliminating margin requirements. Derivatives however have allowed people to legally ignore margin requirements. Munger commented that our civilization has done unbelievably well without them (derivatives), that they (derivatives) are unnecessary and that they desperately need massive oversight. Munger said he supported hugely increased regulation of derivatives markets.

To put this into context: Derivatives are ok when strictly used for example, by producers to lock the future cost of some raw material. Otherwise they are a risk to the system and allow, rather promote, the use of huge leverage.


Financial Companies

Buffett highly recommended people interested in an overview of the mess, to read Jamie Diamond’s annual letter (JP Morgan Chase). I second his recommendation. The letter is attached. It really gets going on page 14.

Wamu and other unnamed banks had many clear signs of trouble. They were hugely leveraged, doing business that they should not have been doing.

Credit card loss rates are (in general) apparently about 10% and they had in some cases increased the interest rates to 18%.

Wells didn’t want tarp: But the government’s reaction was well warranted. Wells will be stronger in the end. (Much more so had none of this happened.) Wells is the low cost producer in the banking industry, 1.12% on deposits.

The 4 largest banks had the same business model, but Wells Fargo followed a different model.

Clayton’s Financing

Gave an example that Clayton’s situation is similar to a situation at Goldman Sachs: unguaranteed loans (400 bp) vs guaranteed loans (100’s of bp less). So obvious disadvantages with respect to unguaranteed loans, but Clayton will adapt-for example, by partnering with certain institutions that have access to this much cheaper capital.


Accounting

Munger, “It’s terribly awful that accounting principles allow financial institutions to record increases in earnings as a consequence of their having significant reductions in credit quality.”

That is, downgrades in bank credit ratings and general market uncertainty led to falling market prices for these banks bonds. Banks that had cash could buy their own debt at very large discounts to face value-allowing them to record an accounting profit.


Government:

Buffett: Overall the Government did a good job considering the scale of the problems and speed with which they needed to react. There’s no way anyone could have satisfied all parties, and while there may have been better solutions (in hindsight) people (politicians and the public generally,) should be satisfied with the current outcome.

Ratings Agencies: Housing (appreciation) optimism was built into the system. Credit agencies didn’t account for the possibility of loss. Their one size fits all checklist rating approach has obvious defects.

AIG outrage over compensation was disproportionate to the realities of that situation.


Health Care System

Munger: Thinks something at least close to European Style is inevitable and that didn’t particularly horrify him (Analogy: Private vs. Public School). Munger did however wish that it would be put off for at least a year so energy can be focused on correcting the financial system.


Housing

Mid American owns the largest Real estate Broker in Southern California. The numbers are beginning to show some stabilization in medium to lower priced real estate. Higher priced real estate markets still erratic.

The general situation:

The US had been increasing households by 1,300,000 per year, but housing starts were increasing at 2,000,000 per year. Currently we have overcapacity of about 1,500,000 million houses. About 1/3 of all owner occupied houses have a mortgage. Therefore, we will reduce capacity by about 500,000 units per year, which will take a few years to absorb. Meaning housing nationally will take a few years to fully stabilize. Buffett singled out his concern for real estate in South Florida, which he thought would have problems for some time. I’m of the impression that this has to do with Southern Florida’s lower average population growth (or household formations) with respect to the regions overcapacity.

Similarly, neither Buffett nor Munger thought there would be a quick turnaround in retail or manufacturing especially those related to the housing markets.

Buffett commented that Retail/Commercial Real Estate purchased at 5% premium Cap Rates will likely turn out to be silly purchases.

The Cap Rate or Capitalization Rate is the income generated from the real estate property relative to the cost of the property (e.g. Annual net operating income / cost). The higher the price paid for the property the lower will be the cap rate. Purchasers who justified their purchase with a 5% cap rate were (likely) assuming that the value of their “prime” location would experience a greater than average increase in property value, which would make up for the low cap rate.


Economy

Buffett and Munger are intrigued by discussions and accusations that include the catch phrase, “Tax Payer dollars”. Taxes haven’t changed and no one has paid anything more than they had been. In reality, China and other purchasers of our governments fixed income securities (treasuries) will be the ones who will ultimately pay, not so much the “Tax Payer”.


Inflation “We will have some.”

Best guard against inflation is (i) your own purchasing power and (ii) owning or investing in good businesses. If you are the best at whatever your do, you will command a greater share of relative purchasing power.

Inflation is unpredictable. But over the next 5, 10, 15 years the dollar will buy less or substantially less. We are however not alone. To offset the contraction of demand, the UK is running a deficit of nearly 12% of GDP and Germany is running a deficit of about 6% of GDP.

That said a little inflation is not bad, just look at the last few hundred years.


