From the Wall Street Journal:
Barack Wrote a Letter . . .
The Born supremacy, and other meltdown myths.
At the October 7 Presidential debate, John McCain said that Barack Obama had encouraged Fannie Mae and Freddie Mac to make risky loans, and that Mr. Obama was the second largest recipient of campaign cash from the government mortgage giants.
Mr. Obama replied that he "never promoted Fannie Mae" and that "two years ago I said that we've got a subprime lending crisis that has to be dealt with." And that's not all. "I wrote to Secretary Paulson, I wrote to Federal Reserve Chairman Bernanke, and told them this is something we have to deal with, and nobody did anything about it," said the Illinois Senator.
There's more. Mr. Obama's March 2007 letter included a stirring call to "assess options" and boldly suggested that the two men "facilitate a serious conversation" about housing. He was even brave enough to suggest that "the relevant private sector entities and regulators" might be able to provide "targeted responses." Then in paragraph four, the Harvard-trained lawyer dropped his bombshell: a suggestion that various interest groups get together to "consider" best practices in mortgage lending.
Some may find it hard to believe that Mr. Obama had nothing to show for this herculean effort to shake up Washington. They may be shocked as well that such passionate language didn't move the Fed and Treasury to action. For our part, we note that nowhere in his letter did Mr. Obama suggest that the government should stop subsidizing loans to people who can't repay them.
This is the latest fad among Beltway liberals who spent years encouraging noneconomic mortgage loans. They now proudly announce that at critical moments they issued a press release, or wrote someone, suggesting that somebody do something. Since soured mortgage loans are a root cause of this panic, and since Democrats did so much to encourage mortgage lending, the most politically useful of these archived warnings are the ones blaming something other than housing.
For example, recent media reports have lauded the prescience of Edward Markey, the Massachusetts Democrat who has long called for increased regulation of financial derivatives. Not that this says much about derivatives. Mr. Markey has also called for increased regulation of the Internet, cable TV, telephones, prescription drugs, nuclear plants, natural gas facilities, oil drilling, air cargo containers, chlorine, carbon dioxide, accounting, advertising and amusement parks, among other things.
But derivatives are the irresistible story now, because they offer the opportunity to shift the blame from bad housing policy, and they suggest that a lack of financial regulation was the problem. While lauding Mr. Markey, the media also cast Brooksley Born, Bill Clinton's Chairman of the Commodity Futures Trading Commission, as the ultimate heroine in this drama. Like Horatio at the bridge, she tried to regulate the derivatives market over the objections of such dummies as Clinton Treasury Secretary Robert Rubin, SEC chief Arthur Levitt, and Federal Reserve Chairman Alan Greenspan.
The left's hope is that derivatives are so poorly understood that people can be convinced that turmoil in the market for credit default swaps -- an effect of soured mortgage loans -- is actually a cause of this crisis. Credit default swaps (CDS) are insurance policies against companies or investment vehicles going bankrupt and being unable to pay their creditors. This insurance is cheap when things are going well, and very expensive when investors expect the relevant entities to fail. Turns out that the markets for CDS and other derivatives not tied to the housing crisis are functioning normally.
Meanwhile, in an amazing coincidence, it is the failure -- or the expected failure -- of entities with heavy exposure to toxic mortgages that is putting extreme financial strain on those who sold insurance. But the problem can't possibly be the toxic mortgages encouraged by Washington, according to the politicians. It must be the system of insuring against the collapse of those who bought the mortgages.
Did many sellers of credit default swaps make horrendous judgments in assessing the likelihood of defaults? Yes, and they were encouraged to make these poor judgments by government-approved credit-rating agencies stamping approval on mortgage-backed securities. If an investment or commercial bank was holding assets branded rock-solid by government's anointed judges of creditworthiness, who wouldn't feel comfortable insuring against their failure?
Much of the subprime disaster could have been avoided if only the credit raters had never agreed to slap the AAA tag on collateralized debt obligations (CDOs). Almost no one understood these instruments, which contained portions from other pools of mortgage-backed securities, but with even less transparency. Most investors around the world had never heard of a CDO before the housing boom. But they knew what AAA meant. They had been told for years by the government's chosen credit raters that this label meant sound, conservative investing. Highly unlikely to default.
If Barack Obama wants to write any more letters, he should urge his colleagues in Washington to focus on the causes of this crisis, not the effects. Unlike Senators, Presidents are expected to solve problems, not merely write about them.
