What if I told you that the current economic downturn and the investment losses Americans endured in 2008 and 2009 are a pittance compared to what almost happened? Something almost came to be that may have completely destroyed a large swath of American lives.

The only thing that saved us? The rapid collapse of Bear Stearns and the housing industry!

For anyone that's followed the runaway train that was the housing boom fueled over several years by easy credit and misaligned incentives, followed by the precipitous decline in home values, and hence, collateralized debt obligations (CDOs), it's evident that it could have been even worse. Fortunately for the US and unfortunately for the rest of the world, US companies exported much of their toxic waste assets to countries the world wide from China to Finland. Note that during the housing collapse last year, with the US housing at the epicenter, US stocks actually held up better than virtually every other stock index (See all 2008 index returns).

It could have been Much Worse - This is NOTHING

How? Fortunately, we were protected from ourselves. Wall Street, for all its ingenuity, failed to package CDOs in such a fashion that they could sell them to retail investors fast enough to beat the collapse. Just like Blackstone sold out at the pinnacle (boy, was that great timing), Wall Street was hard at work in the summer of 2007 to actually bring publicly traded vehicles that hold CDOs to the market. KKR and Bear Sterns were readying these instruments for retail investors. While Americans have suffered 50% declines in equity holdings, layoffs and restricted credit, could you imagine if we each had our own Bernie Madoff experience? Some of these instruments literally would have gone to less than 10 cents on the dollar within a year.

According to an IPO filing with the SEC, one of the firms looking to add retail investors to the pool of suckers, Highland Capital Management, showed that a dozen CDO funds under their management paid annual dividends of 19.6%. Bear Stearns' CDO returns were 24.5%. If "sophisticated investors" fell for Madoff hook, line and sinker with purported returns much lower than this, can you imagine the horror that would ensue if ALL investors were given access to projected returns like this?

As this BusinessWeek article from June 2007 outlines, as is typical, the class of CDOs that investors would have had access to were second rate (oxymoron in this case) with onerous restrictions compared to the junk that already existed. The author rightly predicted that these instruments aren't appropriate for retail investors and poignantly predicts:

"If a credit crunch leaves borrowers unable to refinance, a wave of defaults will follow - along with a wave of losses for investors..."

Now that mortgage rates hit record lows again this week and refinancing activity is burgeoning, there appears to be some light at the end of the tunnel for many Americans able to put more cash back in their pockets, as the Net Present Value for some of these refinancings are absolutely incredible. I'm not out to belittle the pain Americans are enduring now. But, can you imagine if retail investors chasing annual returns of 20%+ had access to these instruments? Now, that might have been enough to put us into the next Depression.




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