Moats

Some moats that were thought, not too long ago, to be quite large and very sustainable, are deteriorating or have altogether disappeared. That is they’re filling up with sand. Example, Newspaper business: Reading the paper has lost its essential need with the coming generation and therefore businesses no longer find it an essential place to advertise.


Board & Executive Compensation:


Boards do a poor job thinking like owners.

Directors responsibility is to measure the CEO, to make sure the CEO does not over-reach, and to get the incentives right.

Buffett said, “Truth is that the Board has little affect on compensation, the CEO basically sets his own package.”

Both Munger and Buffett suggested that compensation committees should be eliminated.

Munger voiced that liberal pay to directors is counter-productive. It becomes club-like and the directors would do a better job if they were not paid at all. What’s needed? -Owners that are knowledgeable representatives.

If the compensation is a large part of the directors well being (income) the director is not independent. Munger compared directorship to public positions (like congress). “No man is fit to be in such a position if he isn’t willing to leave it.

Buffett, said to watch out for companies that need 100 pages to explain their compensation package. He also cited Chesapeake Energy as an example of egregious unwarranted compensation.

Buffett, “Compensation committees operate on the honor system: Shareholders have the honor, Management, the system.”


BYD and China:

Munger called BYD “A damn miracle.”

Business aspects: They are in rechargeable batteries, cell phone components, and Automobiles.

To understand the capability of the company and specifically Wang Chuan-Fu, consider that they started literally from zero, with little to no capital, manufacture everything for their cars except the glass for the windows yet blew away the huge auto manufacturers with all their capital, resources, distribution channels, etc.

New (lithium) battery technology is desperately needed not only for cars and obvious electronic devices, but also by utility companies-true domestically and globally. BYD, “Hit the sweet spot on that one.”

Wang Chuan-Fu hand picks the best Chinese engineers, 17,000 or so to date. “The basic quality of the Chinese people is astounding.“

Munger said that the current Chinese economic policies are very much on point. “The most successful in the world. It’s a governments job to make their country hard to compete with and China has done that very well.”

Berkshire Hathaway Valuation & Derivatives Book Explained

Document with proper format may be downloaded here: http://www.scribd.com/doc/17017305/BRKArcstone

Click images for larger view
Originally published on Gurufocus:
http://www.gurufocus.com/news.php?id=52509



Berkshire Hathaway is Misunderstood & Inexpensive

Buffett goes out of his way to make Berkshire Hathaway’s Annual Report as easily understandable as possible. However as Berkshire Hathaway has grown, complexity followed. This makes putting a price or value on Berkshire increasingly difficult for both the average and professional investor. Complexity coupled with Buffett’s advancing age, not to mention skittish markets, certainly play a role in Berkshire Hathaway’s depressed market price. I will try to break down Berkshire Hathaway’s separate components of value below. The discrepancy between price and value should become very apparent.

The 4 major sources of value may be specified as follows:

Insurance business Utilities and Energy Business Service, Manufacturing, and Retail Business Finance and Financial Products Business

The Utilities & Energy businesses and Service, Manufacturing, & Retail businesses are fairly straightforward as far as we are here concerned. The real complications derive from the insurance businesses and the Finance and Financial Products Businesses.

Part I Finance and Financial Products

Over the past 2-3 years, Berkshire made a few investments in derivatives contracts, which leaves many people scratching their heads. Mark-to-Market, “Fair Value” accounting (Used for Derivatives) causes wide variations in the balance sheet and income statement and produces misleading results. There are four different types of derivative contracts in which Berkshire has entered.

i) Equity puts ii) Credit Default Insurance on a high yield index of 100 companies iii) Credit Default Swaps on individual companies iii) Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)


Equity Puts
Berkshire Hathaway sold equity puts. Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss. The loss in this case is a decline in the general stock market.

Berkshire sold puts and collected premiums up front which Buffett invested. These premiums, like insurance, are invested until the contract expires. These are European style contracts, meaning the seller is liable only for losses that exist on the expiration date of the contract, which is in no less then 15 years. In the meantime Buffett gets the benefit of the use of this money.

Specifics:

2006 seems to be the first year that Buffett personally entered into equity puts. In 2006 the S&P 500 closed at around 1400, as of early March 2009, the S&P 500 stands at 830. Premiums received for these contracts, $4.9 billion. Max loss if the index is zero upon expiration, 15 years hence (at which point money would be all but worthless anyway,) $37 billion.


Credit Default Insurance on a High Yield Index of 100 Companies
First expiration is due in September 2009 and the last expiration due is in December 2013. Premiums received, $3.4 Billion. The amount of actual losses paid as of December 31, 2008: $542 million. Meaning, net, Berkshire has the benefit of the use of $3 billion. This might be considered as “Credit Default Insurance (high-yield index,) Float”. Estimated future losses (loss reserve) are $3.4 billion. These contracts seem the most likely, of the 4 types of derivatives, to produce a “Derivative Underwriting Loss”.