Thursday, October 30, 2008
Wednesday, October 15, 2008
The Blame Game
In Barack Obama's closing statement in Wednesday night's debate, he made a reference that is typical among historical revisionist politicians. It's political pandering. It drives me crazy, and is just plain wrong.
"Washington's unwillingness to tackle the tough problems for decades, has left us in the worst economic crisis since the great depression."
He's completely right, but for the complete opposite reason than his meaning. The implication made by a Democrat Presidential candidate is that the problems of today's financial markets exist because of "failed" policies of the Republican White House. It's crap, and it only panders to the lowest common denominator that is American politics. It's the concept that, "If I say it, it must be true." Obama's not the only politican seeking to lay blame. It's human nature to seek blame, but in a election period, everyone looks to blame someone but themselves, or their associates. However, here are the facts:
The financial problems have many of its roots in the pre- and post-dot com bubble burst. The inflated (and somewhat fictional) economy that was the late 1990s, had already begun to raise real estate prices. Feeling newly flush with money, average American began bidding up real estate. The term "McMansion" came on the scene as the neuvo riche tore down old homes and built monstrosities in their place.
When the technology stocks came crashing in, the average person who had been burned investing in hyped stock valuations, re-evaluated how he or she looked at investing and assets in general. Ownership of companies full of "air" was out-of-favor, and hard and tangible assets became important. I heard my mother-in-law say numerous times the mantra, "real estate is the best investment." Home ownership after the dot com crash became even more important.
In wake of the post 9/11 economic recession, the Federal Reserve kept interest rates extremely low which continued to fuel the public's eagerness to own hard assets. Monetary policy encouraged banks to lend. Mortgage rates were already low, and the public pounced on the opportunity to buy houses. Standard supply and demand in action drove housing prices up even further.
As the economy bouced back from the 9/11 lows and began to surge post the Bush tax cuts, the Federal Reserve sought to reign in economic growth. Without getting too much into monetary policy and the Federal Reserve: their actions were effective on the short end of the interest curve, but not the long end. Developing nations were booming, and investing in U.S. Treasury Securities. Long-term rates were remaining stubbornly low, and Fed Chief, Alan Greenspan, referred to it as a "conunderum." Mortgage rates are based off long-term rates, not short-term ones. Consequently, the Fed, which hoped to pop the housing bubble, was ineffective.
Low interest rates and easily available, cheap corporate credit were allowing companies (even ones with shaky balance sheets) to refinance and borrow at low rates. Stock valuations were high, and returns on bonds were quite low. On top of that, low volatility in the market reduced risk premiums on traditionally risky investments. Basically, proper returns on investments were becoming harder and harder to come by. Traditional institutional investors (pension funds, mutual funds, endowments, banks and hedge funds) sought new ways to improve their returns. It can be accomplished two ways: leverage or increase risk - or a combination of both.
Wall Street, as it always has, stepped up to create products that were in high demand. They expounded upon an idea called securitization. Essentially, a securitization pools a bunch of assets together and chops them up into different tranches. The theory involves a diversification risk. The highest tranches are the safest in that they take the last losses. It was a huge hit - higher returns from riskier assets but with less risk. Wall Street firms repackaged all kinds of assets: home mortgages, commerical mortgages, high yield bonds, investment grade bonds, airplane leases, etc. Wall Street was the conduit, not the originator. These firms are underwriting the securities on behalf of other institutions including the government sponsored entities, Fannie Mae and Freddie Mac. I don't want to blast the securitization process completely. Securitizations work - they provide higher returns with less risk if held through maturity. They do have a flaw, but I'll get back to that.
For now, back to politics and the real problem.
Starting as early as 1999, Congress (led by the Democrats) sought to further home ownership particularly among low income households. Flashback to September 30, 1999, when the New York Times wrote the following:
http://query.nytimes.com/gst/fullpage.html?res=9c0de7db153ef933a0575ac0a96f958260&sec=&spon=&pagewanted=print
"In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
The action ... will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans."
"Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.
In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers.
