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Humpty Dumpty sat on a wall...Merrill Lynch’s (MER) Stan O’Neal is gone, and Citigroup’s (NYSE:C) Chuck Prince remains on the hot seat, let’s boil this down to the only thing that I believe really matters: All of this packaging of the good, bad and ugly loans was really the ultimate example of the Wall Street greater fool theory.

Everybody thought they were smarter than the next guy and nobody (save a few really smart short-sellers and other skeptical sorts that long ago lost credibility as stock prices headed higher) really understood what was happening. Or wanted to believe what was really happening. And it was all perfectly legitimate off-balance sheet hooey that was totally arcane and opaque — only the kind of stuff true financial wonks would watch or care to understand.

Yet, irony of ironies, in the the end the guy left holding the bag was everybody, from the top on down, as the quest to squeeze just a little more make-believe profit out of this make-believe stuff marched on.

And why not? Nobody was looking, it was working and all of the geniuses assured everybody that the risk was being well-managed. It wasn’t, of course, because like the beast that ate Manhattan, the risk was out of its cage and out of control. It was so out-of-control that even Mama Merrill Lynch couldn’t get a handle on it, which suggests this structured-finance fiasco is hardly finished.

This was, after all, a business built on “assumptions,” which in the end is no better, and maybe worse, than weather forecasting.
I don’t care if it’s gain-on-sale accounting or the kind of accounting used for these securitizations. The fallacy of assumptions for these type of machinations is that they involve looking in the rear-view mirror on how things have performed — not how they might perform.

It truly is remarkable that the financial geniuses kept using assumptions as if housing prices would do nothing but go higher, affordability would continue to rise and the low losses would continue to infinity and beyond. Not so much a Toy Story, it was a giant game, that will no doubt recycle itself at some point in the future.

But first, investors might want to get their hands on an October 21 report from Goldman Sachs (NYSE:GS) related to my story from a month or two ago about why California housing matters.

According to the Goldman report, housing prices in the Golden State are 35% to 40% “above the price range implied by current and forecast economic conditions.” The report added, “We believe a downturn is imminent…”

And here’s the really bad news: Goldman believes that after housing prices plummet, credit deterioration won’t be far behind. Not good for those living in the world of option arms, and especially not good — so says Goldman — for Countrywide(CFC) and Washington Mutual (NYSE:WM), which “are disproportionately exposed to Californian housing risk.”

Don’t like what I just wrote? Go blame Goldman. Last time I looked they were supposedly among the smartest guys in the room. (Which they are, of course, as long as they’re saying things will go up and get better.) Ah, but don’t worry, another rate cut or two or three will make it appear as though none of this ever happened. Sorry, Charlie, all the king’s horses and all of the Fed’s men won’t be able to save this economy again.

The beat goes on…

Source: Credit Crisis: Will the Real 'Greater Fool' Please Stand Up?