Credit Default Swaps (CDS) on Individual Companies
Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts. Annually Berkshire receives $93 million for premiums on these contracts. Berkshire is liable for 42 corporations. Should any of them default on their loans, Berkshire is liable for the decline in the market value of the debt relative to value of the debt specified in the CDS contract. I am confident that each of these corporations has substantial amounts of tangible assets or have sustainable earning power well in excess of their respective interest obligations, both of which protect Berkshire from loss. Asset protection protects the price decline in the market value of debt upon default and earning power from default.


Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)
These are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot. Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years. These premiums should be expected annually for the duration of individual contracts.

Berkshire has a total “Derivative Float” of about $8.1 billion primarily from Equity Puts and Credit Default Insurance (high yield index). Current accounting requires Berkshire to record an excessive liability on its balance sheet for the Mark-to-Market changes in the liabilities that accompany derivate float.


Accounting for Derivatives

Derivatives contracts not designated as a hedge, for example sold European Style Equity Index Puts receiving (premiums up front) are accounted by recording premiums as “other liabilities” on the balance sheet. Changes in the “fair value” of these contracts are adjusted quarterly with changes reflected in the income statement as derivative or “unrealized” losses and correspondingly in the in the balance sheet account as an increase or decrease in “derivative contract liabilities”. A more detailed discussion on Berkshire’s Derivatives and the accounting is discussed on page 8. What follows here is a more general, less confusing explanation.

The $8.1 Billion Berkshire received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and declines in the “Fair-Value” of “Mark-to-Market” securities are subtracted from earnings in the period of loss, irrespective of actual economic gains or losses. Due to Mark-to-Market changes in the derivatives that Berkshire holds, their liabilities increased to $14.6 billion in 2008 and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings in 2008. For similar reasons, earnings were overstated by $5.5 billion in 2007 and $2.6 billion in 2006 again due to the nature of Mark-to-Market ,“Fair Value” accounting.

Personally I believe markets will recover in a few years, let alone 15 years, but let’s first consider the contrary. In December 1929 the Dow Jones Industrial Index was at about 370. In 1934, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss. In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion. To break even on this transaction Berkshire Hathaway

would need to compound $4.9 billion at about 10.5%. Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to out live him-and I expect will exceed the breakeven 10.5% (Note the yields on “Other Investments” below). If on the other hand in 15 years the stock market has at least recovered, there is no payment for loss and the derivative float will explicitly become equity. In this case, the value of “Equity Put Float” will have definitely compounded at a rate exceeding 15%. It appears reasonable to me that Berkshire’s “Equity Put Float” is today worth about $12.5 billion. In the event that the market closes down 60% in 15 years, while (assuming) Berkshire continues to compound investments as it has in the past, the Equity Put Float would have a current value between $4 billion and $5.5 billion.

The below table shows Earnings and Net Worth as reported and adjusted for the affects of derivatives:

Adjusting only for derivative gains & losses provides that earnings were understated for 2008 and overstated for 2007 and 2006.


Part II Cash, Securities, & Investments

Berkshire Hathaway’s Insurance business:

Berkshire Hathaway has about $116 billion in Cash & Equivalents, Fixed Maturity investments, and Equities held within various insurance businesses. Primarily by National Indemnity, Columbia Insurance Company, GEICO, GenRe, National Fire and Marine Insurance Company, and Berkshire Hathaway Assurance Company. (These six insurance companies hold roughly $43 billion of Berkshire’s $56 billion (adjusted) equity investments.)

Investments - As Reported:


Other investments make comparing 2008 to 2007 more difficult than necessary and are itemized and reconciled for simplicity below:

Other Investments: (click to enlarge)



Adjustments to Other Investments:

For simplicity, Moody’s and Burlington Northern will be treated as equities and Goldman Sachs, GE, and Wrigley’s as Fixed Maturities:


It’s unclear how much new capital net was invested in or taken out of equities in 2008. My estimates are as follows: Equity sales of Johnson & Johnson, Conoco Phillips, and Proctor and Gamble provided about $2.78 billion, which Buffett used in part to pay for the $14.5 billion private placements of Goldman Sachs, GE, and Wrigley’s. After all sales and purchases that Berkshire made in equities, Berkshire would have received between $2.873 billion and $7.825 billion, an average of $5.349 billion, pre-tax. I am making the assumption that Buffett sold Anheuser Busch for the takeover bid offer of $70 US, which would have provided, $2.475 billion pre-tax.