''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''
There's a reason these sub-prime borrowers pay higher rates and require larger down payments. They are riskier. Continuing:
"In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's. "
"said Peter Wallison a resident fellow at the American Enterprise Institute. 'If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'"
"Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings. "
With Fannie and Freddie lowering its credit standards, loans that would normally be held by the issuing banks (and thus highly scrutinized by credit officers) were being instead sold to investors into packaged deals. Credit Rating Agencies such as Standard & Poor's and Moody's, were fooled by the structure of these securities, and failed to do proper due diligence into the risks. Consequently, the new riskier securities were rated the same investment grade ratings as their previously less risky peers. On top of that, there are companies that insure the performance of the top tier tranche bonds. Companies such as Ambac wrote insurance (in exchange for premiums) guaranteeing the recovery of principal of the highest tranches. Such insurance-wrapped securities almost automatically received AAA ratings from the rating agencies.
Investors, seeking higher yields, were not only gobbling up these securitized bonds under the impression they couldn't lose, but they were suplementing their returns by adding leverage (using borrowed money to purchase securities). Those with the best cost of capital yielded the greatest advantage in these securities. No private companies in the U.S. have better costs of capital than the major financial institutions - such as the major money center banks and companies such AIG.
The logic went as follows: Take the AAA-rated top tier tranche of a package of mortgages. They incur the last losses - meaning, the tranches junior to you have to lose all their principal, before you lose a dollar of yours. On top of that safety feature, the principal and interst of your tranche is insured by a AAA-rated company. If you made the assumption that you could not lose more than $2 of every $100 invested (with the expectation that in fact you would not lose but rather make money), you could borrow $95, and risk less than half of your capital. If your cost of borrowing those funds is 4% and security yields 5%, the return on your capital would be 24%. Had you borrowed no money, and bought the same investment for cash, your return would have been only 5%. 24% vs 5% on a security that if held to maturity had practically no risk given the historical default rate of mortgages in the US. Or so seemed. There were a number of flaws not factored.
First, the monoline insurance companies wrote more insurance than they could reasonably cover. Second, many of the investors funded their borrowings with short term rates which meant they did not lock in their yield advantage. Third, the risk profile of the newest mortgage borrowers were a lot worse than in the past. Fourth, the return parameters of the trade require the securities to be held to maturity.
More on "Wall Street" in a bit. Back to the average consumer.
The demand from investors created an almost insatiable desire for securitized paper and thus mortgage paper. Congress' mandate for the GSEs was a great source of that paper. Orginators of debt were no longer on the hook for the mortgages they sourced. Your hometown bank made money on your mortgage whether you paid it off or not. It created a disincentive to perform proper due diligence at the local level. Local banks relied on a plethora of mortgage brokers who also had no incentive to make sure the the borrower had the ability to repay. The competition to generate mortgages was intense, and devises such as no-doc loans, or no down payment loans sprung up all over the place. These mortgages were sold by the local originator, packaged into securities and sold across the world. As long as real estate prices rose and everyone paid their mortgages, it was a great system.
Consumers were like kids in a candy store - eating until they threw up. People were caught up in the theory that real estate only went up, and bought homes they had no reasonable right purchasing. TV shows such as TLC's "Flip that House" or "The Property Ladder" were obvious signs that the internet bubble had been replaced by a housing bubble.
In the meantime, some in Congress were issuing warnings about the government's responsibility (and potential financial backing) regarding the GSEs. However, any attempt to reform was thwarted by those in Washington that didn't want the gravy train to end. Note that following quotes:
Sept 10, 2003: Rep. Barney Frank (D., Mass.): "The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. . . ."
Rep. Maxine Waters (D., Calif.), "if it ain't broke, why do you want to fix it? Have the GSEs ever missed their housing goals?"
Sept 25, 2003: Rep. Frank: "I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . ."
Rep. Gregory Meeks, (D., N.Y.): "I have sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn't broke. Housing is the economic engine of our economy, and in no community does this engine need to work more than in mine. With last week's hurricane and the drain on the economy from the war in Iraq, we should do no harm to these GSEs... we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. "
Rep. Frank: "I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists."
Oct 16, 2003: Sen. Charles Schumer (D., N.Y.): "And my worry is that we're using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie's mission. And I don't think there is any doubt that there are some in the administration who don't believe in Fannie and Freddie altogether, say let the private sector do it. That would be sort of an ideological position."
Feb 24, 2004: Sen. Thomas Carper (D., Del.): "What is the wrong that we're trying to right here? What is the potential harm that we're trying to avert?"