Berkshire’s cash balance declined by $9.4 billion, adjusted earnings for the year would have contributed $9.6 billion, equity puts and other derivatives contracts sold would have also provided investable capital though exact amounts were not provided. A crude calculation implies that Berkshire would have put between 21.87 and 26.82 to use in various investing activities. We know for certain that Berkshire spent at least, $20.6 billion, $6.1 billion on operating business acquisitions and $14.5 billion on private placements, which is reasonably close. (Buffett stated that the $14.5 billion private placements were paid for with available cash. Cash Balance declined $9.4, meaning $5.1 billion was provided either via equity sales or from operating earnings. The remaining balance would have been used to pay for business acquisitions made throughout the year.)


Part III Berkshire Hathaway Insurers

The Basics (Readers already familiar with the basic economics of insurance businesses, skip to, “Getting to the Point” )

The value of an insurance company comes from the amount of investable funds it generates. Investable funds can come from underwriting profits or from investment income or from securities gains. In the simple sense, if insurance premiums are sufficient to cover the losses incurred over the insurable period the insurer produces an underwriting profit. These profits may be added to surplus, which allows the insurer to write additional business. The amount of business an insurer can write is generally limited to 3 times the insurers surplus - the Statutory Accounting Principles (SAP) definition for shareholders equity.

As stated above, the amount of business an insurer can write is dependent upon surplus. Investable funds are a combination of surplus and float.

The amount of float depends upon the amount of business written. The amount of business written depends upon the amount of surplus. The amount of surplus depends upon underwriting profit or loss, investment income from interest and dividends, and/or capital gains on investments. The underwriting of insurance policies and the investment of surplus and float are separate operations. When both are done well an insurance business compounds capital at VERY attractive rates of return. Such is Berkshire Hathaway.

Berkshire Hathaway has on average earned an underwriting profit. Float to date is about $58 billion and I am of the impression that this number will grow this year. Most insurers earn underwriting losses for reasons I will not go into. These losses must be made up for by interest income and securities gains. If this does not happen, surplus declines (for reasons discussed above) and the amount of business written must also decline. The past year was not a good one for the general stock market. As a result, many insurers suffered large declines in their Statutory Surplus Accounts. In 2008 Berkshire wrote insurance business of about $25 billion on surplus of $51 billion. That is, they are very well capitalized and well positioned to take market share while still generating underwriting profits in 2009.


Getting To the Point

Berkshire Hathaway’s $58 billion of Insurance Float is reasonably worth not less than $70 billion. The $58 billion float is basically invested in Fixed Maturities and Cash Equivalents:


Berkshire’s $56 billion in equities, valued at market are worth substantially more in rational economic terms. Each individual will arrive at different estimates, but they are not economically worth less than the currently quoted market values. Berkshire’s Float and Equity holdings (at market) taken together must be worth at least $126 billion (Fiscal Year 2008).


Part IV It Doesn’t Get Much Easier Than This

Net Worth:

Manufacturing, Service, & Retailing

Working Capital $ 5,497
Fixed and Other Assets 17,586
Total Tangible Assets 23,083
Term Debt and other Liabilities 6,033
Net Worth 17,050

Utilities & Energy

Total Tangible Assets $ 36,290
Total Liabilities 24,448
Net Worth 11,842

Finance & Financial Products (adjusted for Equity Puts)

Total Tangible Assets $ 22918
Payables, Accruals,
& General Other Liabilities 16044
Derivatives Liabilities
(Less $10 billion Equity Put Options
Liability) 4612
Total Liabilities 20656
Net Worth 2,262


Net Worth Manufacturing, Service, & Retailing, Utilities & Energy, Finance & Financial Products

Manufacturing, Service, & Retailing $ 17,050
Utilities & Energy 11,842
Finance & Financial Products 2,262
Net Worth(s) 31,154


Minimum Value, Berkshire Hathaway:

$31.15 billion+ $126 billion = $157.15 billion

Market Value (3/11/09) = $131.76 billion
Market Value (3/10/09) = $ 113.45 billion


Part V A more reasonable value of Berkshire’s non-insurance operating businesses

Berkshire’s Manufacturing, Service, & Retail businesses earned $4023 pretax, a 17.5% return on Total Tangibles, and 23.6% on Net Worth.

Manufacturing, Service, & Retail

2008

Pre-tax income $ 4023
Total Tangibles 23,083
Return on Assets 17.5%

Net Worth 17050
Return on Net Worth 23.6%


Finance and Financial Products

Berkshire’s Finance and Financial Products business using Clayton’s pretax income earned 3.43% on assets in 2008-that’s a 35% return on Net Worth. (A 2% Return on Assets for a bank is considered extraordinary.)

2008
Clayton’s Pre-tax income $ 787
Finance and Financial Products
Total Tangible Assets 22,918
Return on Assets 3.43%

Finance and Financial Products
Net Worth 2,262
Return on Net Worth 35%


I am certain the best method of appraisal and determination of earnings for the Utility and Energy businesses are via the balance sheet. This information is not provided in Berkshire’s annual report and I have not spent enough time digging for it. Therefore I cannot say how much I think it is reasonably worth. Therefore well just take it at book value.

Without going into great detail, I think the non-insurance businesses are reasonably worth no less than $46 billion, which would Value Berkshire Hathaway in its entirety at $172 billion not adjusting for the intrinsic value of equity investments held by its insurers.



Appendix: ("Click Me" links not functional but click images for larger view)

“Fair Value” & Accounting For Berkshire’s Derivatives Book

The charges against net income ($6,821) and the increase in Derivative liabilities ($7,725) are not offsetting. The footnote providing for the exact charges against net income ($7,461) does not match the liability increase in the Balance Sheet either, though it does provide helpful information. Part of the confusion: liabilities appear as though they are specific to Berkshire’s Finance & Financial Products Businesses, but there are “Fair Value” related charges against earnings that are specific to “Insurance & other” as explained in the footnote. The confusion is nearly resolved by comparing the actual amounts charged to earnings against increases in the “Fair Value” of these securities as on the Balance Sheet. As will be found below, there is an $18 deficit that is related to change in the Counter-Party Netting/Collateral. And the books can be closed. Thanks FAS 133!






"Toxic Assets" Explained

There are primarily two types of "toxic assets" (i) mortgages and (ii) derivatives.

Basically, the first type are bad loans. Many people who use such terms are referring to "sub-prime" loans, but not always.


(In what follows ignore federal funds rates-for simplicity)
As you're aware, banks use deposits (savings and checking accounts-which are bank liabilities) to fund long term loans (mortgages-which are bank assets). Deposits are short term in nature and mortgages long term. Generally, short term interest rates are less than long term interest rates so to compensate the amount of time one goes without the use of money. As a result banks earn more interest on their assets than they have to pay on their liabilities. Banks have problems when short term rates are higher than long term rates since they earn less on assets than they must pay on liabilities. In such cases the value of assets would decline and the value of liabilities increase. Simply put, Banks are required to maintain a certain ratio of assets to liabilities. If this ratio falls below the governments requirement they become insolvent, at which point the government assumes control and liquidates the banks assets to other solvent banks. One potential option is to sell (if they can) some of their mortgages before they become insolvent.

Fannie Mae and Freddie Mac, were created to purchase mortgages. Over time traditional banking changed. Banks no longer had to make loans with the intention of holding them, rather they could earn profits by underwriting a loan and then quickly selling it to Fannie and Freddie, who were for the most part obligated to purchase it. Some also made money by "servicing" these loans-that is they were responsible for getting the borrowers mortgage payments to the appropriate party.

Fannie and Freddie basically took these mortgages and turned them into bonds. For example, they might take 1000 mortgages and sell them as debt. The average income on these mortgages might be expected to earn Fannie and Freddie, say, 8%, which they would combine (called securitization) and sell as a 7% bond. These bonds are officially termed Collateralized Debt Obligations (CDO's). Until recently, the rating agencies (Moody's Fitch, & Standard and Poor's) often rated these as AAA, the highest debt rating possible. Insurance companies were big purchasers of these CDO's because they are often required to back their insurance policies with debt investments of the highest quality. AAA rated corporate debt might only yield 5% while these CDO's yielded 7%-hence the incentive to purchase.

The problem began in the 70's and 80's when borrowers increasingly assumed variable and adjustable rate loans. This made it easier to give people loans. The problem was and is that as the probability of default increases, so too does the interest rate on the loan, but the higher interest rate must be paid by individuals that are increasingly less likely to have the means to repay. Banks however no longer made loans with the intention to hold each of them, choosing to earn a little money by originating and servicing the mortgages by quickly selling them to Fannie and Freddie. Mortgage brokers increased in number without any intention of ever owning these mortgages which helped increase overall securitization.

Housing prices should increase with either inflation or by the amount wages increase from year to year-no more no less. But for 30-50+ years housing prices increased annually by 6-7% while inflation increased annually by 3-4%, until 2005. Thats when things got really crazy. Housing prices increased (I'm going by memory though should be close) in 2005 by about 15-20%, similarly in 2006 and part of 2007. That's more than a 40% increase in 2 years-an impossible amount, people's income simply can't support such increases. However many people began to speculate buying one or more investment properties. Others found imaginary money via "home equity" that banks would give them to purchase "better, bigger, or nicer" homes. Loans became increasingly less dependent upon the buyers income and down payment-obvious and big problems. Recently things got really crazy even fraudulent. Buyers were not required to show proof of income though would get 100% financing. All is fine when prices are forever rising, but anything that can't continue forever must end. The rest is (becoming) history.