Sen. Christopher Dodd (D., Conn.): To Fed Chairman Greenspan, "obviously this is one of the great success stories of all time. And we don't want to lose sight of that and [what] has been pointed out by all of our witnesses here, obviously, the 70% of Americans who own their own homes today, in no small measure, due because of the work that's been done here. And that shouldn't be lost in this debate and discussion. . . ."
Apr 6, 2005: Sen. Schumer: "I'll lay my marker down right now ... I don't think they need dramatic restructuring in terms of their mission, in terms of their role in the secondary mortgage market, et cetera."
Jun 16, 2006: Sen. Schumer: "I think a lot of people are being opportunistic, . . . throwing out the baby with the bathwater, saying, 'Let's dramatically restructure Fannie and Freddie,' when that is not what's called for as a result of what's happened here. . . ."
Sen. Chuck Hagel (R., Neb.): "Mr. Chairman, what we're dealing with is an astounding failure of management and board responsibility, driven clearly by self interest and greed. And when we reference this issue in the context of -- the best we can say is, "It's no Enron." Now, that's a hell of a high standard."
In fact, there were major problems brewing at Fannie and Freddie. The eventual bailout of these two firms were just the beginning of what turned out to be a massive taxpayer rescue package. To quote the Wall Street Journal, "The members [of Congress] fought furiously against any attempt to make Fan and Fred less dangerous. The Bush administration was on the right side of this debate for eight years, as was the late Clinton Treasury [Department]. This was a scandal in plain sight that all but a few ignored. And now, having done so much to create this mess, many of the same Members who protected Fan and Fred are denouncing the 'bailout' as a favor to Wall Street."
But I'm getting ahead of myself.
The problems begun to emerge in early 2007, when the housing bubble burst, and "homeowners" began to default on their mortgage. Some were so far under water on the enormous mortgages they had taken, they just walked away. Defaults and foreclosures were at historical highs. Fannie and Freddie failed, and required the government to follow through on their implicit guarantee.
The monoline insurance companies that had insured the highest tranches of paper, were in sudden need to raise additional capital to sustain their ratings. Most failed to retain their investment grade status, and some filed for bankruptcy. That left holders of previously insured paper with the need to get out. The market for such paper is very illiquid to begin with, and in this case there were no buyers. The value of the once stable paper plummeted. Recall that calculation of returns above. However, this time, forget that the paper can only go down $2. This time, take it down $10 - or $20 - or more. All of your equity is gone. Not only was the quality of the paper not as good as expected, but too many people wanted to sell. Ironically, like many of the homeowners, funds that held these securities were under water, or out of business.
Investors (those that couldn't just close their doors) and banks needed to raise cash to pay off the debt they owed. Banks, in particular, need to keep certain levels of capital to be considered solvent. There is an accounting rule called "mark to market." It basically means that even if you have reasonable belief that a security is worth a certain value, you must attribute the price that the market places on the security when valuing your own assets. Consequently, if a bank holds $100 worth of mortgage securities that it believes will ultimately pay off $90, and another bank sells a similar security for $80, the first bank must mark their position at $80 - taking a $10 loss. That loss eates into its capital base, and requires it to raise more capital. One way is to raise equity in the market, another is to sell assets. So that bank sells its $80 asset for $70. Now everyone needs to mark their position at $70, and the cycle continues. It's not that simple in practice, but that's the basics. Stock investors who forsaw the death-spiral were shorting financial stocks, and clients fearful of bankruptcy were pulling money. That in turn led to further ratings declines which required more capital. And so on, and so on, and so on. In the end, securities that in time could be worth $100, were being valued at $22.
[It should be noted that this didn't only happen with mortgages. For instance, another problem was CDOs, which are securitized high yield paper. As the economy began to falter, high yield bond spreads rose, and a similar pattern occurred.]
In the end, Wall Street took the hit, because they were the ones that needed "saving." The financial system is the life blood of the US economy from Boston's Back Bay to San Fran's Mission Hill and everything in between. By federally assisting those that were so severely hurt by the declining value of such securities, you prevent the problem from ruining "Main Street."
Bubbles and Panics are systematic problems. Wall Street is not without fault, but this is not a "Wall Street Fat Cat"-created problem. It began with the average American, was fueled by Congress mandating a need to subsidize low income home ownership, and its subsequent risks were highly underestimated by investors who were seeking better return for their institutional clients, who collect and allocate money for average Americans.