The mortgages discussed above were "packaged" (or combined i.e. securitized) and sold as quasi "bonds" (CDO's). Since the owners of the mortgages did not service the loans the borrowers and lenders had issues renegotiating the terms of problematic loans. Basically the buyers of CDO's didn't properly understand what they were buying. Another case of incompetence, which will certainly go overlooked. The above hypothetical CDO consisted of 1000 loans. Accompanying each of the 1000 loans might very well be a 100 page description of each loan. To properly understand this single CDO the buyer would need to read 100,000 pages. My example doesn't do a real CDO justice. Understanding most CDO's requires reading about 1 million pages. This obviously didn't happen. As defaults on home mortgages have increased the value of these CDO's declined. Investors, having no idea how many loans within the CDO might default, scrambled to "catch up on their reading". Meaning investors were and are uncertain how many loans will default (or worse foreclose,) which means the interest or coupon payments are also unknown. When a Corporation defaults on a loan, debtors take the single entity to bankruptcy court. This is obviously much more difficult when there are thousands of entities. To further complicate the craziness, the declining value of homes means that the principal value of these assets are unknown. That is, unlike the buyers of corporate debt, who might derive a reasonable estimate of the asset value of a businesses assets, holders of CDO's have had a hell of a time figuring out how much the underlying assets are really worth.

Ultimately no one has any interest in buying these CDO's right now-meaning there is no market for these securities. (I must deviate for a moment.) Certain accounting standards require certain assets/liabilities be recorded based upon their "Fair Value" which is basically the quoted market price at the end date of a company's reporting period. (back to the discussion) Since there is currently no market for CDO's, accounting forces companies to report these securities as basically worthless. It should be clear: they are not worthless however, but accounting reports them as worthless. Such are "Toxic assets" Some companies must maintain asset to liability ratios. If large amounts of assets become worthless overnight (or liabilities increase enormously) this is bad. Removing these "Toxic" assets from their balance sheet means they are sold-in many instances at very large discounts to the real economic value separate from accounting "fair" value. If they can be sold, the company will have cash which accounting treats much more favorably. Their "Reported" financial position is then better and people might relax.

There are similar (though worse) problems regarding derivatives that involve AIG, CitiGroup, and many others, but I'll leave that discussion for another time.

To Understand the Current Economic Situation, Problem and Solution Read Below:

I.
The world has been slow to realize that we are living this year in the shadow of One of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full today of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future. Is he now awakening from a pleasant dream to face the darkness of facts? Or dropping off into a nightmare which will pass away?

He need not be doubtful. The other was not a dream. This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We areas capable as before of affording for everyone a high standard of life—high, I mean, compared with,say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.
I doubt whether I can hope, in these articles, to bring what is in my mind into fully effective touch with the mind of the reader. I shall be saying too much for the layman, too little for the expert.For—though no one will believe it—economics is a technical and difficult subject. It is even becoming a science. However, I will do my best—at the cost of leaving out, because it is too complicated, much that is necessary to a complete understanding of contemporary events.

First of all, the extreme violence of the slump is to be noticed. In the three leading industrial countries of the world—the United States, Great Britain, and Germany—10,000,000 workers stand idle. There is scarcely an important industry anywhere earning enough profit to make it expand—which is the test of progress. At the same time, in the countries of primary production the output of mining and of agriculture is selling, in the case of almost every important commodity, at a price which, for many or for the majority of producers, does not cover its cost. When prices fell heavily, the fall was from a boom level at which commodity producers were making abnormal profits; and there is no example in modern history of so great and rapid a fall of prices from a normal figure as has occurred in the past year. Hence the magnitude of the catastrophe.

The time which elapses before production ceases and unemployment reaches its maximum is, for several reasons, much longer in the case of the primary products than in the case of manufacture. In most cases the production units are smaller and less well organized amongst themselves for enforcing a process of orderly contraction; the length of the production period, especially in agriculture, is longer; the costs of a temporary shut-down are greater; men are more often their own employers and so submit more readily to a contraction of the income for which they are willing to work; the social problems of throwing men out of employment are greater in more primitive communities; and the financial problems of a cessation of production of primary output are more serious in countries where such primary output is almost the whole sustenance of the people. Nevertheless we are fast approaching the phase in which the output of primary producers will be restricted almost as much as that of manufacturers; and this will have a further adverse reaction on manufacturers, since the primary producers will have no purchasing power where with to buy manufactured goods; and so on, in a vicious circle.

In this quandary individual producers base illusory hopes on courses of action which would benefit an individual producer or class of producers so long as they were alone in pursuing them, but which benefit no one if everyone pursues them. For example, to restrict the output of a particular primary commodity raises its price, so long as the output of the industries which use this commodity is unrestricted; but if output is restricted all round, then the demand for the primary commodity falls off by just as much as the supply, and no one is further forward. Or again, if a particular producer or a particular country cuts wages, then, so long as others do not follow suit, that producer or that country is able to get more of what trade is going. But if wages are cut all round, the purchasing power of the community as a whole is reduced by the same amount as the reduction of costs; and, again, no one is further forward.
Thus neither the restriction of output nor the reduction of wages serves in itself to restore equilibrium.

Moreover, even if we were to succeed eventually in re-establishing output at the lower level of money-wages appropriate to (say) the 2007 level of prices, our troubles would not be at an end. An immense burden of bonded debt, both national and international, has been contracted, which is fixed in terms of money. Thus every fall of prices increases the burden of this debt, because it increases the value of the money in which it is fixed. Agriculturists and house-holders throughout the world, who have borrowed on mortgage, would find themselves the victims of their creditors. In such a situation it has been proven doubtful whether the necessary adjustments can be made in time to prevent a series of bankruptcies, defaults, and repudiations which would shake the capitalist order to its foundations. Here would be a fertile soil for agitation, seditions, and revolution. It is so already in many quarters of the world. Yet, all the time, the resources of nature and men's devices would be just as fertile and productive as they were. The machine would merely have been jammed as the result of a muddle. But because we have magneto trouble, we need not assume that we shall soon be back in a rumbling wagon and that motoring is over.

II.
We have magneto trouble. How, then, can we start up again? Let us trace events backwards:—
1. Why are workers and plant unemployed? Because industrialists do not expect to be able to sell without loss what would be produced if they were employed.
2. Why cannot industrialists expect to sell without loss? Because prices have fallen more than costs have fallen—indeed, costs have fallen very little.
3. How can it be that prices have fallen more than costs? For costs are what a business man pays out for the production of his commodity, and prices determine what he gets back when he sells it. It is easy to understand how for an individual business or an individual commodity these can be unequal. But surely for the community as a whole the businessmen get back the same amount as they pay out, since what the business men pay out in the course of production constitutes the incomes of the public which they pay back to the business men in exchange for the products of the latter? For this is what we understand by the normal circle of production, exchange, and consumption.
4. No! Unfortunately this is not so; and here is the root of the trouble. It is not true that what the business men pay out as costs of production necessarily comes back to them as the sale-proceeds of what they produce. It is the characteristic of a boom that their sale-proceeds exceed their costs; and it is the characteristic of a slump that their costs exceed their sale-proceeds. Moreover, it is a delusion to suppose that they can necessarily restore equilibrium by reducing their total costs, whether it be by restricting their output or cutting rates of remuneration; for the reduction of their outgoings may, by reducing the purchasing power of the earners who are also their customers, diminish their sale-proceeds by a nearly equal amount.
5. How, then, can it be that the total costs of production for the world's business as a whole can be unequal to the total sale-proceeds? Upon what does the inequality depend? I think that I know the answer. But it is too complicated and unfamiliar for me to expound it here satisfactorily. (Elsewhere I have tried to expound it accurately.) So I must be somewhat perfunctory.

Let us take, first of all, the consumption-goods which come on to the market for sale. Upon what do the profits (or losses) of the producers of such goods depend? The total costs of production, which are the same thing as the community's total earnings looked at from another point of view, are divided in a certain proportion between the cost of consumption-goods and the cost of capital-goods. The incomes of the public, which are again the same thing as the community's total earnings, are also divided in a certain proportion between expenditure on the purchase of consumption-goods and savings. Now if the first proportion is larger than the second, producers of consumption-goods will lose money; for their sale proceeds, which are equal to the expenditure of the public on consumption-goods, will be less (as a little thought will show) than what these goods have cost them to produce. If, on the other hand, the second proportion is larger than the first, then the producers of consumption-goods will make exceptional gains. It follows that the profits of the producers of consumption goods can only be restored, either by the public spending a larger proportion of their incomes on such goods (which means saving less), or by a larger proportion of production taking the form of capital-goods (since this means a smaller proportionate output of consumption-goods).

But capital-goods will not be produced on a larger scale unless the producers of such goods are making a profit. So we come to our second question—upon what do the profits of the producers of capital-goods depend? They depend on whether the public prefer to keep their savings liquid in the shape of money or its equivalent or to use them to buy capital-goods or the equivalent. If the public care reluctant to buy the latter, then the producers of capital-goods will make a loss; consequently less capital-goods will be produced; with the result that, for the reasons given above, producers of consumption-goods will also make a loss. In other words, all classes of producers will tend to make a loss; and general unemployment will ensue. By this time a vicious circle will be set up, and, as the result of a series of actions and reactions, matters will get worse and worse until something happens to turn the tide.