"Washington's unwillingness to tackle the tough problems for decades, has left us in the worst economic crisis since the great depression."
He's completely right, but for the complete opposite reason than his meaning. The implication made by a Democrat Presidential candidate is that the problems of today's financial markets exist because of "failed" policies of the Republican White House. It's crap, and it only panders to the lowest common denominator that is American politics. It's the concept that, "If I say it, it must be true." Obama's not the only politican seeking to lay blame. It's human nature to seek blame, but in a election period, everyone looks to blame someone but themselves, or their associates. However, here are the facts:
The financial problems have many of its roots in the pre- and post-dot com bubble burst. The inflated (and somewhat fictional) economy that was the late 1990s, had already begun to raise real estate prices. Feeling newly flush with money, average American began bidding up real estate. The term "McMansion" came on the scene as the neuvo riche tore down old homes and built monstrosities in their place.
When the technology stocks came crashing in, the average person who had been burned investing in hyped stock valuations, re-evaluated how he or she looked at investing and assets in general. Ownership of companies full of "air" was out-of-favor, and hard and tangible assets became important. I heard my mother-in-law say numerous times the mantra, "real estate is the best investment." Home ownership after the dot com crash became even more important.
In wake of the post 9/11 economic recession, the Federal Reserve kept interest rates extremely low which continued to fuel the public's eagerness to own hard assets. Monetary policy encouraged banks to lend. Mortgage rates were already low, and the public pounced on the opportunity to buy houses. Standard supply and demand in action drove housing prices up even further.
As the economy bouced back from the 9/11 lows and began to surge post the Bush tax cuts, the Federal Reserve sought to reign in economic growth. Without getting too much into monetary policy and the Federal Reserve: their actions were effective on the short end of the interest curve, but not the long end. Developing nations were booming, and investing in U.S. Treasury Securities. Long-term rates were remaining stubbornly low, and Fed Chief, Alan Greenspan, referred to it as a "conunderum." Mortgage rates are based off long-term rates, not short-term ones. Consequently, the Fed, which hoped to pop the housing bubble, was ineffective.
Low interest rates and easily available, cheap corporate credit were allowing companies (even ones with shaky balance sheets) to refinance and borrow at low rates. Stock valuations were high, and returns on bonds were quite low. On top of that, low volatility in the market reduced risk premiums on traditionally risky investments. Basically, proper returns on investments were becoming harder and harder to come by. Traditional institutional investors (pension funds, mutual funds, endowments, banks and hedge funds) sought new ways to improve their returns. It can be accomplished two ways: leverage or increase risk - or a combination of both.
Wall Street, as it always has, stepped up to create products that were in high demand. They expounded upon an idea called securitization. Essentially, a securitization pools a bunch of assets together and chops them up into different tranches. The theory involves a diversification risk. The highest tranches are the safest in that they take the last losses. It was a huge hit - higher returns from riskier assets but with less risk. Wall Street firms repackaged all kinds of assets: home mortgages, commerical mortgages, high yield bonds, investment grade bonds, airplane leases, etc. Wall Street was the conduit, not the originator. These firms are underwriting the securities on behalf of other institutions including the government sponsored entities, Fannie Mae and Freddie Mac. I don't want to blast the securitization process completely. Securitizations work - they provide higher returns with less risk if held through maturity. They do have a flaw, but I'll get back to that.
For now, back to politics and the real problem.
Starting as early as 1999, Congress (led by the Democrats) sought to further home ownership particularly among low income households. Flashback to September 30, 1999, when the New York Times wrote the following:
http://query.nytimes.com/gst/fullpage.html?res=9c0de7db153ef933a0575ac0a96f958260&sec=&spon=&pagewanted=print
"In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
The action ... will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans."
"Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.
In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers.
''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''
There's a reason these sub-prime borrowers pay higher rates and require larger down payments. They are riskier. Continuing:
"In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's. "
"said Peter Wallison a resident fellow at the American Enterprise Institute. 'If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'"
"Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings. "
With Fannie and Freddie lowering its credit standards, loans that would normally be held by the issuing banks (and thus highly scrutinized by credit officers) were being instead sold to investors into packaged deals. Credit Rating Agencies such as Standard & Poor's and Moody's, were fooled by the structure of these securities, and failed to do proper due diligence into the risks. Consequently, the new riskier securities were rated the same investment grade ratings as their previously less risky peers. On top of that, there are companies that insure the performance of the top tier tranche bonds. Companies such as Ambac wrote insurance (in exchange for premiums) guaranteeing the recovery of principal of the highest tranches. Such insurance-wrapped securities almost automatically received AAA ratings from the rating agencies.
Investors, seeking higher yields, were not only gobbling up these securitized bonds under the impression they couldn't lose, but they were suplementing their returns by adding leverage (using borrowed money to purchase securities). Those with the best cost of capital yielded the greatest advantage in these securities. No private companies in the U.S. have better costs of capital than the major financial institutions - such as the major money center banks and companies such AIG.
The logic went as follows: Take the AAA-rated top tier tranche of a package of mortgages. They incur the last losses - meaning, the tranches junior to you have to lose all their principal, before you lose a dollar of yours. On top of that safety feature, the principal and interst of your tranche is insured by a AAA-rated company. If you made the assumption that you could not lose more than $2 of every $100 invested (with the expectation that in fact you would not lose but rather make money), you could borrow $95, and risk less than half of your capital. If your cost of borrowing those funds is 4% and security yields 5%, the return on your capital would be 24%. Had you borrowed no money, and bought the same investment for cash, your return would have been only 5%. 24% vs 5% on a security that if held to maturity had practically no risk given the historical default rate of mortgages in the US. Or so seemed. There were a number of flaws not factored.
First, the monoline insurance companies wrote more insurance than they could reasonably cover. Second, many of the investors funded their borrowings with short term rates which meant they did not lock in their yield advantage. Third, the risk profile of the newest mortgage borrowers were a lot worse than in the past. Fourth, the return parameters of the trade require the securities to be held to maturity.
More on "Wall Street" in a bit. Back to the average consumer.
The demand from investors created an almost insatiable desire for securitized paper and thus mortgage paper. Congress' mandate for the GSEs was a great source of that paper. Orginators of debt were no longer on the hook for the mortgages they sourced. Your hometown bank made money on your mortgage whether you paid it off or not. It created a disincentive to perform proper due diligence at the local level. Local banks relied on a plethora of mortgage brokers who also had no incentive to make sure the the borrower had the ability to repay. The competition to generate mortgages was intense, and devises such as no-doc loans, or no down payment loans sprung up all over the place. These mortgages were sold by the local originator, packaged into securities and sold across the world. As long as real estate prices rose and everyone paid their mortgages, it was a great system.
Consumers were like kids in a candy store - eating until they threw up. People were caught up in the theory that real estate only went up, and bought homes they had no reasonable right purchasing. TV shows such as TLC's "Flip that House" or "The Property Ladder" were obvious signs that the internet bubble had been replaced by a housing bubble.
In the meantime, some in Congress were issuing warnings about the government's responsibility (and potential financial backing) regarding the GSEs. However, any attempt to reform was thwarted by those in Washington that didn't want the gravy train to end. Note that following quotes:
Sept 10, 2003: Rep. Barney Frank (D., Mass.): "The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. . . ."
Rep. Maxine Waters (D., Calif.), "if it ain't broke, why do you want to fix it? Have the GSEs ever missed their housing goals?"
Sept 25, 2003: Rep. Frank: "I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . ."
Rep. Gregory Meeks, (D., N.Y.): "I have sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn't broke. Housing is the economic engine of our economy, and in no community does this engine need to work more than in mine. With last week's hurricane and the drain on the economy from the war in Iraq, we should do no harm to these GSEs... we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. "
Rep. Frank: "I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists."
Oct 16, 2003: Sen. Charles Schumer (D., N.Y.): "And my worry is that we're using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie's mission. And I don't think there is any doubt that there are some in the administration who don't believe in Fannie and Freddie altogether, say let the private sector do it. That would be sort of an ideological position."
Feb 24, 2004: Sen. Thomas Carper (D., Del.): "What is the wrong that we're trying to right here? What is the potential harm that we're trying to avert?"
Sen. Christopher Dodd (D., Conn.): To Fed Chairman Greenspan, "obviously this is one of the great success stories of all time. And we don't want to lose sight of that and [what] has been pointed out by all of our witnesses here, obviously, the 70% of Americans who own their own homes today, in no small measure, due because of the work that's been done here. And that shouldn't be lost in this debate and discussion. . . ."