This is an unduly simplified picture of a complicated phenomenon. But I believe that it contains the essential truth. Many variations and fugal embroideries and orchestrations can be superimposed; but this is the tune.

If, then, I am right, the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment. Since trade is international, an in sufficient output of new capital goods in the world as a whole affects the prices of commodities everywhere and hence the profits of producers in all countries alike.

Why is there an in sufficient output of new capital goods in the world as a whole? It is due, in my opinion, to a conjunction of several causes. In the first instance, it was due to the attitude of lenders—for new capital-goods are produced to a large extent with borrowed money. Now it is due to the attitude of borrowers, just as much as to that of lenders.

For several reasons lenders were, and are, asking higher terms for loans, than new enterprise can afford. First, the fact, that enterprise could afford high rates for some time after the war whilst war wastage was being made good, accustomed lenders to expect much higher rates than before the war. Second, the existence of political borrowers to meet Treaty obligations, of banking borrowers to support newly restored standards, of speculative borrowers to take part in Stock Exchange booms, and, latterly, of distress borrowers to meet the losses which they have incurred through the fall of prices, all of whom were ready if necessary to pay almost any terms, have hitherto enabled lenders to secure from these various classes of borrowers higher rates than it is possible for genuine new enterprise to support. Third, the unsettled state of the world and national investment habits have restricted the countries in which many lenders are prepared to invest on any reasonable terms at all. A large proportion of the globe is, for one reason or another, distrusted by lenders, so that they exact a premium for risk so great as to strangle new enterprise altogether. For the last two years, two out of the three principal creditor nations of the world, namely, France and the United States, have largely withdrawn their resources from the international market for long-term loans.

Meanwhile, the reluctant attitude of lenders has become matched by a hardly less reluctant attitude on the part of borrowers. For the fall of prices has been disastrous to those who have borrowed, and anyone who has postponed new enterprise has gained by his delay. Moreover, the risks that frighten lenders frighten borrowers too. Finally, in the United States, the vast scale on which new capital enterprise has been undertaken in the last five years has somewhat exhausted for the time being—at any rate so long as the atmosphere of business depression continues—the profitable opportunities for yet further enterprise. By the middle of 2008 new capital undertakings were already on an inadequate scale in the world as a whole, outside the United States. The culminating blow has been the collapse of new investment inside the United States, which to-day is probably 20 to 30 per cent less than it was only a few years back. Thus in certain countries the opportunity for new profitable investment is more limited than it was; whilst in others it is more risky.
A wide gulf, therefore, is set between the ideas of lenders and the ideas of borrowers for the purpose of genuine new capital investment; with the result that the savings of the lenders are being used up in financing business losses and distress borrowers, instead of financing new capital works.

At this moment the slump is probably a little overdone for psychological reasons. A modest upward reaction, therefore, may be due at any time. But there cannot be a real recovery, in my judgment, until the ideas of lenders and the ideas of productive borrowers are brought together again; partly by lenders becoming ready to lend on easier terms and over a wider geographical field, partly by borrowers recovering their good spirits and so becoming readier to borrow.

Seldom in modern history has the gap between the two been so wide and so difficult to bridge. Unless we bend our wills and our intelligences, energized by a conviction that this diagnosis is right, to find a solution along these lines, then, if the diagnosis is right, the slump may pass over into a depression, accompanied by a sagging price-level, which might last for years, with untold damage to the material wealth and to the social stability of every country alike. Only if we seriously seek a solution, will the optimism of my opening sentences be confirmed—at least for the nearer future.

It is beyond the scope of this article to indicate lines of future policy. But no one can take the first step except the central banking authorities of the chief creditor countries; nor can any one Central Bank do enough acting in isolation. Resolute action by the Federal Reserve Banks of the United States, the Bank of France, and the Bank of England might do much more than most people, mistaking symptoms or aggravating circumstances for the disease itself, will readily believe. In every way the more effective remedy would be that the Central Banks of these three great creditor nations should join together in a bold scheme to restore confidence to the international long-term loan market; which would serve to revive enterprise and activity everywhere, and to restore prices and profits, so that in due course the wheels of the world's commerce would go round again. I am convinced that the creditor-nations, like-minded and acting together, could start the machine again within a reasonable time; if, that is to say, they were energized by a confident conviction as to what was wrong. For it is chiefly the lack of this conviction which today is paralyzing the hands of hands of authority on both sides of the Channel and of the Atlantic.

I changed a few dates and that is all. This was from [End of The Great Slump of 1930 by John Maynard Keynes] Amazingly accurate depiction of the problem and solution.