Apr 6, 2005: Sen. Schumer: "I'll lay my marker down right now ... I don't think they need dramatic restructuring in terms of their mission, in terms of their role in the secondary mortgage market, et cetera."
Jun 16, 2006: Sen. Schumer: "I think a lot of people are being opportunistic, . . . throwing out the baby with the bathwater, saying, 'Let's dramatically restructure Fannie and Freddie,' when that is not what's called for as a result of what's happened here. . . ."
Sen. Chuck Hagel (R., Neb.): "Mr. Chairman, what we're dealing with is an astounding failure of management and board responsibility, driven clearly by self interest and greed. And when we reference this issue in the context of -- the best we can say is, "It's no Enron." Now, that's a hell of a high standard."
In fact, there were major problems brewing at Fannie and Freddie. The eventual bailout of these two firms were just the beginning of what turned out to be a massive taxpayer rescue package. To quote the Wall Street Journal, "The members [of Congress] fought furiously against any attempt to make Fan and Fred less dangerous. The Bush administration was on the right side of this debate for eight years, as was the late Clinton Treasury [Department]. This was a scandal in plain sight that all but a few ignored. And now, having done so much to create this mess, many of the same Members who protected Fan and Fred are denouncing the 'bailout' as a favor to Wall Street."
But I'm getting ahead of myself.
The problems begun to emerge in early 2007, when the housing bubble burst, and "homeowners" began to default on their mortgage. Some were so far under water on the enormous mortgages they had taken, they just walked away. Defaults and foreclosures were at historical highs. Fannie and Freddie failed, and required the government to follow through on their implicit guarantee.
The monoline insurance companies that had insured the highest tranches of paper, were in sudden need to raise additional capital to sustain their ratings. Most failed to retain their investment grade status, and some filed for bankruptcy. That left holders of previously insured paper with the need to get out. The market for such paper is very illiquid to begin with, and in this case there were no buyers. The value of the once stable paper plummeted. Recall that calculation of returns above. However, this time, forget that the paper can only go down $2. This time, take it down $10 - or $20 - or more. All of your equity is gone. Not only was the quality of the paper not as good as expected, but too many people wanted to sell. Ironically, like many of the homeowners, funds that held these securities were under water, or out of business.
Investors (those that couldn't just close their doors) and banks needed to raise cash to pay off the debt they owed. Banks, in particular, need to keep certain levels of capital to be considered solvent. There is an accounting rule called "mark to market." It basically means that even if you have reasonable belief that a security is worth a certain value, you must attribute the price that the market places on the security when valuing your own assets. Consequently, if a bank holds $100 worth of mortgage securities that it believes will ultimately pay off $90, and another bank sells a similar security for $80, the first bank must mark their position at $80 - taking a $10 loss. That loss eates into its capital base, and requires it to raise more capital. One way is to raise equity in the market, another is to sell assets. So that bank sells its $80 asset for $70. Now everyone needs to mark their position at $70, and the cycle continues. It's not that simple in practice, but that's the basics. Stock investors who forsaw the death-spiral were shorting financial stocks, and clients fearful of bankruptcy were pulling money. That in turn led to further ratings declines which required more capital. And so on, and so on, and so on. In the end, securities that in time could be worth $100, were being valued at $22.
[It should be noted that this didn't only happen with mortgages. For instance, another problem was CDOs, which are securitized high yield paper. As the economy began to falter, high yield bond spreads rose, and a similar pattern occurred.]
In the end, Wall Street took the hit, because they were the ones that needed "saving." The financial system is the life blood of the US economy from Boston's Back Bay to San Fran's Mission Hill and everything in between. By federally assisting those that were so severely hurt by the declining value of such securities, you prevent the problem from ruining "Main Street."
Bubbles and Panics are systematic problems. Wall Street is not without fault, but this is not a "Wall Street Fat Cat"-created problem. It began with the average American, was fueled by Congress mandating a need to subsidize low income home ownership, and its subsequent risks were highly underestimated by investors who were seeking better return for their institutional clients, who collect and allocate money for average Americans.
Saturday, October 4, 2008
I'm Back
Ok, ok, ok.
I'm back. I've been out of work since the Spring, and its funny, when you're not going into the office and sitting in front of a PC all day, there are some innane things you just don't do. Blogging appears to be one of them.
I'm still not officially working, but frankly, not working in this market may be the best thing for me. Yes, I'm getting a little bored being at home, but the people I know working are ripping their hair out.
So a few notes:
1. The Paulson bailout plan was very needed
2. The problems weren't created by a greedy Wall Street - everyone loves a scapegoat
3. More regulation would NOT really have stopped this financial mess
4. I'm highly disgusted with the House Republicans
5. Chip Carey and his partner are terrible MLB play-by-play announcers
6. Two reasons I don't like the Angels:
a. Thunder Sticks
b. The Rally Monkey
7. No, Sarah Palin isn't ready to be President tomorrow, and I don't like her folksy "charm"
8. Sarah Palin isn't as stupid as she is being made out to be, and she can be a perfectly capable VP
9. Is there a more annoying player in baseball than K-Rod? Yes K, not A.
10. How great is it that the last game in the House that Ruth Built had no meaning?
11. I'm not overly distressed that Tom Brady is out for the year
12. I do, however, expect the Patriots to show up each week, unlike the Miami game
13. There's a great book that is part math, part finance, part philosophy - The Black Swan. It nailed the banking problems a year before, even though its not the thesis of the book.
14. My golf handicap is down 4 strokes since leaving my job
15. The Celtics are in training camp after winning the World Championship, and I don't really care. Boy how things have changed.
16. There was humorous, actual discussion in New York that Hank Steinbrenner should "not fire Joe Girardi." Boy, how things don't change.
17. The family went to a Marlins game in Miami. We were on the Jumbotron, but I'm not sure it was a big deal. I think all 5,000 fans there made it on the screen.
18. Pro Football Prospectus 2008 is in bookstores. It marks the third nationally published book which lists me as an author. 2007 and 2006 and the others.
19. I miss Manny. I hate how things ended. I understand he needed to go.
20. Stocks have gotten crushed. The bailout plan will help, but the economy is still rough in its own right.
21. Remember, stocks will begin to upturn BEFORE a recession is over. I have no specific picks
22. It's disappointing that my kids are getting into baseball, and can't hardly see a single playoff game
23. I'll post again before another six months is up.
I'm back. I've been out of work since the Spring, and its funny, when you're not going into the office and sitting in front of a PC all day, there are some innane things you just don't do. Blogging appears to be one of them.
I'm still not officially working, but frankly, not working in this market may be the best thing for me. Yes, I'm getting a little bored being at home, but the people I know working are ripping their hair out.
So a few notes:
1. The Paulson bailout plan was very needed
2. The problems weren't created by a greedy Wall Street - everyone loves a scapegoat
3. More regulation would NOT really have stopped this financial mess
4. I'm highly disgusted with the House Republicans
5. Chip Carey and his partner are terrible MLB play-by-play announcers
6. Two reasons I don't like the Angels:
a. Thunder Sticks
b. The Rally Monkey
7. No, Sarah Palin isn't ready to be President tomorrow, and I don't like her folksy "charm"
8. Sarah Palin isn't as stupid as she is being made out to be, and she can be a perfectly capable VP
9. Is there a more annoying player in baseball than K-Rod? Yes K, not A.
10. How great is it that the last game in the House that Ruth Built had no meaning?
11. I'm not overly distressed that Tom Brady is out for the year
12. I do, however, expect the Patriots to show up each week, unlike the Miami game
13. There's a great book that is part math, part finance, part philosophy - The Black Swan. It nailed the banking problems a year before, even though its not the thesis of the book.
14. My golf handicap is down 4 strokes since leaving my job
15. The Celtics are in training camp after winning the World Championship, and I don't really care. Boy how things have changed.
16. There was humorous, actual discussion in New York that Hank Steinbrenner should "not fire Joe Girardi." Boy, how things don't change.
17. The family went to a Marlins game in Miami. We were on the Jumbotron, but I'm not sure it was a big deal. I think all 5,000 fans there made it on the screen.
18. Pro Football Prospectus 2008 is in bookstores. It marks the third nationally published book which lists me as an author. 2007 and 2006 and the others.
19. I miss Manny. I hate how things ended. I understand he needed to go.
20. Stocks have gotten crushed. The bailout plan will help, but the economy is still rough in its own right.
21. Remember, stocks will begin to upturn BEFORE a recession is over. I have no specific picks
22. It's disappointing that my kids are getting into baseball, and can't hardly see a single playoff game
23. I'll post again before another six months is up.
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